What are Gilt funds?
Mutual funds which invest only in Government of India bonds are Gilt funds. These bonds are highly liquid and are free from default risk as the government can always print rupees at will. Gilt funds have been in existence for over 20 years.
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Performance of Gilt funds
Interest Rate Risk
You have purchased 1 bond each of A, B and C. Let us assume that due to market changes, the interest rates change. We will consider case 1 where interest rate increases by 1% and case 2 where interest rate decreases by 1%.
Case 1: When interest rate increases by 1%, your bond will still pay you the same maturity amount at the contracted rate of 7%. However, if you purchase a new bond, it will give you an interest rate of 8%. What will be the current value of the bonds which you have already purchased? It will decrease. The below table shows the current value of your bonds
The value of Bond A decreases the least due to the short maturity period of 1 year, which the Bond C with the longest maturity is the biggest loser.
Case2: When interest rate decreases by 1%, the reverse happens and the current value of the bonds increase as shown below:
Value of Bond A rises the least and the Bond C rises the most. This is due to the difference in the remaining duration.
From these cases, it is clear that the longer remaining duration, the higher the interest rate risk.
There have been 1-year periods during which the returns have been negative. This has happened in 2005, 2014 and 2018 when interest rates have moved up. This makes the holding period of 1 year risky, especially at the bottom of the interest rate cycle such as now. Let us check out 3 year rolling returns.
The 3 year holding period is much better with always positive returns for all funds considered. A minimum holding period of 3 years is required for investing in Gilt funds.
Is it a good time to invest in Gilt funds now?
In my opinion, we are at the bottom of the interest rate cycle. I believe that interest rates are less likely to move lower from here as the inflation is moving up. RBI has kept the Repo rates unchanged for now in the last meeting. As the economy improves post COVID, inflation is likely to remain steady and higher than 6%. In my opinion, interest rates may move up after 6 month to 1 year. Hence any investment in Gilt funds now may see short term negative movement. Hence invest in long duration Gilt funds with caution.
It is prudent to remain invested in short duration debt funds which are predominantly gilt or good rated commercial papers for the next 6 months to a year. Gilt funds could be good investment once the interest rates have moved up. If you are considering investments in Gilt funds now, you need to remain invested in it for at least 3 years and be prepared for short term negative returns.