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The lowering of interest rate by 150 basis points on small savings was a major measure taken by the FM in his budget of 2001-02. Other than lowering the bench mark for the cost of capital in the economy, this change also heralds a new era where progressively these rates will be lowered further. So, what does the small investor do in a scenario like this when his haven of fixed return tax free investment is threatened? He looks for the next best option obviously. And in this case G-sec Funds or Gilt funds are just the instrument for him.

G-Sec funds are dedicated to investing primarily in Government securities. Apart from safety, which is inherent in any government security, investors in gilt-edged mutual funds enjoy liquidity, affordability, the minimum amount being just Rs 5000 and the mutual fund always offers buy-back of the fund at a rate related to the Net Asset Value (NAV). Thus, an investor can withdraw his money anytime either partially or fully (in case of open-ended funds) rather than wait for 6-15 years for withdrawing the PPF money. In fact this attribute of gilt funds combined with an average promised return greater than the savings bank deposit, is giving the bank a run for its money. Since a bank deposit scores over the other instruments in terms of liquidity, most open-ended mutual funds are trying to match this attribute by enabling encashment of units in 24-48 hours.

With returns on various G-Sec’s ranging from 8.25% upto 12.5% for a 14 year G-Sec, these Gilt funds compare well against the traditional bank deposits which offer between 5-10.5% p.a over the time horizon of 15 days to 3 years. Thus, we can see that Yields-to-maturity in government securities are generally significantly higher than that available from bank deposits for similar tenures and absolutely safe. Gilt edged funds by buying into the G-Secs are in a position to tap the higher returns and pass it on to the Gilt Fund investor. Private debt offerings do offer higher yields but are not comparable due to the much higher element of risk associated with it. Gilt edged funds are attractive to investors who seek a post tax rate of return higher than the traditional bank deposits - but are not willing to take on "risk" like that in equity or equity based mutual funds.These funds would attract the attention of investors who have retired or nearing their retirement, mainly because of its safety and liquidity attribute. Investors who have exhausted Sec 80L benefits : With greater tax efficiency due to tax-free dividends under the dividend plans and indexation benefit with lower tax rate of 20% on capital gains, the schemes are suited to high tax-bracket investors who have exhausted their Sec 80L benefits. Investors want to avail Sec 54EA and EB benefits. Investment in these funds would also help in reducing the overall portfolio risk of an individual investor, thus deriving the benefits of portfolio diversification. With the lowering of the dividend tax to 10%, these funds would obviously benefit as they will have greater income to from which to declare income.

Typically, gilt funds offer investors two plans - the dividend plan and the investment plan. Under the dividend plan, the fund would declare dividends from the net income earned by way of interest and realised capital gains. Under the investment/growth plan, these payouts would be, instead, reinvested.

But are Gilt funds as risk free as a PPF? Well not really. The NAV is the function of the market price of G-secs. G-secs represent full assurance on repayment of principal and interest on time, which means that there will be no delay or default in the payment of interest and principal. The downside in G-secs like in any other debt instruments could arise due to two primary reasons. : Market Risk and Interest Rate Risk. Thus, market price of G-secs is subject to volatility and where there is volatility, there is risk.

When there are tight money supply conditions in the banking system and banks have to meet their SLR (Statutory Liquidity Ratio) and CRR (cash reserve ratio) commitments with RBI or raise money to buy dollars etc. there is selling pressure on G-secs and this would send their prices down, affecting the NAV. Also since interest rate and price of a bond are inversely related, whenever there is an upward revision in the interest rate expectations, the market price of G-secs take a "hit". This is because the existing price of G-secs would adjust to the higher yield expectations. So, then, the NAV of a gilt fund is directly dependent on the interest rate.

Now, both the market risk and interest rate risk is highly difficult to predict. So, where then is the case for claiming that gilt funds are risk-free investment? But considering the post-tax returns of these gilt funds and the bank term deposits, the question for the investor is this additional risk worth taking?. This can be very good investment instrument provided an investor chooses a right fund. One criteria in selecting which Gilt fund to choose can be based on the analysis of past performances of "Income Funds" offered by the same Mutual Fund company. Also Fund managers who actively managed their average portfolio maturity, and capitalised on trading opportunities, generated additional returns. When interest rates are falling, as in the past year, fund managers try to increase returns by increasing the average maturity of their portfolio. Interest rate changes affect longer maturity gilts more than short-term gilts, and fund managers often switch back and forth between the two to maximise returns. Also it pays to remain invested in gilt funds for at least three years so as to ride out the volatility in the markets.

So, study these options of investments which are sure to be a part of any investor’s portfolio in the coming few years.

Aru Srivastava

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