Role of gilt funds in portfolio diversification

For investors, diversification is key to mitigating risks. Gilt funds are a type of debt fund offering investors a way to access the relatively stable domain of government securities. This article will help you understand gilt funds and how they can help you make your investment portfolio more robust.

• Table of contents

1. What are gilt funds?
2. Types of gilt funds
3. How to diversify your portfolio with gilt funds?
4. Benefits of including gilt funds in your portfolio
5. Risks associated with gilt funds

Gilt funds are a unique type of

Gilt funds are a unique type of debt fund that invests primarily in government securities. The government, in need of funds, approaches the Reserve Bank of India (RBI), which acts as its banker. The RBI, in turn, raises capital from various financial institutions and channels it to the government through the issuance of government securities. These securities, with fixed tenures and interest rates, are then subscribed to by gilt fund managers. Upon maturity, the government repays the principal amount along with accumulated interest to the gilt fund, which then passes on the returns to its investors.

Government securities are generally perceived as having minimal credit risk due to the backing of the sovereign entity. Gilt funds have a mandate to allocate a minimum of 80% of their total assets to government securities. This substantial exposure to government debt underpins their reputation as a relatively stable investment avenue.

Gilt funds aim to generate returns primarily through the interest payments received on the government securities they hold. Additionally, they may also benefit from capital appreciation if the market value of the underlying securities increases. However, the performance of gilt funds is closely tied to interest rate movements. When interest rates fall, the value of existing bonds tends to rise, positively impacting gilt fund returns. Conversely, rising interest rates can lead to a decline in bond prices and potentially affect the net asset value (NAV) of gilt funds.

Types of Gilt Funds

There are two main categories of gilt funds, each catering to specific investment preferences and risk appetites.

1. Gilt Funds with Varying Maturities: This category encompasses gilt funds that invest in a diverse range of government securities across different maturity periods. The fund manager strategically allocates investments across short-term, medium-term, and long-term government bonds, aiming to achieve an optimal balance between risk and return. This flexibility allows the fund to adapt to changing interest rate environments and potentially capitalize on opportunities across the yield curve.

2. Gilt Funds with a Constant 10-Year Maturity: As the name suggests, these gilt funds maintain a consistent focus on government securities with a Macaulay duration of ten years. At least 80% of their total assets must be invested in such securities. This approach offers a more targeted exposure to the 10-year segment of the yield curve, which is often considered a benchmark for interest rate movements in the Indian economy. While potentially offering higher returns compared to funds with varying maturities, these funds also carry a higher degree of interest rate risk.

How to Diversify Your Portfolio with Gilt Funds

The inclusion of gilt funds within an investment portfolio can offer several advantages, particularly for those seeking a balance between relative stability and potential returns. For risk-averse investors, gilt funds present a suitable option due to their inherent stability, stemming from the backing of the government. Their relatively stable returns can act as a counterbalance to the volatility often associated with riskier asset classes like equities.

Moreover, gilt funds can play a crucial role in diversifying a portfolio. By adding an asset class with a low correlation to equities, investors can potentially reduce the overall risk of their portfolio. During periods of market turbulence, when equity prices may decline, gilt funds can provide a degree of insulation, helping to mitigate the impact on capital. However, it's important to approach gilt fund investments with a clear understanding of your financial objectives, investment horizon, and risk appetite. While offering stability, gilt funds are not immune to risk, particularly interest rate risk. Their performance can be influenced by changes in interest rates, potentially leading to fluctuations in their net asset value.

Therefore, careful consideration is necessary to ensure that gilt funds align with your overall investment strategy. If your goals include limited impact on capital invested, generating income, or diversifying your portfolio against market volatility, gilt funds may be a valuable addition.

Benefits of Including Gilt Funds in Your Portfolio

Gilt funds, with their unique attributes, offer a combination of relative stability, steady income potential, and diversification benefits. Their inclusion in a portfolio can contribute to a more balanced and resilient investment strategy, particularly for risk-averse investors or those seeking to navigate volatile market conditions.

