Best Gilt Funds And Why We Should Invest Now

Source: Tavaga Research

Debt funds have drawn a lot of flak in the aftermath of the Franklin Templeton debacle. But it needs reminding that not all debt funds are high-risk. While the beleaguered AMC’s offerings baited investors with extra returns by investing in questionable low-rated bonds, such risk is rather the exception to the rule with underlying assets of debt funds. And, if it is a gilt fund in question, which is a kind of debt fund, then the risks are much lower. 

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What are gilt funds and how do they differ from other debt funds

Debt funds invest in an array of fixed-income instruments such as corporate bonds, commercial papers as well as government securities and treasury bills. 

The winding-up of six debt funds of Franklin Templeton has dampened investor confidence in such MFs, traditionally believed to generate steady returns, but we should remember the bonds of those funds were rated below AAA, ie. the issuing companies had below-par credit credentials.

Gilt funds are also fixed-income funds but they invest only in fixed-interest-generating government securities issued by the state and central governments. The risk in these securities are less than other market instruments due to their sovereign guarantee. The underlying products also take longer to mature than corporate debt products. 

It does not mean gilt funds in India are without their share of risks. Market-linked products always have a risk factor. 

Like other bond funds, gilt funds have interest rate risks. Fluctuations in the interest rate could erode the value of the investors. 

The infographic depicts how gilt funds perform better than other debt fund categories:-

Gilt funds vs Debt funds performance
Source: Tavaga Research


Which investors may look at gilt funds?

Given that gilt funds are backed by a sovereign guarantee, they have minimal default risk which makes them a viable investment vehicle for risk-averse investors. 

Risk averse investors
Source: Tavaga


Sovereign guarantees mean governments issuing the securities guarantee they would not default on their repayments, that mitigates likely credit risk seen in most other debt funds. 

When would it be beneficial to invest in gilt funds?

As gilt funds invest primarily in government-issued securities, a low-interest-rate environment would be ideal to pool money in a gilt fund. That is because lower interest rates mean lower yields (the bond’s face value) on government securities which drives up the bond’s portfolio value (or the present value of its future returns). Hence, our portfolio value would be high as well. 

A low-interest rate regime would increase the net asset value (Nav) of a gilt fund over time, signaling a ripe time to buy into a gilt fund. 

Besides the interest rate, it may be worth noting that in distressing times when the economy is troubled, such as the times we are living in, gilt funds are usually expected to deliver higher returns than equity MFs. The underlying assets of gilt funds, afterall, are backed by sovereign guarantees that are considered to be safer in a volatile market. So, it could be said that we should be investing in gilt funds now.

However, that said, retail Investors like us should not be worrying too much about timing our investments in funds, including gilt funds. What should dictate our choice is our goals and portfolio diversification needs. 

For example, it may be a good idea for investors with no appetite for credit risk to stay invested in gilt securities  for at least three-five years to take advantage of interest rate changes over time. . 

But if the metric-driven among us still want to be absolutely sure of the right gilt fund to look at, we round up the parameters below that we should consider.

