A Primer on Investing in Gilt Funds
What are Gilt Funds?
Gilt Funds invest in Securities which are issued by Reserve Bank of India on behalf of Government of India. Securities are also issued by State Government which are also considered to have an implicit sovereign guarantee.
What are the features of Government Bonds?
The Government bonds are considered to be the most secured instruments, as it has backing of the Government. The Government bonds has two major components: Coupon Rate and Duration.
Coupon Rate is the interest paid by the Government on quarterly, half-yearly or annual basis. The coupon rate is a function of the current interest rate prevailing in the country.
The nomenclature of a typical dated fixed coupon G-Sec contains the following features – coupon, name of the issuer, maturity year.
For the sake of our discussion, consider that the Government issues a 10-year bond today (12th May 2020) at 6.25% coupon rate with a face value of INR 100. The bond will be denoted on exchanges as 6.25 GS 2030 Post the issuance, the bond will start trading in the secondary market. Basis the bond-price change the bond yield will fluctuate and reflect the market sentiment.
Bond Price = Total Cash Flows from Bond during its tenure/ ((1 + YTM)^(n))
YTM : Yield to Maturity n: Number of Years
In the above formulae, the total cash flows is a constant and does not change during the entire tenure of the bond (assuming coupon rate is fixed and not variable). Therefore, as the bond price increases, the YTM drops and vice-versa. In simple terms, if bond prices is above face value of INR 100, the YTM is lower than the coupon rate, which means the market participants are expecting a lower interest rate environment. The investors would always want the bond prices to increase and YTM to drop leading to higher capital gains.
Now, what are the risks the bond price will face?
Interest Rate Risk
Let us assume that RBI reduces the repo rate by 40 bps to 4% and our 10-year bond is yielding 6% returns at current bond-price level. Now because the interest rates in the system is expected to further drop, the demand for 10-year bonds which is providing 6.25% coupon on yearly basis will increase substantially. This will lead to rally in bond prices and the yields will drop significantly.
However, in a scenario of increasing interest rates the reverse will happen. Because, our 10-year bond is still providing only 6.25% coupon and markets are expecting interest rates to increase, the investors will look to sell the existing Government bonds and invest in fresh issuances which offer higher coupon rates. This will lead to drop in bond prices and increase in bond yield.
Therefore, an investor in Gilt funds also needs to plan his entry and exit accordingly. If investor believes, interest rates will increase then he/she can avoid investing in gilt for short-run or invest only with an investment horizon of minimum 3 years.
Rating Risk
Downgrades by Global rating agencies is a very big risk for investors of gilt funds and Government securities, as the risk perceived with the investment increases. As the rating drops, the investors would re-calibrate their yield requirement to discount for higher amount of risk. For example, if India is downgraded from Baa2 to Baa3 by Moody’s, there may be sell-off in Government securities leading to increase in Yields or YTM.
Increase in Fiscal Deficit may impact returns
If the fiscal deficit of a country increases, then rating agencies may downgrade the sovereign rating to discount for the higher risk incase of possible default on bond interest payments. The Government has been able to rein in the fiscal deficit from high of 4.9% in fiscal 2013 to 3.3% in fiscal 2020. Therefore, India’s sovereign rating by Moody’s improved from Baa3 to Baa2. However, a downgrade again may lead to sell-off and increase in Government yields
Consistent lower Growth coupled with high fiscal deficit may impact sovereign rating
Needless to say, if Government’s fiscal deficit of around 3-4% is backed by robust growth, then the rating agencies would view the fiscal deficit with less caution. However, an increasing deficit with stuttering growth is certainly a red flag for rating agencies
However, these are only two major factors highlighted and other variables which determine sovereign ratings are: Political Risks, Current Account Deficit, Inflation Rate, Forex Reserves, etc.
Can you make real negative returns by investing for long-term (more than 5 years) in gilt funds?
It is unlikely but possible that an investor makes real negative return (returns lower than inflation rate) over the long-run. The interest rates in the country will have to keep on increasing for prolonged-period of time leading to sell-off in existing bonds and rise in YTMs.
For example, if the repo rates increased from 4.4% as on date to 7% over a period of 3-years, then it is unlikely that Gilt Fund investors will record positive real returns. However, this is a very unlikely scenario to play out.
If such a scenario does play out, the investor will have to wait for a period of consolidation in the repo rates and then wait till the downcycle in the interest rates. Therefore, only investors with a investment-horizon of more than 3 years at minimum should look to invest in Gilt Funds.
Alternatively, if an investor is actively tracking economy fundamentals he/she may buy gilt fund/Government securities or short interest rate futures
Past Performance of Gilt Funds as compared to liquid funds
Performance of Gilt Fund vs Liquid Fund
Source: MoneyControl, Fund Factsheet
In the above chart, we have compared the performance of SBI Magnum Gilt Fund (Growth Plan) and SBI Liquid Fund (Growth Plan). The returns are compared on absolute basis. As illustrated, the Gilt Fund provided 48% return during the 5-year period compared to 41% return provided by the liquid Fund. Also, kindly note that during this period the repo rate dropped from 8% in May 2014 to 4.4% as on date which has supported the returns for gilt fund investors.
However, the Gilt Funds have not outperformed Liquid Funds during every timeframe. During May 2017 to May 2018, the Gilt funds hardly provided any returns, as the RBI increased Repo rate by 25 bps in June 2018 and August 2018.
Should You Invest in Gilt Funds in current economic scenario?
The current repo rate in India is lowest ever in history. The previous low was 4.75% in 2009 post the global financial crisis. There is very limited room for further downside on repo rate front though it is quite a possibility that RBI further reduces the repo by 50 bps in-order to lower lending rates in the system.
However, as the Government announced fiscal stimulus and growth kicks in (post situation around Covid-19 normalizes) leading to inflation, the RBI is likely to increase the repo rate over the next 24 months. In such a scenario, Gilt funds may not be the ideal asset class for investors with short investment tenure as we are already in a low interest regime.
To conclude, Gilt funds are suitable only for long-term with 5-years of investment horizon and who are looking for flight to safety. It is not advisable to invest in this asset class expecting a double digit return over short-run like many investors have enjoyed over last one year.
HAPPY INVESTING!