Some of their benefits are:

• Relative Stability: Backed by the faith and credit of the government, gilt funds carry minimal risk of default. This inherent stability makes them a suitable choice for investors who prioritize low volatility and seek relative stability for their investments.
• Steady Income Stream: Gilt funds generate regular income through interest payments from the underlying government securities. This predictable income stream can be particularly suitable for individuals seeking a reliable source of cash flow, such as retirees or those looking to supplement their income by receiving Income Distribution cum Capital Withdrawal (IDCW) from the fund.
• Indirect Access to Government Securities: For many retail investors, direct access to certain government securities may be limited or impractical. Gilt funds provide a convenient avenue to gain exposure to these securities, allowing investors to participate in the government's borrowing activities and potentially benefit from their relative stability and returns.

Risks Associated with Gilt Funds

While gilt funds offer a relatively stable investment avenue due to the backing of the government, they are not entirely devoid of risks. It is crucial for investors to be cognizant of these risks before incorporating gilt funds into their portfolios.

• Interest Rate Risk: The primary risk associated with gilt funds is interest rate risk. This arises from the inverse relationship between bond prices and interest rates. When interest rates rise, the market value of existing bonds tends to decline, leading to a potential decrease in the net asset value (NAV) of the gilt fund. Conversely, when interest rates fall, bond prices generally rise, potentially boosting the fund's NAV.
  The extent of interest rate risk in a gilt fund depends on the maturity profile of the underlying bonds. Long-term gilt funds, holding bonds with longer maturities, are more sensitive to interest rate changes compared to short-term gilt funds. Therefore, investors need to assess their risk tolerance and investment horizon before choosing a specific gilt fund.
• Other Risks: While credit risk is minimal in gilt funds due to the government's backing, other risks may still be present. These include liquidity risk, particularly for funds investing in less liquid government securities, and market risk, where broader market sentiment can impact the fund's performance.
• Assessing the risks:
• Investors should consider their risk tolerance and investment horizon. If you have a longer-term investment horizon and are comfortable with potential fluctuations in NAV due to interest rate movements, gilt funds can be a suitable option. However, if you prioritize stability and require readily available liquidity, other investment avenues may be more appropriate.

Conclusion

Gilt funds offer a one-of-a-kind opportunity to diversify your portfolio. Their stability, stemming from government backing, and their potential for steady income make them an appealing choice for many investors.
However, gilt fund investments should be approached with a clear understanding of their inherent interest rate sensitivity. The performance of these funds is closely tied to the trajectory of interest rates, with falling rates generally favouring them and rising rates posing potential challenges. If you possess the knowledge and ability to navigate the intricacies of interest rate movements, gilt funds can be a valuable tool in achieving your long-term financial aspirations.

FAQs

How do gilt funds contribute to portfolio diversification?

Additionally, gilt funds can significantly contribute to portfolio diversification. By including an asset class that has a low correlation with equities, investors may be able to lower the overall risk of their portfolio. In times of market volatility, when equity prices might fall, gilt funds can offer a layer of protection, helping to cushion the impact on capital.

What are the benefits of investing in gilt funds compared to other types of bonds?

• Minimal Credit Risk: Gilt funds invest exclusively in government securities, virtually eliminating credit risk as the government is considered a highly reliable borrower.
• Potential for Capital Appreciation: Gilt funds can benefit from capital appreciation when interest rates decline.

How can I choose a suitable gilt fund for my investment needs?

• Investment Horizon: Align the fund's duration with your investment horizon.
• Risk Tolerance: Assess your comfort level with potential fluctuations in NAV due to interest rate movements.
• Expense Ratio: Compare the expense ratios of different gilt funds. Lower expense ratios can translate to higher net returns over time.
• Fund Performance: Evaluate the fund's historical performance, considering its track record across different interest rate cycles and comparing it with its peers.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.