Gilts or government securities are issued by the Central (or State) Government to fund government activities like infrastructure, defence, education or anything that requires funding as per the Union Budget.
These bonds are issued at various maturities:
as 91-day, 182-day and 364-day bonds, called T-Bills, that do not pay interest and behave like cumulative FDs
as longer duration bonds (up to 40 years maturity) usually pay interest every 6 months. These interest payments are called coupons.
This article discusses the second option and explains what investors should know while investing in gilt mutual funds.
What drives the return in a gilt mutual fund?
As the decomposition shows in the above chart, there are two sources of return in a gilt fund:
payment of coupon and principal that is used to buy new bonds
the movement of interest rates in the economy
Credit risk in gilt funds
Of these, the first one talks about credit quality. Since the government is the borrower of the money, there is zero risk that the government may be unable to pay back the interest and the principal. Therefore there is no credit risk. However, there is a risk in interest rate movements.
Interest rate risk in gilt funds
Consider an existing bond offering a 7% coupon rate versus a new bond with a 6% coupon. The current bond is more desirable, and the NAV of the debt fund holding it will be higher since the 7% bond is more valuable due to the higher coupon. Similarly, the reverse happens, i.e. debt fund NAVs fall if interest rates rise in the economy.
The chart above shows that bond yields fluctuate significantly due to economic factors.
The metric for measuring interest rate risk is Modified Duration. It is available for all debt funds (higher the average portfolio maturity). It measures the portfolio NAV rate of change due to changes in interest rates.
As the chart shows above, there is quite a bit of fluctuation in the NAV movement of gilt funds that investors should be mindful of.
The graph has a long-term upward trend (dotted blue line). Still, there have been many periods with sharp rises, falls and even sideways movement in the NAV, as shown in red ovals. These characteristics mean that gilt funds have similar movement characteristics to equity funds but are less intense in both rises and falls.
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How do yield movements determine returns from gilt funds?
The chart above compares the NAV movement of a 10-year constant maturity gilt fund and the yield movement of the 10-year bond in India. The 10-year constant maturity gilt fund invests only in the 10-year maturity bond or in an equivalent portfolio of bonds with similar interest rate risk exposure. The critical takeaway is that fund NAV moves in the opposite direction as interest rates.
Can past performance be used to predict gilt fund returns?
One of the critical mistakes that investors make is to consider past performance for determining the future performance of mutual funds. Unfortunately, gilt funds are not an exception to this rule.
As the chart above shows, there is no practical correlation between past and forward returns since the maximum impact, as the decomposition chart above displays, comes from movements in interest rates.
Should investors choose gilt mutual funds?
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In 2020, these funds gave huge returns due to falling rates but ran the risk of significant losses when interest rates rose as they did in 2022. Therefore, investors should continuously monitor interest rates and asset allocation if they invest in Gilt funds. However, the investor can accept the volatility of interest rate movements and rebalance as per their plan. In that case, Gilt mutual funds can be considered if the goal horizon is 10 years or more.
The recent (2019, 2020) high returns of gilt funds are due to falling interest rates abruptly reversed in 2022 and lead to heavy losses. Since short-term interest rates can be volatile, so can gilt fund NAVs.
Recent returns of debt funds do not predict future returns in any way, it is up to the investor’s risk appetite to try to profit from this volatility or avoid this category altogether. This is the guide for choosing such debt mutual funds: How to choose a debt mutual fund?.
In a future article, we will cover
SIP and lump sum return history of gilt mutual funds
how to combine gilt funds with other categories in debt mutual funds for long-term goals
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This post titled Gilt funds do not always go up in value. Should you invest in gilt funds? first appeared on 04 Jun 2023 at https://arthgyaan.com
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