I am not surprised at all to see the recent love for Gilt Funds. Why should someone not fall for them when they have generated one of the best returns in recent years. And all this without any risk.
Really? Let’s check it out!
Gilt funds invest in government securities hence, cannot default. Yes, this is true 99%. But we can’t say they are risk free. The evil is the risk that come from changes in interest rates.
Why do you think Gilt Funds have generated such high returns when the underlying G-Sec pay interest between 7% to 8% only? How can a G-Sec generate 10% to 12% returns when it has interest rate between 7% to 8%?
The answer lies in the changes in their price due to changes in interest rates. Price of a bond or G-sec change when interest rates change. Bond price rise when interest rates in the economy fall and bond price fall when interest rates rise.
Over last 1 year G-Sec yields have fallen due to rate cuts by the RBI. G-Sec yields have fallen from 7.5% levels to 6%. This has led to sharp rise in the price of G-Secs contributing to higher returns in Gilt Funds.
So one may have a question, what is the risk? As I mentioned, the risk lies in price of these bonds. The way prices have risen due to fall in interest rates, they may also fall once interest rates starts rising again.
A simple calculation to check the potential risk is this – Expected returns = change in yields x Modified duration of the fund + Portfolio yield
Currently, most Gilt Funds have Modified Duration of around 6+ years. Let’s see how much returns they can generate under various scenarios.
|Change in Yields||Modified Duration||Returns from Change in Price||Portfolio |
|Approximate Total Returns|
|No Change||6 years||0.0%||6.0%||6.0%|
|Rise by 0.5%||6 years||-3.0%||6.0%||3.0%|
|Rise by 1%||6 years||-6%||6.0%||0.0%|
|Rise by 1.5%||6 years||-9.0%||6.0%||-3.0%|
|Fall by 0.5%||6 years||3.0%||6.0%||9.0%|
|Fall by 0.1%||6 years||6%||6.0%||12.0%|
|Fall by 1.5%||6 years||9.0%||6.0%||15.0%|
As visible from the above calculations, returns in gilt funds over next 1 year can vary between -3% to 15% range. If interest rates don’t change then returns shall be lower than 6% post expense. However, if interest rates continue to fall then returns can be upwards of 9%. If you are investing in Gilt Funds, be ready for any of these outcomes over next one to two years.
Over next 1 to 2 years the odds of reversal in interest rate cycle are high. At best they may remain stagnant if RBI decides to maintain status quo and maintain lower interest rate policy. While we cannot rule out further fall in interest rates, the odds are very low.
So where should one invest given such a scenario?
Let us go into history and see how different category of funds have performed during different interest rate cycles. Specifically when interest cycle has reversed.
|Calendar Year||Low duration Funds||Short Term Funds||Dynamic Duration Funds||Gilt |
|Change in 10 yr G-Sec Yield (bps)|
Note the year 2009, 2013 and 2017 when yields have bounced back, Gilt Funds have underperformed Low Duration and Short Term Funds. This is not surprising as we just saw how high duration gilt funds can get hit if interest rates rise.
Whenever Gilt Funds have generated double digit returns, in the following years, Low Duration and Short Term Funds have outperformed Gilt Funds. As interest rates rise Low Duration and Short Term Funds are able to reinvest their proceeds in higher yielding bonds. Since the carry lower duration risk, the impact of rising interest rates gets offset with higher accrual in the portfolio.
So what should investors do?
- Invest in Gilt Funds only for tactical purpose and time your exit smartly before interest rate cycle reverse.
- Avoid investing in Gilt Funds if you are looking for 1 to 2 years parking, instead invest in Low Duration and Short Term Funds as they are better poised in case of interest rate reversal.
- If you still want to invest in Gilt Funds for long term and you can stomach the volatility, investing in staggered way would be more prudent approach. Probably through an SIP.