TEST BANK For Corporate Finance, 13th Edition By Stephen Ross, Randolph Weste...
Gilt funds
1. 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
2. Introduction:
Definition:
Gilt Funds are mutual funds that invest in several different types of medium and long-term government
securities in addition to top quality corporate debt. Gilts originated in Britain. Gilt funds differ from bond
funds because bond funds invest in corporate bonds, government securities, and money market
instruments. 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 invested
money. Thus this scheme invests in instruments, which are generally considered to be safer than AAA
grade investments. In its most basic form Gilt-edged securities are bonds issued by certain national
governments. The term is of British origin, and originally referred to the debt securities issued by the
Bank of England, which had a gilt (or gilded) edge. Hence, they are known as gilt-edged securities or gilts
in 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 same
time, are looking for reasonable returns on their money. Gilt funds are a good option when interest rates
are not expected to go up. It should be noted that these funds are not risk free because there is an
inverse relationship between bond prices and interest rates, when interest rate rise, prices of government
securities fall, adversely impacting the performance of gilt funds. Typically it is noticed that, higher the
fund’s average maturity, higher the volatility. The current scenario in which interest tares are not expected
to 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 widely
available in a number of nations, including India and many of the countries that were formally considered
colonies of the United Kingdom. Because of the high-grade nature of these investments, the bonds were
originally adorned with decorated, gilded edges. As this type of investment became more popular and
was 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.
3. Tax Benefits: Investors should note that not only are these returns higher than those offered by
traditional investment avenues like bank fixed deposits, but they are also more efficient in terms of tax
benefits. Gilt funds are given the same treatment as debt funds and are thus, eligible for the benefit of
indexation on capital appreciation.
Open to retail investors: Only institutional investors can invest in G- sec market but Gilt funds provide
retail 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 secondary
markets. This means that as a small, individual investor, it is possible to do the buying, selling and trading
of 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-secs
are not actively traded. Moreover, if there is a sudden redemption pressure, fund houses will have no
other means but resort to a distress sale. Also, investors must avoid those gilt funds that have a small
corpus because these funds are not able to perform well in case of sudden volatility in interest rates and
if there is a sudden redemption pressure. 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.
Mostly ideal for short term investment: Makes ideal short-term investment as most of the funds tend to
be 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 care
of 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
4. Why are gilt funds in the news?
First, let's understand the relationship between bond prices and the interest rates. The two are inversely
related. Hence a fall in interest rates, leads to a rise in bond prices. In recent times, the RBI has
undertaken a series of rate cuts to infuse liquidity into the system. The falling interest rates have
translated into an appreciation in prices of long-term bonds and G-Secs alike. Expectedly, funds that are
invested in such securities have benefited.
Average maturity:
Mostly, the average maturity and duration of such funds is on the higher side. Average maturity indicates
the tenor of a portfolio and duration measures how sensitive the price of a fixed income security is in
relation 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 is
defined by the DMO is as follows: short 0–7 years, medium 7–15 years and long 15 years+. Gilts with a
maturity of less than three years are also referred to as "ultra short", while the new gilts issued since
2005 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 bond
issue in April 2012 with an annual coupon of 8% and face value of Rs.100. If interest rates were to be
lowered in the next couple of months, subsequent bond issues of 10-year tenor are likely to have a lower
coupon rate. Now, this will increase the demand for the former 8% coupon bond, which now has a
residual 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 is
farther away (from any new bond issuances today) and hence, the advantage of the relatively higher
interest rate is more. In the above example, if the residual maturity of the 8% coupon bond was only one
year, 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, bond
prices will fall and the impact or extent of damage will be greater where a fund has a high duration. In the
past, 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 a
period of one year & above are eligible for indexation benefits(as per the current tax ruling).If you sell the
unit in less than a year, the returns are added to your income and taxed according to the slab you fall
under (short-term capital gains tax). If you sell it after a year long-term capital gains tax is applied. It
should be noted that these are debt funds and not subject to the securities transaction tax.
5. How investing in GILT Fund is a better investment than investing in Fixed
Deposits?
FD is for an investor with low risk appetite and who wants a stable fixed return. In a gilt fund one could
generate higher than FD returns but there is an element of risk due to movement in interest rates in the
market. Redemption from a GILT fund after a certain period (in our case one month) would not attract any
exit load thus the investor has the option of redeeming the money without any additional charges unlike
an FD where there could be a penalty for premature withdrawal. FD as per current income tax rules is
subject to a tax as per the applicable income tax bracket. However any gains from a gilt fund is
considered as capital gains and hence taxed at a lower rate. Investment in an FD does involve an
element 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 yields
When do these investments perform well?
