In today’s time when the stock market may seem volatile, investors might be on the lookout for less risky investment avenues. Debt-based mutual funds tend to be a common choice in such times. One category of debt-based fund which has gained popularity in recent times is gilt funds.
Gilt funds, as a category, have earned almost 10% return over the last year and more than 12% return over the last 2 years1. This recent trend has brought gilt funds to the forefront amongst investor groups today.
Are you considering these recent returns as a basis for picking gilt funds for your portfolio?
But is there any flipside to gilt fund investments? And should you consider them in your investment portfolio today? Let’s understand gilt funds to analyse this choice in greater detail…
What are Gilt funds?
Gilt funds are debt-based mutual funds that invest majority of their corpus in government securities. These government securities can vary in maturity duration depending on the investment strategy of the gilt fund. Government securities are backed by and guaranteed by the government of India hence they carry no re-payment or default risk. While companies and industries may rise and fall with changing times, the government will always remain, making investments in its debt instruments seemingly credit-risk free.
Before you get carried away.... are gilt funds really ‘risk free’?
Most investors believe that gilt funds are practically risk free as they are backed by the government. While this may be true to the extent of credit risk as there is no risk of non-payment of principal and interest, these funds are in fact subject to a different type of risk. These funds carry another type of risk which can often be ignored- ‘interest rate risk’.
Interest rates in the economy are regulated by the Reserve Bank of India (RBI). Interest rates are altered from time to time in the RBI’s monetary policy basis the needs of the economy – primarily interest rates can be reduced to infuse liquidity in the economy and boost growth and interest rates can be increased to control inflation and rising prices.
When interest rates in the country are reduced, the price of government securities bearing higher interest rates increase in response to reduced economy interest rates. Similarly, when interest rates are increased, the price of government securities bearing lower interest rates fall. This inverse relationship between economy interest rates and price of government securities, is responsible for ‘interest rate risk’ that these securities are subject to. This interest rate risk has a considerable impact on the returns generated by gilt funds.
Rationale behind recent numbers
Over the last nearly 2 years2, interest rates have been consistently reduced by the RBI. The current covid pandemic has only further accelerated this situation prompting the RBI to reduce interest rates to boost growth in a decelerating economy. The most recent rate cut being announced in May 2020, after which the repo rate stands at an all-time low of 4%. This steady reduction in interest rates over the last 2 years has worked to the advantage of gilt funds as base government securities have witnessed price rise with each reduction in interest rate.
Are these recent performance numbers, short-lived?
While nobody can predict where the economy is headed or how the central bank will alter its interest rate policy to adapt to the needs of a changing economy – one thing is certain that interest rates will not always move in only one direction.
As the economy begins to recover and growth accelerates, the monetary policy may see an increase in interest rates. Increase in interest rates can prompt a fall in prices of government securities from their current highs. So, expecting a repeat of the returns over the last two years for these funds in the years to come may not be wise.
When and how then can one consider gilt funds?
An effective strategy to invest in gilt funds is based on timing entry and exit from these funds based on interest rate fluctuations. This may not be feasible for a common investor for whom a strategy of staying invested over a medium to long term to balance out interest fluctuations may work better. But with gilt funds having delivered reasonable returns over the last few years, a continuation of such returns over the next few years may not be guaranteed.
The advantages of these funds however can certainly not be undermined especially in a time when markets are witnessing high volatility. Gilt funds can certainly be considered but the price volatility and interest rate risk that they are subject to should be understood before investing. Gilt funds can be well utilised as a balance element in your portfolio to aim for returns with moderate risk for your money.
1. As on 24th July 2020 - https://www.moneycontrol.com/mutual-funds/performance-tracker/all-categories
2. RBI repo rate has reduced from 6.50% in August 2018 to 4% in May 2020 - https://www.cnbctv18.com/economy/rbis-414-repo-rate-lowest-ever-heres-a-look-at-the-historical-benchmark-rates-5570851.htm
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.