BM-201: Management Concepts and Practices Report Submission on Prepared by: Karan Tyagi -11113048 Kasu Naveen Raju-11113049 Jyotika Khatri-11113045 Kanishk Dabakra-11113046 Kishan Kumar-11113050
Introduction:Definition:Gilt Funds are mutual funds that invest in several different types of medium and long-term governmentsecurities in addition to top quality corporate debt. Gilts originated in Britain. Gilt funds differ from bondfunds because bond funds invest in corporate bonds, government securities, and money marketinstruments. Gilt funds stick to high quality-low risk debt, mainly government securities.Gilt funds originate from the requirement of investors to ensure higher safety levels for their investedmoney. Thus this scheme invests in instruments, which are generally considered to be safer than AAAgrade investments. In its most basic form Gilt-edged securities are bonds issued by certain nationalgovernments. The term is of British origin, and originally referred to the debt securities issued by theBank of England, which had a gilt (or gilded) edge. Hence, they are known as gilt-edged securities or giltsin short as they are government securities (G-Secs).These are ideal for those who want more safety for their investments or are risk-averse and, at the sametime, are looking for reasonable returns on their money. Gilt funds are a good option when interest ratesare not expected to go up. It should be noted that these funds are not risk free because there is aninverse relationship between bond prices and interest rates, when interest rate rise, prices of governmentsecurities fall, adversely impacting the performance of gilt funds. Typically it is noticed that, higher thefund’s average maturity, higher the volatility. The current scenario in which interest tares are not expectedto up these gilt funds can be a good investment option.Origin:The concept of the gilt fund is generally thought to have originated in Great Britain and is now widelyavailable in a number of nations, including India and many of the countries that were formally consideredcolonies of the United Kingdom. Because of the high-grade nature of these investments, the bonds wereoriginally adorned with decorated, gilded edges. As this type of investment became more popular andwas lumped into larger funds, the name stuck.As with any other investment, gilt funds do have their advantages and disadvantages:-Advantages:Less credit risk: As they are backed by government there is almost no credit risk.
Tax Benefits: Investors should note that not only are these returns higher than those offered bytraditional investment avenues like bank fixed deposits, but they are also more efficient in terms of taxbenefits. Gilt funds are given the same treatment as debt funds and are thus, eligible for the benefit ofindexation on capital appreciation.Open to retail investors: Only institutional investors can invest in G- sec market but Gilt funds provideretail investors a low-cost way to invest in G-sec, which otherwise was open only to large players.Easiness: Just like stocks or bonds, government securities are traded in both the primary and secondarymarkets. This means that as a small, individual investor, it is possible to do the buying, selling and tradingof securities yourself.Diversification: Investment in Gilt funds provides for effective diversification.Disadvantages:Interest rate risk: If the interest rate increases the price of G-sec fall which is a big risk to the investor.Not Liquid: Investors have to keep in mind that gilt funds are not as liquid as other debt funds as G-secsare not actively traded. Moreover, if there is a sudden redemption pressure, fund houses will have noother means but resort to a distress sale. Also, investors must avoid those gilt funds that have a smallcorpus because these funds are not able to perform well in case of sudden volatility in interest rates andif there is a sudden redemption pressure. Underlying securities are illiquid as they are not frequentlytraded. So if the fund manager opts for distress sell, to relieve redemption pressure, the fund may sufferloss.Mostly ideal for short term investment: Makes ideal short-term investment as most of the funds tend tobe volatile over longer investment time frame and equity scores over gilt in the long term.Complications: The paperwork and intricacies of these transactions can be very complicated, however,so gilt funds provide the benefit of pooling money with other investors and having larger buyers take careof the transaction logistics.Trends:The most noticeable trends in the gilt market in recent years have been: A substantial and persistent decline in market yields as the currency has stabilised compared to the 1970s and more recently UK gilts are seen as a safe haven compared to certain other government bonds A decline in coupons: several gilts were issued in the 1970s with coupons of around 15% per annum, but these have now matured A decline in the number of different gilts in issue, as the policy of the government has been to issue large quantities of each gilt (around £10 billion-30 billion) to maximise liquidity in global markets An increase in the volume of issuance as the Public Sector Borrowing Requirement has increased A large volume of gilts have been repurchased by central government under its quantitative easing programme
