Gilt funds can be double-edged swords

With equity funds ruling the investors' preferences, other types of funds offered by the mutual fund houses have been totally ignored. One of them is gilt fund, which have not received the credit they deserved.

However, with the current market crash, the focus has been shifted to these funds. Here we take a look at these funds and whether you should include them in your portfolio.

What are gilt funds?

Gilt funds are nothing but debt funds that primarily invest in government securities (G-Secs). However they differ from conventional debt funds in that, while a traditional debt fund invests in all types of debt instruments, gilt funds have narrow investment objective. They just focus on G-Secs.

What are G-Secs?

G-Secs are government securities, produced by RBI on behalf of Indian government. Since they are sovereign paper, there are no credit risks associated with this investment.

Hence it is ideal for those looking for safety of their capital. But the biggest problem with G-Secs is that it is suitable only for large institutional investors, it effectively excludes small retail investors.

Gilt funds stepped in to provide these investors a low-cost way to invest in G-Secs. Investors can decide between short-term and long-term gilt funds, according to their investment time frame.

What returns can I expect from gilt funds?

While no investment option can guarantee returns, over the past one year, top-performing gilt funds have managed to generate returns exceeding 20%.

This is because in the recent times, the Reserve Bank of India has introduced number of interest rate cuts. As there is an inverse relationship between the interest rates and the prices of bonds, reduction in interest rates, causes an increase in bond prices.

As a result, this has caused an increase in prices of long-term bonds and G-Secs. This has led to appreciation in NAVs of gilt funds, letting investors enjoy such stupendous returns.

I want to invest, but I need to understand the pros and cons of investing in gilt funds.

As with any other investment, gilt funds do have their own share of pros and cons.

Pros:

• Quite safe as the underlying investments are backed by government.
• Allows you to tap the G-sec market, which otherwise was open only to large players.
• Proves for effective diversification.

Cons:

• Interest rate risk
• Underlying securities are illiquid as they are not frequently traded. So if the fund manager opts for distress sell, to relieve redemption pressure, the fund may suffer loss.
• Makes ideal short-term investment as most of the funds tend to be volatile over longer investment time frame.

Should I invest in gilt funds?

To invest successfully in gilt funds, it is essential to watch the economic indicators that can predict the decrease in interest rates. Some essential factors leading to interest rate reduction are higher inflation, reduction in IIP (Index of Industrial Production), slow GDP growth and likelihood of reduction in corporate earnings.

Also consider your capacity to take risk, goal and fund's track record. Don't be swayed by only returns, as you may end up suffering losses.