Post the IL&FS crisis of 2018, the fixed-income space has been frequently hit by downgrades, defaults, and segregations. The COVID-induced liquidity freeze and credit dislocation has resulted in Franklin Templeton Mutual Fund winding up six of its debt schemes. Credit-risk funds have witnessed some massive outflows due to rising investor concerns about their holdings. Given these, investors have grown wary of debt funds and are looking for options that don't entail liquidity and credit issues. From this perspective, gilt funds, which rank last in terms of credit and liquidity risk, have been gaining a lot of interest.
As gilt funds invest in government securities, they have a low default risk because of the inherent government backing. Further, G-secs are the most liquid debt instruments. What's more, the category has been delivering returns which are far above anything else in the fixed-income space. If you sort the performance numbers across debt categories over one year period or above, gilt funds would come among the top performers. So does all this mean that gilt funds are an excellent investment option? Let's dive deeper into them.
The tactical element
As of July 3, 2020, the one-year category returns of gilt funds were 11.98 per cent. Generally, you would expect an equity fund to deliver returns of that kind. The key reason for this high number is a low-interest-rate scenario. Given the economic slowdown due to the pandemic, the central bank has cut interest rates multiple times over the last one year. The high returns have led greater inflows into the gilt-fund category. The AUM of these funds has surged by about 133 per cent over the last one year, reaching about Rs 19,000 crore as on July 31, 2020 (look at the graph below).
Such returns, that too from a category which is free of any credit or liquidity issues, are certainly appealing. Even the worst-performing fund in the category has given about 8.3 per cent over the last one year (as on July 3, 2020). But there is a catch here. If we see the median one-year rolling returns of gilt funds over the last 10 years, they appear to move in crests and troughs (look at the graph titled 'Highly volatile'). The peaks have gone as high as 20 per cent and the dips have gone as low as -1.69 per cent. That's quite some volatility, very much reminiscent of how equity moves.
If you compare these moves in gilt funds to those in short-duration ones, the volatility of gilt funds clearly stands out. Short-duration funds are much less volatile, with the difference between their highest and lowest points remaining within reasonable limits.
What causes gilt funds to be more volatile in spite of their good-quality holdings? The interest-rate sensitivity of the underlying of these funds is the culprit here. Gilt funds typically invest in medium- to long-duration government securities and thus their returns are mapped to G-sec prices (look at the graph 'Gilt-fund returns vs G-sec yields). These securities react sharply to interest-rate changes. If interest rates rise, their prices fall and vice-versa.
In fact, in a falling interest-rate scenario, these funds can offer elevated returns, quite like those of equity funds. But in a rising interest-rate environment, they will struggle to even match the returns from a savings bank account.
Their irregular return profile results in intermittent flows into these funds as investors time their entry into and exit from these funds (see the graph 'A tactical play'). Amid the current low-interest-rate regime, the category has been witnessing massive flows lately.
So to make money off these funds, you will have to predict interest-rate cycles and move into and out of these funds tactically. But that's not all. There is another aspect to the gilt story. Even if one correctly predicts the interest-rate movements, the returns from this category do not come in a linear fashion. They are rather lumpy. An analysis of the daily median rolling returns points out that about 70 per cent of the annual median returns in 2019 were made only in 10 trading days. So, if you were not invested in those 10 days, your returns would have been down by about 7 percentage points and you would have missed out on most gains.
A long-term bet?
Given their volatility and the need for being tactical with your entry and exit, can one have a buy-and-hold approach with them? Over a complete interest-rate cycle, their returns tend to average out. Thus, unlike equity, these funds do not reward handsomely over the long term. In the graph titled 'Long-term performance', you can see that these funds do not provide any exceptional returns over the long term. In any seven-year period, one can expect to broadly earn returns ranging from 6-9 per cent. But short-duration funds can provide you similar (or even better) returns with lesser volatility.
So, a buy-and- hold approach in gilt funds will not likely give you the kind of returns you saw in the last one year.
So who should invest in gilt funds? Given their volatility, need for tactical timing and average long-term performance, they are meant for someone who knows how to play the interest-rate cycle and has a nuanced understanding of debt markets. Even such investors should have a small, tactical allocation to these funds. That's because timing the interest-rate cycle is not easy. Many times, interest-rate announcements come as a surprise, like those in March and May this year. Such moves by the central bank can catch you off guard. Before you react, your fund would have already made a plunge, thus wiping off your hard-earned returns. Therefore, it makes little sense for retail investors to have these funds in their portfolio.
This does not mean that government bonds do not add any value. These bonds are the most liquid and have almost no default risk. Hence, government securities do have a place in your portfolio. However, this allocation can easily be achieved from funds with a broader investment mandate, like high-quality short-duration funds. These funds have the flexibility to invest in G-secs and many of them do have a G-sec exposure. So you won't need a separate gilt allocation that you will have to manage actively.
Finally, Value Research has always maintained that you shouldn't get adventurous with your debt allocation. The last thing you want from your debt allocation is equity-like volatility. The primary reason for a debt component in your portfolio is to provide it stability and returns above bank deposits. You can achieve this by investing in just short-duration funds for your medium-term goals and liquid funds for your short-term goals. The rest is dispensable.