Why are gilt funds in the news?First, lets understand the relationship between bond prices and the interest rates. The two are inverselyrelated. Hence a fall in interest rates, leads to a rise in bond prices. In recent times, the RBI hasundertaken a series of rate cuts to infuse liquidity into the system. The falling interest rates havetranslated into an appreciation in prices of long-term bonds and G-Secs alike. Expectedly, funds that areinvested in such securities have benefited.Average maturity:Mostly, the average maturity and duration of such funds is on the higher side. Average maturity indicatesthe tenor of a portfolio and duration measures how sensitive the price of a fixed income security is inrelation to change in interest rates. While the investment objective does not define the average maturity,typically it ranges from a low two-year to as high as 15 years in some cases. The maturity of gilts isdefined by the DMO is as follows: short 0–7 years, medium 7–15 years and long 15 years+. Gilts with amaturity of less than three years are also referred to as "ultra short", while the new gilts issued since2005 with a maturity of 50 years have been referred to as "ultra long".Advisability of investment duration:In case of bonds, if interest rates rise, bond prices fall and vice-versa. Let’s say there is a 10-year bondissue in April 2012 with an annual coupon of 8% and face value of Rs.100. If interest rates were to belowered in the next couple of months, subsequent bond issues of 10-year tenor are likely to have a lowercoupon rate. Now, this will increase the demand for the former 8% coupon bond, which now has aresidual maturity of around 9 years; hence, the price would increase.Also, the longer the duration, the higher would be the impact on prices due to change in interest rates.This happens simply because higher duration means the maturity date of the bond or portfolio of bonds isfarther away (from any new bond issuances today) and hence, the advantage of the relatively higherinterest rate is more. In the above example, if the residual maturity of the 8% coupon bond was only oneyear, the advantage of a comparatively higher coupon will be for another year, limiting the price rise.Keep in mind though that this is also true in case the reverse happens. So if interest rates rise, bondprices will fall and the impact or extent of damage will be greater where a fund has a high duration. In thepast, gilt funds have seen negative returns in rising rate environment.How are these investments taxed?Similar to any other Debt Fund, Dividends are Tax Free in the hands of the investor. Units if held for aperiod of one year & above are eligible for indexation benefits(as per the current tax ruling).If you sell theunit in less than a year, the returns are added to your income and taxed according to the slab you fallunder (short-term capital gains tax). If you sell it after a year long-term capital gains tax is applied. Itshould be noted that these are debt funds and not subject to the securities transaction tax.
How investing in GILT Fund is a better investment than investing in FixedDeposits?FD is for an investor with low risk appetite and who wants a stable fixed return. In a gilt fund one couldgenerate higher than FD returns but there is an element of risk due to movement in interest rates in themarket. Redemption from a GILT fund after a certain period (in our case one month) would not attract anyexit load thus the investor has the option of redeeming the money without any additional charges unlikean FD where there could be a penalty for premature withdrawal. FD as per current income tax rules issubject to a tax as per the applicable income tax bracket. However any gains from a gilt fund isconsidered as capital gains and hence taxed at a lower rate. Investment in an FD does involve anelement of credit risk as one relies on the ability of the bank torepay the FD as per schedule.What major events affect the gilt funds performance in a big way?- RBI monetary policy- Supply / Maturity of government debt- Inflation & Inflationary expectations- Economic growth outlook- Deposit Growth/Credit growth- Global bond yieldsWhen do these investments perform well?Gilt funds give good returns when other asset classes like equity are not doing well but to investsuccessfully in gilt funds, it is essential to watch the economic indicators that can predict the decrease ininterest rates. Some essential factors leading to interest rate reduction are peaking of inflation, reductionin IIP (Index of Industrial Production), slow GDP growth and likelihood of reduction in corporate earnings.At the same time you must also consider your capacity to take risk, goals and funds track record you areinvesting in. Investors would do well to keep an eye on indicators that can be precursors to a fall ininterest rates. A slowdown in GDP growth, rising inflation, a decline in IIP (Index of Industrial Production)and expectations of a fall in corporate earnings, to name a few. Broadly speaking, a situation wheninterest rates have peaked and a downturn seems imminent, would be an opportune time to invest in giltfunds. Of course, investors must understand that to make the most of their gilt fund investments, beinginvested for the long haul (to cover an interest rate cycle) is important.Are gilt funds really risk free?While a gilt fund is sometimes thought of as being free of any risk, this is not strictly the case. Many ofthese types of funds are structured to include investments that carry a variable or floating rate of interest.