Key points to consider before going for a gilt fund

  • The interest rate environment: The yield-curve trajectory, depicting yield to maturity across different contract durations, is a strong parameter to monitor our fixed-income investments. In 2019, gilt funds as a category outperformed most of the asset classes as yields fell on most of the government securities.RBI performed open market operations, and it bought 6.45 percent of 10-year government bonds, from December 2019, worth an aggregate of Rs 10,000 crore, in a bid to infuse liquidity. Consecutive rate cuts amounting to 135 bps since February, 2019 and lower inflation led to the 10-year yields further falling from around 7.5 percent in March, 2019 to around 6.1 percent in April, 2020. Such sustained decline in yields may make it worth our while to increase the duration of our gilt portfolios, as longer maturity-securities would benefit from further fall in yields. 
  • Consistent returns year on year: Less volatility of a gilt fund compared to the average of the gilt-funds category would be a winning trait. A beta would be a good measure for this.
  • Expense ratio: Expense ratio tells us how much of our invested sum would be working to get us returns. The management and operation cost charged by the AMC’s fund manager is the expense ratio of the gilt fund. It indicates how much the fund charges us, its investors, for managing our money. It is expressed as a percent of the total assets managed by a fund and includes all the recurring and non-recurring expenses incurred by the fund house. According to Sebi’s notification in 2018, the expense ratio was capped at 2.5 percent. It is advisable to go for a fund with a lower expense ratio.
  • Ratings: The bonds in which gilt funds invest carry a sovereign rating which is the highest available credit rating in India. Hence, monitoring the country’s macroeconomic indicators and tracking ratings given by global ratings agencies helps us keep a check on the health of such funds.
  • Portfolio diversification: Aligned with the  investing doyen, Warren Buffett’s strategy, a debt investment portfolio should comprise an analytically computed portion of gilt funds and not a random allocation. This helps to diversify the risk-reward profile of our portfolio, to maximize our gains
  • Duration and maturity period: Gilt funds with duration in line with our money goals should be chosen. 
  • Nav: The Nav of a gilt fund is defined as the total market value of the investments (inclusive of receivables in the form of accrued income or interest) minus the liabilities/expenses and divided by the number of outstanding units of the funds. The Nav is marked to market daily. 
  • Risk: The risk of losing the principal amount invested in a gilt fund. Sebi classifies risk for funds in five levels: low, moderately low, moderate, moderately high, and high.
  • Sharpe ratio: This is one of the risk-adjusted return metrics.
  • Yield to maturity: This is the rate of return an investor should expect if all the securities in the fund are held till maturity.
  • Modified duration: This is a commonly-used risk metric for fixed income instruments. It is determined by a formula that measures the change in the value of the gilt bond, in this case, as a result of a change in interest rates (shows how a 1 percent change in rates would change the price of a bond). 

Types of gilt funds

  • Long-term gilt funds: These invest in government securities with maturity periods ranging from five years to as long as 30 years. Long-term gilt funds offer the benefits of yield and interest rate movement. 
  • Short-term gilt funds : These invest in short duration government bonds and in long-term bonds with short-term residual maturities. Given the underlying assets have a short duration, the funds are less sensitive to interest rate fluctuations, making them suitable for risk-averse investors.
  • Gilt ETFs: Recently Nippon India filed draft papers with Sebi to launch a five-year gilt ETF. Gilt ETFs, unlike gilt MFs, bring with them the benefits of passive investing. Debt investing has a lot to reap from ETFs as well, as the Bharat Bond ETF’s popularity showed us. Gilt ETFs like other ETFs track an underlying benchmark index. While actively-managed gilt funds play on duration to maximise alpha (excess returns) over the benchmark, gilt ETFs replicate the movement of the underlying index.

The earlier two proposed offerings by Reliance and SBI Mutual Funds were benchmarked against the 10-year government bond GSEC 10 NSE and the CRISIL 10-year gilt index, respectively. While a clear benefit of gilt ETFs over gilt MFs is the lower expense ratio, a major pitfall remains the liquidity concern owing to low trading volumes that may leave investors unable to find the right price for their investments. 

So, should we invest in gilt funds?

If we are looking for an alternative to fixed deposits, then gilt funds could be an option. Gilt funds allay our fears of credit risk while giving us returns higher than say, FDs or our savings bank accounts. But they are not as liquid as some other fixed-income instruments like liquid funds (investing in bonds of AAA or A1+ companies), which are also another kind of debt funds.

For those of us with frequent redemption needs, gilt funds won’t be a good fit. But for those of us looking for credit-risk-free returns over a long period of time, these set of funds are worth exploring. 