Gilt funds give good returns when other asset classes like equity are not doing well but 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 peaking of inflation, reduction
in 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 fund's track record you are
investing in. Investors would do well to keep an eye on indicators that can be precursors to a fall in
interest 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 when
interest rates have peaked and a downturn seems imminent, would be an opportune time to invest in gilt
funds. Of course, investors must understand that to make the most of their gilt fund investments, being
invested 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 of
these types of funds are structured to include investments that carry a variable or floating rate of interest.
6. This means that if the average interest rate should fall, the amount of returns generated for the fund may
be less than anticipated. From this perspective, the investor in a gilt fund does carry the risk of possibly
making less from the investment than originally projected. Depending on how severe the shift in interest
rates happen to be, this could mean the investor would do better to withdraw and invest in a different type
of mutual fund.
Increasingly, gilt funds are being promoted by fund houses and investment advisors, by emphasising on
their risk free nature. That isn't entirely correct. We have already discussed how the underlying
instruments i.e. G-Secs do not expose investors to any credit risk. However, that doesn't make gilt funds,
risk free investment avenues in the conventional sense. Unlike small savings schemes wherein investors
enjoy 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 fund's average maturity, more it is prone to volatility. In the table above, several
funds 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 the
liquidity, lower is the risk. A gilt fund can be invested in a G-Sec paper which isn't actively traded i.e. it is
illiquid. Now consider a scenario wherein to meet redemption pressure, the fund manager is forced to
make a distress sale i.e. incur a loss. This in turn will adversely affect the fund's performance.
One strong benefit of a gilt fund that does limit volatility is that the investments acquired for the fund tend
to be covered with some type of investment insurance. What this means is that even if circumstances
occur that preclude the delivery of any type of return from the fund, investors are highly likely to at least
recoup the original contribution. Since trade laws and regulations vary from one nation to the next, it is
important to review the terms and conditions associated with a particular gilt fund and find out exactly
what 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 risk
appetite, investment objective and existing portfolio, among a host of other factors. An investment avenue
that is apt for one investor could be grossly unsuitable for another. Therefore, investors would do well to
consult their investment advisors/financial planners to determine the suitability of gilt funds in their
portfolios. Price change in long duration bonds result in sharp moves in net asset value. Of course, if you
hold the fund for the stated average maturity, you are likely to earn the yield on the securities and you will
not lose money, but that can mean remaining invested for as long as 10 years. Some gilt funds have an
exit load extending up to a year. If you are looking for accrual income from fixed income, such funds are
not 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)
7. Gilt-Edged Switching:
It is the selling and repurchasing of certain high grade stocks or bonds to capture profits. Gilt-edged
switching involves gilt-edged security, which can be high-grade stock or bond issued by a financially
stable company such as the Blue Chip companies or by certain governments. They are considered to be
low-risk investments because they are backed by strong, established entities. Gilt-edged securities are
generally 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 and
Ireland. An example of a Gilt-edged switching is selling one bond in favor of another one. Higher-yielding
bonds may increase the potential for profit. Gilt-edged switching may also involve selling one bond at a
discount 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 payment
and the return of the principal.
Coupon rate: Conventional gilts are denoted by their coupon rate and maturity year, e.g. 4¼% Treasury
Gilt 2055. The coupon paid on the gilt typically reflects the market rate of interest at the time of issue of
the 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 the
market rate. A few undated gilts pay quarterly interest.)
Gilt names: Historically, gilt names referred to their purpose of issuance, or signified how a stock had
been created, such as 10¼% Conversion Stock 1999. In more recent times, gilts have been generally
named 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 the
first developed economies to issue index-linked bonds in 1981. Initially only tax-exempt pension funds
were allowed to hold these bonds. The UK has issued around 20 index-linked bonds since then. Like
conventional 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 the
General 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
8. the month of indexation of the bond). This was so that the amount of the next coupon was known at the
start 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 be
redeemed in the next few years.
Undated gilts:
There exist eight undated gilts, which make up a very small proportion of the UK government's debt. They
have 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 the
discretion of the UK government, but because of their age, they all have low coupons, and for a long time
there has therefore been little incentive for the government to redeem them. However in early 2009, and
again in late 2011, the yield on these gilts, and in some cases also the coupon, was higher than the
redemption yield on long-dated redeemable gilts, which implied that the market was pricing in the chance
that the government might redeem these gilts at some point. The question of the redemption of War Loan
has now been publicly raised. Because the outstanding amounts are relatively very small, there is a very
limited market in most of these gilts. However in May 2012 the Debt Management Office issued a
consultation 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 body
of all gilt funds ever since. The gilt funds provide to the investors the safety of investments made in
government securities and better returns than direct investments in these securities through investing in a
variety 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 government
securities 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 Bank's Remittance Facility Scheme and access to call money
market to dedicated gilt funds. These facilities are provided to encourage gilt funds to create a wider
investor 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
9. 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.