This means that if the average interest rate should fall, the amount of returns generated for the fund maybe less than anticipated. From this perspective, the investor in a gilt fund does carry the risk of possiblymaking less from the investment than originally projected. Depending on how severe the shift in interestrates happen to be, this could mean the investor would do better to withdraw and invest in a different typeof mutual fund.Increasingly, gilt funds are being promoted by fund houses and investment advisors, by emphasising ontheir risk free nature. That isnt entirely correct. We have already discussed how the underlyinginstruments i.e. G-Secs do not expose investors to any credit risk. However, that doesnt make gilt funds,risk free investment avenues in the conventional sense. Unlike small savings schemes wherein investorsenjoy both safety of capital and assured returns, gilt funds are not equipped to offer assured returns.For instance, investments in gilt funds are vulnerable to interest rate risks. When interest rates rise,prices of government securities fall; this in turn has an adverse impact on the performance of gilt funds.Typically, higher the funds average maturity, more it is prone to volatility. In the table above, severalfunds have languished in negative territory over the 1-Mth period.A security is termed as liquid, if it can be easily bought and sold. It can be broadly stated that higher theliquidity, lower is the risk. A gilt fund can be invested in a G-Sec paper which isnt actively traded i.e. it isilliquid. Now consider a scenario wherein to meet redemption pressure, the fund manager is forced tomake a distress sale i.e. incur a loss. This in turn will adversely affect the funds performance.One strong benefit of a gilt fund that does limit volatility is that the investments acquired for the fund tendto be covered with some type of investment insurance. What this means is that even if circumstancesoccur that preclude the delivery of any type of return from the fund, investors are highly likely to at leastrecoup the original contribution. Since trade laws and regulations vary from one nation to the next, it isimportant to review the terms and conditions associated with a particular gilt fund and find out exactlywhat type of protections are in place before choosing to participate in the fund.What should investors do?The question is - should investors consider investing in gilt funds? That would ideally depend on their riskappetite, investment objective and existing portfolio, among a host of other factors. An investment avenuethat is apt for one investor could be grossly unsuitable for another. Therefore, investors would do well toconsult their investment advisors/financial planners to determine the suitability of gilt funds in theirportfolios. Price change in long duration bonds result in sharp moves in net asset value. Of course, if youhold the fund for the stated average maturity, you are likely to earn the yield on the securities and you willnot lose money, but that can mean remaining invested for as long as 10 years. Some gilt funds have anexit load extending up to a year. If you are looking for accrual income from fixed income, such funds arenot for you.Thus, the factors an investor consider in selecting the “Best Gilt Fund” are:- Expense ratio- Load charges and load period- Past Performance (though not an indicator for future performance)- Fund size (at times a very large fund would be a disadvantage in case of extreme volatility)
Gilt-Edged Switching:It is the selling and repurchasing of certain high grade stocks or bonds to capture profits. Gilt-edgedswitching involves gilt-edged security, which can be high-grade stock or bond issued by a financiallystable company such as the Blue Chip companies or by certain governments. They are considered to below-risk investments because they are backed by strong, established entities. Gilt-edged securities aregenerally inversely linked to interest rates, and therefore experience price fluctuations.Gilt-edged switching is utilized by governments like those of the United Kingdom, South Africa andIreland. An example of a Gilt-edged switching is selling one bond in favor of another one. Higher-yieldingbonds may increase the potential for profit. Gilt-edged switching may also involve selling one bond at adiscount in order to purchase a more favorably yielding instrument. Categories of Gilt Funds:Conventional gilts:A conventional gilt is a bond issued by the UK government which pays the holder a fixed cash payment(or coupon) every six months until maturity, at which point the holder receives his final coupon paymentand the return of the principal.Coupon rate: Conventional gilts are denoted by their coupon rate and maturity year, e.g. 4¼% TreasuryGilt 2055. The coupon paid on the gilt typically reflects the market rate of interest at the time of issue ofthe gilt, and indicates the cash payment per £100 that the holder will receive each year in two payments.