Portfolio

Are gilt funds risk-free?

Nalinakanthi V | Updated on March 23, 2014

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Not fully. Tenure and interest rate movements determine their returns



Gilt funds invest only in government securities. What is safer than parking money with the government, right?

But if you thought gilt funds are completely risk-free, you are wrong. Gilt funds invest predominantly in bonds with a sovereign guarantee and hence carry no risk of default.

Zero credit risk means that there is little chance that you may not receive your interest or the principal money in time.

But that does not make gilt funds absolutely risk-free. They are still subject to interest rate risk. That is, the returns on gilt funds are vulnerable to changes in interest rates.

A rise in interest rates will result in a fall in G-sec prices. This will impact the returns on gilt funds. For instance, in July 2013, when the central bank hiked the marginal standing facility (MSF) and bank rates by almost 200 basis points each, the yield on 10-year G-sec galloped by 100 basis points. On an average, the net asset value (NAV) of gilt funds fell by over 3 per cent between July 12 and 25, 2013.

Inverse link

Conversely, a fall in interest rates is good for gilt fund investors. This is because bond price and yield share an inverse relationship. A fall in interest rate will lead to an increase in the price of the G-sec and thereby boost the gilt fund returns.

For instance, between August 20 and September 5, 2013, when the yield on 10-year G-sec fell by 1.2 percentage points, the NAVs of gilt funds on an average rose by about 2.8 per cent. Likewise, during the November 22, 2013-January 21, 2014 period, gilt fund NAVs gained 2.7 per cent on the back of a 0.6 percentage point fall in 10-year G-sec yields.

But are all gilt funds equally risky? Actually not. Gilt funds that hold longer-term bonds are more risky. The returns of gilt funds which hold 10-year or 15-year G-Secs are far more volatile compared with short-term gilt funds which hold one-year or five-year paper. When interest rates move up, the price of a G-sec slated to mature in 10 years tends to fall much sharper than the one which matures in one year. This is because as soon as market interest rates rise, investors would prefer to own the new bond rather than the older one offering lower interest rates.

Prices of longer term G-secs fall more because their investors are forced to forego higher rates for a much longer period.

So, investing in a short-term gilt fund will cushion one against volatility in a rising interest rate scenario. However, do note that when rates are on a falling spree, long-term gilts can fetch you higher gains. Investing in long-term gilt funds is thus a great idea , if you anticipate that interest rates will soften.

Published on March 23, 2014

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