Mutual Funds

Gilt Funds: The unsung heroes

Amit Tripathi | Updated on September 06, 2020 Published on September 06, 2020

It’s the safest, most liquid debt category with attractive yields

There are only two assets whose absolute value is sacrosanct in local currency terms, Cash and Sovereign Obligations (like Treasury Bills, Central Government Securities (CG), State Development Loans (SDL)). The starting point for investing into Gilt Funds is the appreciation of zero credit risk. Arguably, a government cannot default on its domestic obligations.

Wait, it gets better from here.

First, as the amount of sovereign borrowing in India is large both in an absolute and relative sense, the sovereign assets with their zero-credit risk comfort still do not command that kind of price premium. Today, a three-year CG Bond yield is almost similar to a three-year AAA PSU bond. Even a 10-year CG Bond trades at a premium of hardly 0.5-0.75 per cent over a AAA PSU bond. If we look at SDL vs Corporate Bond yield, the difference is minimal — the message being that you are not losing much by sticking to a portfolio of CG/SDL vs at least a high-grade corporate bond portfolio.

However, if you proactively seek credit risk & balance-sheet risk, then investment into higher yielding debt instruments or equity/quasi equity is always a separate risk/return dynamic.

Second, the visibility on returns and risk. A sovereign asset portfolio with zero credit risk is available for investments as short as three months to and as long as 60 years. There is no parallel in terms of potential solutions for various requirements ranging from short-term liquidity management to long-term retirement solution with underlying sovereign investments. And that too with a very high visibility on returns, if held for a reasonable time.

Third, a sovereign asset portfolio is best placed to protect reinvestment risk due to easier availability across tenors and lower impact costs. In an economy where the structural trend on rates has been lower for a good part of the last two decades, this is critical for long-term investment goals.

Let’s talk risk. With no credit risk, the other risks are liquidity and interest rate risk. Sovereign papers are the most liquid assets in India, across not only debt category but arguably all asset classes, and across tenors. So, it’s as easy to buy and sell with minimal impact cost a 91-day treasury bill as it is to do it in a 30-year government bond.

Make it a core allocation

The interest rate risk is a function of the maturity of the bond portfolio. Longer the tenor, more the price impact of any change in interest rates. On a ballpark basis, if interest rates move down or up by 1 per cent, investor will make an immediate 1 per cent absolute gain or loss in a one-year instrument, but approximately 7 per cent gain or loss in a 10-year instrument. So how to solve this short-term volatility. Fairly simple, if we hold the investment long enough, interim price volatility gets evened out.

The thumb rule to even out volatility is to hold the investment for a period not less than half to 2/3rd of the portfolio maturity. So, for a 10-year average maturity portfolio, that means an investment horizon of 5 to 7 years. With that discipline, your holding period return will be subject to low holding period volatility and minimal negative surprises. With this background, we would always want to encourage investors to look at Government Bond Funds as a core allocation in their investment basket. It’s the safest, most liquid debt category; the only thing to solve for is volatility, which doesn’t hurt, if the discipline around the holding period is maintained. More important, the yields are very attractive compared to all other safe traditional saving avenues like fixed deposits, AAA-rated tax fee bonds, etc.

And by the way, the five-year median rolling return for this unsung category is nearly 8 per cent.**

Happy Investing.

** Daily NAV data for regular plan of Gilt Funds from July 31, 2005 to July 31, 2020

The writer is CIO – Fixed Income Investments, Nippon India Mutual Fund

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Published on September 06, 2020
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