(Historically some gilts, intended primarily for higher rate taxpayers, were issued with coupons below themarket rate. A few undated gilts pay quarterly interest.)Gilt names: Historically, gilt names referred to their purpose of issuance, or signified how a stock hadbeen created, such as 10¼% Conversion Stock 1999. In more recent times, gilts have been generallynamed Treasury Stocks. Since 2005-2006, all new issues of gilts have been called Treasury Gilts.Index-linked gilts:These account for around a quarter of UK government debt within the gilt market. The UK was one of thefirst developed economies to issue index-linked bonds in 1981. Initially only tax-exempt pension fundswere allowed to hold these bonds. The UK has issued around 20 index-linked bonds since then. Likeconventional gilts, index-linked gilts pay coupons which are initially set in line with market interest rates.However, their semi-annual coupons and principal payment are adjusted in line with movements in theGeneral Index of Retail Prices (RPI).Indexation lag: As with all index-linked bonds, there is a time lag between the collection of prices data,the publication of the inflation index and the indexation of the bond. From their introduction in 1981,index-linked gilts had an eight-month indexation lag (between the month of collection of prices data and
the month of indexation of the bond). This was so that the amount of the next coupon was known at thestart of each six-month interest accrual period.Double-dated gilts:In the past, the UK government issued many double-dated gilts, which had a range of maturity dates,such as 12% Exchequer Stock 2013-2017. There is now only one of these gilts remaining in issue, a"rump gilt" with a relatively small amount outstanding and a very limited market, and this is likely to beredeemed in the next few years.Undated gilts:There exist eight undated gilts, which make up a very small proportion of the UK governments debt. Theyhave no fixed maturity date. These gilts are very old: some, such as Consols, date from the 18th century.The largest, War Loan, was issued in the early 20th century. The redemption of these bonds is at thediscretion of the UK government, but because of their age, they all have low coupons, and for a long timethere has therefore been little incentive for the government to redeem them. However in early 2009, andagain in late 2011, the yield on these gilts, and in some cases also the coupon, was higher than theredemption yield on long-dated redeemable gilts, which implied that the market was pricing in the chancethat the government might redeem these gilts at some point. The question of the redemption of War Loanhas now been publicly raised. Because the outstanding amounts are relatively very small, there is a verylimited market in most of these gilts. However in May 2012 the Debt Management Office issued aconsultation document which raised the possibility of issuing new undated gilts. Gilt Funds in India:The first gilt fund in India was set up in December 1998. The Reserve Bank of India is the governing bodyof all gilt funds ever since. The gilt funds provide to the investors the safety of investments made ingovernment securities and better returns than direct investments in these securities through investing in avariety of government securities yielding varying rate of returns gilt funds, however, do run the risk.Government securities mean and include central government dated securities, state governmentsecurities and treasury bills.Facilities from Reserve Bank of India:The Reserve Bank provides liquidity support and other facilities, such as, SGL and current accounts,transfer of funds through the Reserve Banks Remittance Facility Scheme and access to call moneymarket to dedicated gilt funds. These facilities are provided to encourage gilt funds to create a widerinvestor base for government securities market. The facilities provided to gilt funds include: Liquidity support: The objective of extending liquidity support to dedicated gilt funds is to support short-term liquidity requirements of such mutual funds. The Reserve Bank of India provides liquidity support to gilt funds by way of reverse repurchase agreements (reverse repos). Reverse repos are done in government of India dated securities eligible for repo transactions and treasury bills of all maturities. The quantum of liquidity support on any day is up to 20 per cent of
the outstanding stock of government securities, including treasury bills, held by the gilt funds as at the end of the previous working day. SGL and current accounts: The Reserve Bank opens one subsidiary general ledger (SGL) account and one current account for gilt funds own transactions at all centers of the Reserve Bank wherever desired by the gilt funds. Funds transfer facility: The gilt funds are given the facility of transfer of funds from one center to another under the Remittance Facility Scheme of the Reserve Bank. The gilt funds are also given the facility of clearing of cheques arising out of government securities transactions, tendered at the Reserve Bank counters. Access to call market: Gilt funds can access the call money market as lenders. Ready forwards: The Reserve Bank of India will also recommend to the Government of India to permit the gilt funds to undertake ready forward transactions in Government securities market.