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Long-term investors should consider investing in gilt funds through SIPs

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Gilt funds posted stellar returns in the past one and a half years (barring the past few weeks) and their dream run may continue. The good run started with policy rate cuts and easing stance of the monetary policy committee (MPC) and now the covid-19 shock. Many investors have rushed into gilt funds; monthly net inflows and folio numbers have increased.

Investors, however, should not turn a blind eye towards the risks involved in gilt funds—interest rate or duration risk. When interest rates rise, their net asset values (NAVs) fall and when rates decline, NAVs rise. Returns of gilt funds are volatile and there could be periods of negative returns. However, credit risk is negligible in gilt funds as government securities (G-secs) in which they invest are backed by sovereign guarantee. Liquidity risk, which is much talked about after the Franklin Templeton MF episode, does not concern G-secs, which have maximum liquidity.

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Normally, investors look at any debt fund as a safe investment option with the objective to earn better returns than fixed deposits (FDs) that gilt funds offer. While gilt funds offer protection against credit risks, they are highly sensitive to interest rate risks. Gilt funds usually have higher modified duration or average maturity and, thus, have higher interest rate risk (higher volatility).

Tactical investing not for everyone

If an investor understands the interest rate cycles, macro factors and the overall landscape, he can take tactical calls in gilt funds. Timing is a crucial aspect in gilt funds, and one can make healthy returns by taking such tactical calls. But it is not easy to predict the interest rate trajectory as there are multiple factors to consider. Investors who have recently added gilt funds in their portfolio for a short-term period as a safety net during this downturn should be active enough to exit once signs of interest rate reversal is visible. Tactical calls in gilt funds is the best approach, but it is not everyone’s cup of tea.

The case for SIPs

The systematic investment plan (SIP) route for gilt funds is a decent option that long-term (at least three years) investors can consider. SIPs, as an investment technique, is, typically, associated with equity funds which works on the principle of rupee-cost averaging due to the volatility involved. The rupee-cost averaging concept in equity SIPs can also work in gilt funds, but to a smaller extent. SIP delivers better returns than lump sum only when we see a dip during the investment period.

In case of gilt funds, there are basically two components of returns—one is the interest or coupon of underlying instruments and the other is price gains due to mark-to-market adjustment on account of interest rate changes. Regular interest accruals take the NAV higher, thereby limiting sharp falls in the NAV.

Having SIPs in gilt funds makes sense given the interest rate volatility and fall in prices in case of a rising interest rate scenario. Gilt fund SIPs should form a part of one’s asset class diversification strategy. Gilt funds are preferred for SIPs, given that other longer duration-based funds adds some credit risk. Also, when the economy is going through a recession or slack phase, a portion of investment in gilt funds would provide stability to the overall portfolio.

What you should consider?

Investors taking the SIP route for investing in gilt funds for the long term should be able to stomach the volatility and not get carried away with ups and downs in the NAV. Also, one should consider the tax implications at the time of withdrawal as debt funds are tax efficient after three years, so the three-year cut-off for each instalment will be different. SIPs in gilt funds would be a prudent approach for long-term investors, as it would provide decent returns as interest rate movements evens or smoothens out. Investing through SIPs in gilt funds is more beneficial to individuals habituated to investing in recurring deposits.

Starting an SIP in gilt funds will help investors divert funds consistently, thereby inculcating a savings habit and adhere to one’s asset allocation strategy. SIP in safe and prudently managed gilt funds will give decent returns with sufficient tax efficiency and can be used as part of a long-term portfolio with systematic rebalancing.

Deepak Jasani is head of retail research, HDFC Securities

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