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All you need to know about Gilt Funds

Personalfn.com | January 22, 2009 13:47 IST

Over the last few years, when equity markets were on an ascent, equity funds were favourites with investors. On the other hand, debt funds were considered unnecessary as they dragged down the portfolio's performance. Even risk averse investors didn't want to miss the boat by being invested in debt instruments. However, the investment scenario has now changed radically. Investors are increasingly shunning equity funds in favour of debt funds.

Within the debt funds segment, there's a lot of buzz around gilt funds at the moment. Newspapers and magazines are carrying articles eulogising their performance. Fund houses and investment advisors are busy promoting the cause of gilt funds. Clearly, gilt funds have emerged as the season's flavour.

What are gilt funds?
Simply put, gilt funds are mutual funds that predominantly invest in government securities (G-Secs). Unlike conventional debt funds that invest in debt instruments across the board, gilt funds target just a given category of debt instruments i.e. G-Secs. The latter are securities issued by the Reserve Bank of India [Get Quote] (RBI) on behalf of the Government of India. Being sovereign paper, they do not expose investors to credit risk. Since the market for G-Secs (as is the case with most debt instruments) is largely dominated by institutional investors, gilt funds offer retail investors a convenient means to invest in G-Secs. Depending on their investment horizon, investors can choose between short-term and long-term gilt funds.

Why are gilt funds in the news?
First, let's understand the relationship between bond prices and the interest rates. The two are inversely related. Hence a fall in interest rates, leads to a rise in bond prices. In recent times, the RBI has undertaken a series of rate cuts to infuse liquidity into the system. The falling interest rates have translated into an appreciation in prices of long-term bonds and G-Secs alike. Expectedly, funds that are invested in such securities have benefited.

Top performing long-term gilt funds
Long-term Gilt FundsNAV (Rs)1-Mth (%)3-Mth (%)6-Mth (%)1-Yr (%)
DSP BlackRock G-Sec (G)33.14 4.4621.6834.0331.82
Escorts Gilt (G)20.52 -0.7018.5123.7931.06
JM Govt. Securities (G)28.73 -0.4415.3529.3029.46
Sahara Gilt (G)16.78 -3.1910.7022.8227.71
ICICI [Get Quote] Prudential Gilt Inv. (G)32.06 -2.1214.1732.5526.98
Templeton India G-Sec LT (G)22.31 0.8313.3020.8922.91
UTI Gilt Advantage LT (G)20.20 -3.3412.5126.5022.65
IDFC [Get Quote] G Sec Investment (G)18.08 -3.5713.1020.9220.33
Kotak Gilt Investment (G)30.63 -2.6911.9520.9418.38
Birla Sun Life Gilt Plus (G)31.26 -2.5310.8718.8217.80
(NAV data as on January 20, 2009)

Clearly, gilt funds have proven to be attractive investment options for investors. The performance in recent times i.e. over 3-Mth and 6-Mth time frames has been particularly impressive. The same is further accentuated, given that investors have borne the brunt of falling equity markets over the same period.

Are gilt funds really risk free?
Increasingly, gilt funds are being promoted by fund houses and investment advisors, by emphasising on their risk free nature. That isn't entirely correct. We have already discussed how the underlying instruments i.e. G-Secs do not expose investors to any credit risk. However, that doesn't make gilt funds, risk free investment avenues in the conventional sense. Unlike small savings schemes wherein investors enjoy both safety of capital and assured returns, gilt funds are not equipped to offer assured returns.

For instance, investments in gilt funds are vulnerable to interest rate risks. When interest rates rise, prices of government securities fall; this in turn has an adverse impact on the performance of gilt funds. Typically, higher the fund's average maturity, more it is prone to volatility. In the table above, several funds have languished in negative territory over the 1-Mth period.

A security is termed as liquid, if it can be easily bought and sold. It can be broadly stated that higher the liquidity, lower is the risk. A gilt fund can be invested in a G-Sec paper which isn't actively traded i.e. it is illiquid. Now consider a scenario wherein to meet redemption pressure, the fund manager is forced to make a distress sale i.e. incur a loss. This in turn will adversely affect the fund's performance.

When should one invest in gilt funds?
Investors would do well to keep an eye on indicators that can be precursors to a fall in interest rates. A slowdown in GDP growth, rising inflation, a decline in IIP (Index of Industrial Production) and expectations of a fall in corporate earnings, to name a few. Broadly speaking, a situation when interest rates have peaked and a downturn seems imminent, would be an opportune time to invest in gilt funds. Of course, investors must understand that to make the most of their gilt fund investments, being invested for the long haul (to cover an interest rate cycle) is important.

What should investors do?
Now the question is - should investors consider investing in gilt funds? That would ideally depend on their risk appetite, investment objective and existing portfolio, among a host of other factors. At Personalfn, we have always maintained that a 'one size fits all' approach doesn't work while investing. An investment avenue that is apt for one investor could be grossly unsuitable for another. Therefore, investors would do well to consult their investment advisors/financial planners to determine the suitability of gilt funds in their portfolios.

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