Amidst on-going credit events, one category of debt funds—gilt funds stand out.
Over the last one year, gilt funds have generated returns in the range of 10% and 18%—commendable considering double-digit losses incurred by some debt funds. But before you jump the gun and put your money in gilt funds it’s time to assess the potential of gilt funds more closely.
We’ll explain ahead but Big Spoiler… it’s got a lot to do with ‘interest rate movements’ in the economy. And interestingly, falling interest rates mean good times for gilt funds.
Coming to the very basics, gilt funds primary invest in medium to long term government securities(g-secs) issued by the central government. Of course, a few of them might invest in bonds issued by the state government called SDLs (State Development Loans).
As you’ve figured out, gilt funds don’t have a credit risk or risk of default since the government is the borrower. And theoretically, governments can even print money to repay their obligations to bondholders.
There are a number of factors determine the returns of gilt funds, some of them are rather technical. But here are the two that you could watch out for while assessing the potential of gilt funds
Bond yields primarily depend on the tenure of the bond, credit ratings and the prevailing interest rates. Bond yields and interest rates are inversely related to bond prices.
Since government bonds don’t have any credit risk, their yields are low as compared to those of corporate bonds; the 10-year government bond is currently trading at 6.6-6.9%. Last year, the yields on 10-year benchmark bonds were around 8%. As yields dropped bond prices jumped. As a result,1-year returns of gilt funds have been between 10-18%.
If we had to explain this intuitively, it is because over the period of a year, while the interest rates fell, the demand for last year’s bonds increased as they were offering a better return than bonds that have been recently issued. This led to an increase in the market price of last year’s bonds. Smart fund managers could make the most of this situation and delivered returns that were higher than the initial coupon rate. So, you see how a fall in interest rates makes bond prices and therefore bond yields rise?
The impact of these factors on the returns of gilt funds might be rather obvious, but it can drag or enhance the end returns for the end investor. Naturally, the higher the expense ratio, the lower the returns for the investor, but if the fund manager is able to generate higher returns by his strategy or trading skills, the expense ratio might be easily compensated.
Gilt fund as a category has generated attractive returns over last one year mainly due to a series of rate cut of 75 bps (bps – basis point) since January 2019. Going ahead, allocation in a gilt fund should be a tactical call rather than a longer-term strategy in a portfolio. Is there any elbowroom for further rate cuts? Anybody’s guess for now.
If RBI continues to maintain accommodative policy stance and cuts rates further, it would bode well for sovereign securities and for gilt funds.
So, the bottom line is gilt funds are a good play for as long as interest rates in the economy are expected to go down. One may hold onto investments until interest rates bottom out.
The recent rate cuts by RBI have again put the spotlight on gilt funds, especially funds that invest in longer maturity g-secs.
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