FundsIndia Explains : Short-term and long-term gilt funds

What they are? Where they invest?
Gilt funds are debt mutual fund schemes that invest in government issued bonds and securities of varying maturities. The various types of gilt funds include long-term gilt funds and short-term gilt funds. Long-term gilts funds invests in long dated government bonds with maturities, typically greater than 5 years up to even 30 years, while short-term gilt funds invest in short term government bonds as well as long-term bonds with short term residual maturities. Though long-term gilt funds are more risky and volatile compared to short-term gilt funds (reasons for which we will look at later in the article), the long-term gilt funds are more popular, especially among institutional investors. This is because they are most sensitive to interest rate changes and therefore allow such investors to bet on rate cycles. There are not too many short-term gilt funds as the theme can be played with other short-term debt funds as well.

How they work
Gilt funds predominantly generate returns through interest rate risk. Interest rate risk and credit risk are two of the major risks that tend to affect bonds. Since gilt funds entirely consist of government bonds they carry zero credit risk. These bonds are backed by the government, hence the probability of default is nil given the sovereign guarantee. But gilt funds derive their risk from interest rate movements.

A bonds’ price movement is inversely correlated to the movement of interest rates in the economy. And it is more sensitive when it has a longer residual maturity. As interest rates rise, the prices of the existing bonds will fall to adjust themselves to the new coupon. This is because investors will prefer the current higher coupon paying bond as opposed to holding on to a lower coupon paying bond. But as interest rate moves up, the fall in price of a bond that is slated to mature 10 years hence will be much more sharper compared with a bond that is likely to mature in the next two years. This is so since the investors purchasing the old lower coupon paying bonds will have to forego the higher coupon for longer period. Therefore the fall in price of a longer maturity bond is greater than a shorter maturity bond.

The opposite holds true as well, where a fall in interest rates will cause an increase in the price of long-term bonds greater than that of short-term bonds.

Apart from that, Government bonds are the most liquid of bonds and are heavily traded. This makes their price movements extremely sensitive to the changes in interest rate in the economy. So any change in interest rates are immediately reflected in the prices of these bonds.

Apart from that the inflation expectation and the fiscal deficit in a country are some other factors that affect the yields and prices of government bonds.
These factors make gilt funds volatile.

How they generate returns
Unlike most of the other bond fund strategies which typically generate income through accrual, gilt funds predominantly generate returns taking duration calls and by trading in the underlying instruments. Depending on the interest rate outlook, a fund manager will tend to trade in and out of gilts with varying maturities, thereby generating trading returns in the fund apart generating returns on the coupon (interest income).

By this we mean that the fund manager takes a view on the future movement of interest rates in the economy and invests either in short or long duration gilts. When a fund manager expects the interest rates to fall, a major part of the portfolio will be loaded with gilts with longer maturity. As discussed earlier, when interest rates are expected to fall, the price of the existing long-term bonds tend to rise and also rise greater than those gilts with shorter maturity. Since gilts are marked to market on a daily basis, the price movement is reflected in the NAV of the fund.

In short, gilt funds generate their returns mostly from the capital appreciation arising from rate movements.

Typically with respect to other corporate bond funds, yield to maturity can be a good indicator of the returns an investor can expect from the fund, but this is not so with respect to gilt funds. An understanding of interest rate movements and their impact of the returns of a portfolio (defined by modified duration) is required to understand the return potential of gilt funds.

How their returns are over the long term
Long-term gilt funds have potential to generate abnormal returns over short periods of time; and equally sharp losses in adverse rate situations. Hence, their returns tend to normalise and look ordinary over longer time frames. This is evident from the fact that when we look at their returns over 3,5 and 10 year time periods, their average returns have been 11.6%, 9.7% and 8.5% respectively (average performance of long-term gilt funds as of 31 Mar 2017). At the same time they had returned an average of 15% in the calendar year 2016 when the interest rates were falling.

Such normalising of returns happen as the underlying gilts approach their maturity (funds reduce their average maturity once rate fall cycle is at its end), their volatility reduces and they trade closer to their par value and as the underlying bond matures, they earn their stated coupon.

How they differ from dynamic bond funds
Dynamic bond funds, as the name suggests, have the flexibility to invest in a host of bonds – gilt and corporate – across varying maturities.Depending on the interest rate cycle the fund manager, as he/she deems fit, will either choose to invest a major portion of the fund in gilts or corporate bonds, with long or medium-term or short-term maturities, while gilt funds will stay invested only in government bonds and securities. Hence in a downward interest rate cycle a dynamic bond fund will consist of a majority of gilts and as the cycle turns the fund manager may choose to move to an accrual strategy, with higher exposure to typically top-rated corporate bonds. However in a gilt fund, a fund manager can only choose to invest between short-term gilts and long-term gilts depending on the rate cycle and the fund’s mandate

Who can invest
Gilt funds are meant for astute investors who can take a call on the interest rate cycle and dynamically enter and exit these funds based on such cycles to capture returns optimally.