Here’s Why Gilt Funds Can Be Highly Risky Even Though They Invest In G-Secs

Contrary to popular belief, gilt funds, which invest in G-secs, are highly volatile during interest rate fluctuations
Here’s Why Gilt Funds Can Be Highly Risky Even Though They Invest In G-Secs

Gilt mutual funds are widely considered a safe harbour for investment because they invest in government securities. Technically, mutual funds that invest only in government securities are known as gilt funds. 

These government securities and/or bonds typically have very high credit rating. As such, they are considered safe as compared to their peers. Their returns are also quite low. According to guidelines by the Securities and Exchange Board of India (Sebi), gilt funds must invest at least 80 per cent of their assets in government securities.

According to data from the Association of Mutual Funds in India (Amfi), gilt funds received an inflow of Rs. 368.6 crore in August 2022, when the interest rate was hiked for the third time in the year. A month later, in September 2022, the inflow in gilt funds fell to Rs 6.62 crore, a decrease of 98.2 per cent.

Types Of Gilt Funds
There are two types of gilt funds – short-term maturity gilt funds and long-term maturity gilt funds. Long-term gilt funds can carry bonds of up to 10 years’ maturity, which make them a high-risk investment. Due to the long maturity date, gilt funds with longer maturity dates are more volatile than the gilt funds with shorter maturity dates.

Interest Rates Risk 
Gilt funds are susceptible to interest rate swings in the economy, because of the long maturities of the underlying Government securities (G-secs). This also makes gilt funds very risky and highly volatile over short periods. 

“Interest rate risk typically depends on the duration or maturity of a debt instrument or portfolio of debt securities. For gilt funds (or debt funds in general), higher the duration, higher the interest rate risk and vice-versa,” says Dhaval Kapadia, director – managed portfolios, Morningstar Investment Adviser India.

Falling Interest Rate
When interest rates are falling, gilt funds can generate high positive returns, as the demand for G-secs rise due to their offering of relatively high interest rates, because the new bonds will carry low interest rates. Then, the demand in a rising market scenario for previously issued bonds result in a scenario in which these bonds begin trading at a premium, and so the net asset value (NAV) of gilt funds rise. 

“In a falling interest rate scenario, bond prices move up and gilt funds generate positive returns,” Kapadia adds. 

Rising Interest Rate
When the interest rates are in a downward trend, gilt funds are likely to face severe losses, and in some cases, negative returns. This is because investors are more likely to switch to newly issued securities or bonds that offer higher interest rates than older ones. 

“When yields rise, the price of a bond falls. Accordingly, the NAV of a gilt fund would typically fall when yields on the underlying securities rise. If the rise in yields is substantial, then the fund could generate a negative return. Although over the medium- to- long-term, the coupon or interest earned on the underlying holdings (gilts) could set off these losses due to price movements,” Kapadia says.

Modified Duration
The metric known as modified duration is used to assess how sensitive the price of underlying bonds is to changes in interest rates in the economy. 

For instance, when the interest rates rise, it will have a significant impact on the modified duration of the gilt fund. They will rise significantly, which will drive the unit’s price down. 

Adds Kapadia: “Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. Modified duration measures the change in the value of a bond in response to a 100 basis points (bps), i.e., 1 per cent change in interest rates. If one believes that interest rates could move up by 100 bps, one can estimate the change in the value of the bond (or gilt fund) by multiplying the expected change in interest rates by the duration of the bond fund. For instance, assuming that the duration of a gilt fund is five years, the estimated change will be -1%*5= -5%, in case interest rates move up by 100 bps. The duration of each gilt fund could vary based on the duration or maturity of the underlying holdings.”

Yield-To-Maturity (YTM) is essentially the returns anticipated from the investment, provided the underlying securities are held by investors till maturity.

The YTM ratio of the fund is fluctuating, based on changes in interest rates, bond values, and credit ratings. Larger risks and portfolio volatility are anticipated for the funds with higher YTM ratios.

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