7 questions on gilt funds answered

By Dhaval Kapadia |  27-11-21 | 

A number of investors are considering an investment in gilt funds as interest rates seem to have bottomed out. Morningstar's Dhaval Kapadia, Director, Portfolio Specialist, helps investors arrive at a decision.

What are gilt funds?

Government Securities, or G-Secs, are debt paper issued by the Reserve Bank of India, or RBI, on behalf of the Government of India or state governments.

When the government requires money, it issues bonds of various maturities. Debt funds, banks, insurance companies, provident funds and other financial institutions purchase these instruments. Within debt funds, there are specific mutual funds that invest only in such instruments. These are called gilt funds.

Gilt funds are pure debt funds that have a minimum of 80% of the portfolio invested in Government Securities (G-Secs) and State Development Loans (SDLs), the balance in cash and cash equivalents. These funds have no exposure to corporate securities.

What duration are the securities?

Gilt funds have no restriction on the duration positioning. As of October 2021, gilt funds had a modified duration ranging from 2.6 to 7.7 years. Modified Duration is a measure of sensitivity of bond prices to changes in interest rates.

There are two kinds of gilt funds, both of which invest minimum 80% of their portfolio in G-Secs. One, gilt funds that invest in G-Secs across maturities. Second, gilt funds that invest with a constant maturity of 10 years, such that the Macaulay Duration of the portfolio equals 10 years.

You can read What is Maturity and Duration? for an explanation on Modified Duration and Macaulay Duration.

How much of a return can I expect?

Returns from debt funds, including gilt funds, are composed of interest accrued or yield on instruments held and any capital appreciation or capital loss.

Capital appreciation or capital loss occurs due to movements in bond prices which are inversely related to interest rates. Hence if interest rates rise, bond prices would fall and vice-versa, with longer maturity bonds being more sensitive to movements in interest rates vis-à-vis shorter maturity bonds. This is explained in What is yield?

Gilt funds tend to hold medium to longer maturity papers, hence a larger proportion of their return is generated from capital appreciation or capital loss. Returns from gilt funds aren’t assured and vary based on the prevailing interest rate cycle and fund manager’s skills.

What is the current interest rate scenario?

Since 2019, the RBI has cut the policy rate sharply and announced steps to support the slowdown in the economy.

These measures along with abundant liquidity in the banking system resulted in yields falling across the yield curve, particularly at the shorter end leading to a steepening of the yield curve. Currently, the medium-end of the curve (4 to 7 year segment) offers an attractive yield pick-up relative to the shorter end (1 to 3 year segment) of the curve.

With further normalization of liquidity conditions by RBI, we may see the yield curve flatten, resulting in short-term interest rates rising more than the longer-end of the curve which is now close to the pre-pandemic levels (December 2019).

How must gilt funds be positioned in a portfolio with respect to the above?

Gilt funds positioned around the medium-to-long term segment of the yield curve presents a reasonable opportunity currently and a small allocation of around 5 to 7% of one’s portfolio can be considered.

Funds maintaining a higher duration are more volatile due to higher sensitivity to changes in interest rates, and as a result present potentially higher mark-to-market risk. However, these would deliver subdued performance in case interest rates move north. Investors should consider the suitability of gilt funds from an overall portfolio perspective and make allocations in line with their risk-appetite.

How do they compare with corporate bond funds?

Corporate bond spreads, particularly for AAA & AA+ rated bonds, have narrowed significantly compared to their long-term averages; subsequent widening of spreads could present additional downside risk to investors. Hence, gilt funds also score above corporate bond funds at this juncture.

How are gilt funds taxed?

Short-term capital gains (on units held for 36 months or less) are taxed based on the investor’s income tax bracket, whereas dividends are taxed at 28.84%.

Long-term capital gains are taxed at 20.8% (including cess) with the indexation benefit.

To gain from a favourable tax treatment, investments in gilt funds should be at least over 3-year holding periods.

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