At a time when the risk of corporates defaulting on their debt commitments is high, investing in gilt funds will help you
In favourable times, investors regard high returns as the most important criterion for choosing an investment instrument. Not so any more. On account of global uncertainties and credit-quality risks, investors are pulling their money out of all other types of funds except gilt funds, a mutual fund that invests in government securities and money-market instruments.
The theory
Government securities include central government securities, state government securities, and treasury bills. All these are dated securities that have a fixed coupon rate and a fixed maturity period.
The price and yield of a bond share an inverse relationship. When price is high, yield is low, and vice-versa. Coupon rates remain fixed. If the government decides to raise interest rates, an existing bond?s price would fall and its yield would rise to come at par with interest rates being offered by newly-issued bonds. On the other hand, if interest rates fall, its price would rise until its yield comes at par with the new rates.
The reason for this inverse relationship is that when interest rates rise, fixed deposits (FDs) and newly-issued bonds offer higher returns. Hence an existing bond becomes less attractive. Investors then sell off their existing bonds and switch to newer bonds being issued at the current higher rates. The selling pressure in the bond market causes the prices of the older bonds to drop. The opposite dynamics come into play when interest rates decline.
Current scenario
During the last three-four months, gilt funds have given an average 10-11 per cent annualised returns. The RBI has lowered the repo rate and the cash reserve ratio (CRR) to 7.5 per cent and 5.5 per cent respectively. The recent cuts in CRR and repo rates have favoured gilt funds since it has made the mark-to-market valuations of government securities (and also corporate bonds) attractive. As is to be expected, long-term gilt funds have performed better over the one-, three- and five-year horizons compared to short-term gilt funds. (See table).
The gilt advantage
Gilt funds offer many benefits to their investors. Says Veer Sardesai, a Pune-based financial planner: ?As these securities are backed by the government, there is no chance of a default, hence no credit risk is involved. Moreover, these funds are tax efficient. If a dividend is declared by a gilt fund, only a dividend distribution tax of 14 per cent is charged. On the other hand, investments in fixed-income instruments such as fixed deposits get taxed at the rate of around 30 per cent if the investor is in the highest tax bracket.? These funds are also highly liquid, and levy no entry or exit load on investors.
Disadvantages
While gilt funds are entirely free of credit risk, they do carry other types of risks. These funds are interest-rate sensitive. Long-term gilt funds are affected more by interest-rate changes than short-term gilt funds. So, if the interest-rate cycle turns and rates start moving northward, both types of funds will under-perform, but the long-term gilt funds will under-perform more.
Before you invest
Look at a few variables before you invest in a gilt fund. ?Maturity is a major criterion,? says Dhirendra Kumar, chief executive, Valueresearch. As said earlier, long-term gilt funds yield higher returns but are also riskier. Adds Lahar Bhasin, head of research, ICRA Online: ?Investors should look at funds that have a low expense ratio and have given consistent returns through various market cycles.? Since the returns on these funds are low (compared to equity funds), a higher expense ratio has a bigger impact on the final returns.
Bottomline
Finally, should you invest in gilt funds? According to Prasunjit Mukherjee, a Kolkata-based mutual fund analyst, ?Long-term debt funds are a better investment option as these funds invest in a diverse basket of papers, 90 per cent of which are AAA rated. And their returns are higher than those from gilt funds. A conservative investor may invest 20-25 per cent of his debt portfolio in gilt funds, 40-45 per cent in long-term debt funds, and the rest in liquid funds.?
