A company may need money for a variety of purposes. It may want to expand its business, build a new plant, buy machinery, buy new land to build a factory, or even purchase another company. One of the ways to raise money is to issue a corporate bond.
When you buy a bond, you lend money to the company that issued the bond (issuer). In exchange, the company promises to return your money (principal) on a predetermined date (maturity date), and till it does so, it will pay you a specified rate of interest (coupon rate).
Now the same happens with the government.
When the government requires money, it issues bonds of various maturities.
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.
Debt funds, banks and financial institutions purchase these instruments. Besides debt funds, there are specific mutual funds that invest only in such instruments. These are called gilt funds. They are pure debt funds that have a minimum of 80% of the portfolio invested in G-Secs and State Development Loans (SDLs), the balance in cash and cash equivalents.
Why are G-Secs called gilts?
Gilts is the name given to bonds issued by the U.K. government through the Bank of England. They are called gilts because the original certificates issued by the British Government had gilded edges.
The term is used in the U.K. and other countries such as India and South Africa.
The first gilt issuance was in 1694 to King William III who needed to borrow 1.2 million pounds to fund a war against France.
What are the risks?
- Credit Risk: None. When a company issues a bond, it makes a legal commitment to pay interest on the principal and to return the principal. But what if the company runs into a cash-flow problem or stars incurring massive losses and cannot return your money. That is a credit risk. There is no question of the government defaulting on the repayment. G-Secs have a sovereign guarantee as the central and state governments issues these securities.
- Liquidity Risk: Low. A vibrant secondary market exists for trading such instruments.
- Interest Rate Risk: High. This is what makes the funds extremely volatile and can even give negative returns during shorter holding periods. Higher the duration of the fund/bond, greater the interest rate risk.
This is important.
Retail investors are also permitted to purchase gilts, but it is wiser to take exposure via gilt funds.
Never let a gilt fund be a core holding. It should be a tactical bet. That means, investors should buy such funds when the interest rates are high, or it is inevitable that they are going to start falling in the near or immediate future.