Top-performing gilt funds 

The following are the best gilt funds in 2020

  1. SBI Magnum Gilt Fund : 
  • investments in government securities issued by the Central Government and/or a State Government.
  • Moderate risk
  • CAGR/Annualized return of 8.4% since its launch. Return for 019 was 13.1% , 2018 was 5.1% and 2017 was 3.9% .
SBI Magnum Gilt fund details
Source: Tavaga Research

  2. Nippon India Gilt Securities Fund:

  •  The primary investment objective of the scheme is to generate optimal credit risk-free returns by investing in a portfolio of securities issued and guaranteed by the Central Government and State Government.
  • Moderate risk 
  • CAGR/Annualized return of 9.5% since its launch. Return for 2019 was 12.4% , 2018 was 8% and 2017 was 3.4% .

Nippon India Gilt Securities Fund details
Source: Tavaga Research

3. SBI Magnum Constant Maturity Fund:

  • Investments in government securities issued by the Central Govt. and State Govt.
  • Moderately Low Risk
  • CAGR/Annualized return of 8.3% since its launch.  Ranked 1 in 10 Yr Govt Bond category.  Return for 2019 was 11.9% , 2018 was 9.9% and 2017 was 6.2% .
SBI Magnum Constant Maturity Fund details
Source: Tavaga Research

4.   UTI Gilt Fund:

  • Investment in sovereign securities issued by the Central Government and / or a State Government and / or any security unconditionally guaranteed by the Central Government and / or a State Government for repayment of principal and interest. However there can be no assurance that the investment objective of the Scheme will be achieved.
  • Moderate Risk.
  • CAGR/Annualized return of 8.9% since its launch.  Ranked 7 in Government Bond category.  Return for 2019 was 11.8% , 2018 was 6.3% and 2017 was 4.3% .
UTI Gilt Fund details
Source: Tavaga Research

The chart below depicts the annualised one-year, three-year and five-year returns of the top-performing gilt funds in India in 2020.

Annualised returns of gilt funds
Source: Tavaga Research


Historical returns of Gilt bonds 

Gilt mutual funds as an asset class have been among the toppers on the returns chart. The average return posted by the category is 13.24 percent in one year till 2020. 

However, the outperforming gilt funds have been generating returns in the range of around 16 percent in one year, while even the worst of the gilt fund performers have clocked double-digit returns. 

Fund managers have been putting their money in these schemes because of a host of favourable factors, both on the domestic and international fronts. 

Data over the last 10 years indicates quite a lot of volatility in the returns for gilt funds . The one-year annualised returns have touched highs of around 26.2 percent in 2009 (evidently a lower interest-rate environment prevalent during the global financial crisis helped this), as well as lows of around -8.7 percent in 2010 (an expected correction after the reversal in our monetary policy stance). A fair conclusion to draw would be gilt funds show equity-like return characteristics during periods of volatile interest rates.

Here is a look at how one-year returns of gilt funds have moved historically, compared to the movements of 10-year bond yields. The graph below shows the average return of all funds in the gilt category.

Source: Tavaga Research

The graph goes to show the negative correlation between the gilt fund returns and the 10-year bond yields. Spikes in the returns are common and negative and near-zero returns have also been seen on a number of occasions.

Taxation of Gilt funds

Capital gains realised from appreciation in value of the gilt bond (the underlying asset of gilt funds) is taxable. The rate of taxation is based on the holding period. 

Short-term capital gains: Capital gains made in less than three years of possession is known as the short-term capital gain (STCG). We will receive the STCG from gilt funds, and have to pay the income tax according to our tax slab.

Long-term capital gains: A capital gain made beyond three years of possession is known as long-term capital gains (LTCG). LTCG tax, on the other hand, is a flat 20 percent with indexation benefits.

It is to be noted that capital gains are taxed at the hands of the investors and need to be filed at the time of filing our annual income tax returns.

Gilt Funds have an advantage over debt funds in terms of returns and are most suitable for risk averse investors. 

Investors looking to pocket hefty gains over a period of two-four years may go for gilt funds, keeping in mind a volatile interest rate environment. We should be ready to face interim losses as well during a high-interest rate regime.

But a slump in the economy would be a good time to consider gilt funds, depending on our portfolio diversification needs.



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