Indeed, Gilt Funds are safer than other classes of mutual funds,But it's important to recognise that higher safety does not mean elimination of all risks. These funds invest in government securities, or gilts, which can be considered default free since they carry sovereign risk. Yet, the net asset values (NAVs) of gilt funds can fluctuate, as the government securities market is extremely price sensitive.
Like most traded financial instruments, gilt prices too are a function of market sentiment, which, in turn, is affected by a host of factors. These include demand and supply of gilt paper, interest rates in the economy, foreign exchange movements, Reserve Bank of India (RBI) auctions and government borrowings, most of which are not constant over a sustained period of time. In fact, the government securities market is at times as volatile as the stock market, which is reflected in the changing NAVs of gilt funds.
Yet, for the small investor, gilt funds have opened a hitherto inaccessible investment avenue. The large size of individual transactions limits the gilts market to entities like banks, financial institutions, provident funds and insurance companies. Statutory requirements compel banks to invest 25 per cent of their funds in government securities, because of which the gilts market is highly developed and liquid. But what about the risk associated with such instruments?
No credit risk. Government securities are the only asset class free from default risk. "There are two primary reasons why the government will not fail on its obligations. One, the government can print money to pay you back. Two, it can also tax you to pay you back."
In fact, the world over, governments are not expected to default. Gilt funds invest in purely government securities. Hence, there is no credit risk because the government guarantees it.
There have been a few exceptions like Russia, but they have either postponed their debt obligations or rolled it over. A sovereign default has far-reaching implications. If a country defaults, the value of the domestic currency falls dramatically. This sparks of chaos, and along with government securities, every other financial asset too falls in value.
only price risk. While there's no credit risk, it's the price risk that can actually hurt a gilt fund's NAV. Although the gilts market is largely liquid, it's also extremely volatile. Trading activity in the money market and the forex market has a huge impact on the gilts market.
The money market is extremely active, with the RBI holding regular auctions of short- and long-term paper. Moreover, various entities have to comply with statutory requirements regarding investments in government securities. On a day-to-day basis, the prices of sovereign paper varies, largely due to changes in the expectations of market players and the demand-supply position.
Even small changes in the forex market affect gilt prices. For example, if there's a run on the rupee, the RBI might tighten the call money market to reduce speculation on the rupee. If there is a shortage of liquidity, borrowing rates on the call money market move up. This leads to a drop in prices in the shorter end of the gilts market (paper with up to one-year tenure), and in some cases, even two-year paper. And when call money rates start coming down, the reverse happens. These are short-term swings that tend to even out over a period of time.
But a policy change usually has a longer-term impact on gilt prices. For instance, a cut in the Bank Rate (the rate at which the RBI lends money to banks) will see prices of longer duration government securities soar and that of shorter-duration paper increase marginally.
In fact, the liquid gilts market reacts sharply even to the smallest change in interest rates. For instance, when interest rates rise, gilt prices fall, with longer-duration gilts leading the decline.
Conversely, when interest rates fall, gilt prices rise. Reason: when rates fall, interest payments on existing gilts become more attractive, since new papers offer lower yields. In other words, the current yields adjust to the prevailing rate of interest.
At any given point of time, the risk associated with shorter-duration paper is lower than for higher-duration paper-the longer the duration of the security, the greater its sensitivity to interest rate movement, and vice-versa.
Managing the risk. With this kind of volatility, fund managers assume a great degree of importance. They fine tune their investment techniques and strategies to reduce the impact of this volatility on their fund's NAVs.
One of the best ways to reduce volatility is to hold shorter-duration paper. "Volatility depends on the kind of dated paper you hold. If your portfolio is leaning towards long-dated paper, there is too much of volatility, but in short-dated paper there is not much volatility."
However, there's a consolation: gilt prices move within a narrow band. In absolute terms, the annual volatility in gilts is estimated to be around 2 to 3 per cent. Hence, despite the volatility, NAVs of gilt funds wouldn't be hit significantly. Moreover, in a debt fund, the NAV accrues interest everyday. The NAV comprises of interest income and changes in security prices. So, even if prices dip for a short period, the interest accruals make up for the loss.
Investors should hold on to gilt funds for a reasonably long period of time and not be scared of falls in the NAV or a drop in yields. Ideally, investors should hold on for six months or more. Investors going in for shorter duration like 15 days will feel the pinch.
What most fund managers are confident about is the swift return to normalcy in gilt prices. If prices of gilts fall drastically, for reasons such as hardened call rates, they bounce back to original levels in a short span of time. It takes between a couple of days and about three months for gilt prices to restore, but they eventually come back to original levels."
In fact, fund managers like such short-term dips, as it gives them much-needed entry points.
A case for gilts. Why gilt funds make an attractive investment is the decent returns they give to an investor, without any credit risk at all.
Today, gilts have become attractive when one considers the risk-adjusted rate of return they offer.
