Gilt Funds — No Credit Risk Is Not the Same as No Risk

Securities issued by the government to borrow money, held by the scheme, which receives the interest and the repayment on maturity.

Because the borrower is the sovereign, the risk that the borrower fails to pay is about as low as it gets in rupee terms. That is the genuine advantage of the category and it is a real one, particularly compared with schemes that hold corporate paper of varying quality, as our page on debt funds sets out.

What that advantage does not do is fix the price of the units. The scheme values its holdings at what they are worth in the market each day, and what they are worth in the market changes.

A bond pays a fixed amount. If borrowing rates in general rise, an existing bond paying the older, lower amount is worth less to anybody buying it today, so its price falls. If rates fall, the same bond becomes more attractive and its price rises.

That is interest rate risk, and it applies fully to government securities. The government paying reliably has nothing to do with what somebody else will pay you for the bond in the meantime.

So a gilt scheme can show a decline over months, and it can do so at exactly the time investors expected safety. The word government in the name is about who repays, not about the price along the way.

How far a bond price moves for a given change in rates depends mainly on how long it has left to run.

A security maturing shortly barely moves, because the money is coming back soon regardless. One maturing in twenty years moves a great deal, since two decades of a below-market payment is a much larger disadvantage.

Gilt schemes frequently hold longer-dated securities, which is why the category moves more than most people expect from something described as government-backed. The fact sheet shows the average maturity and the duration, and those two numbers tell you more about how the scheme will behave than anything else on the page, as our page on the fact sheet explains.

Somebody wants safety, hears government securities, and puts money there that was needed in eight months.

That is a mismatch rather than a bad scheme. The category is not built for short horizons, because a rate move during those eight months lands on the whole holding with no time to pass. For money that has to be available, a liquid scheme or a deposit is the appropriate answer, as our page on liquid funds covers.

The second version of the mistake is treating it as an equity substitute for long-horizon money. It is not that either. It is a lending arrangement whose price moves, sitting on the stable side of a portfolio rather than the growth side, which our page on asset allocation deals with.

In practice this is a category for people who have a specific reason rather than a general preference for safety.

Somebody who wants exposure to government paper without buying securities themselves, who has a horizon long enough to sit through rate movements, and who understands they are taking a view on rates whether or not they meant to. That last part is the honest description: holding longer-dated paper is a position on interest rates, even for an investor who never thought of it that way.

Worth noting that most households here already lend to the government without calling it that, through small savings and certificates at the post office. Those state their terms in advance and this does not, which our page on SIP versus post office schemes sets out. Same borrower, entirely different arrangement.

For most households building towards something, the stable portion of the portfolio does not need this category to do its job. That is not a criticism of gilt schemes. It is an observation that the problem they solve is not the problem most households have.

This is the distinction that resolves most of the confusion about the category, and almost nobody explains it.

If you hold a government security yourself and keep it until it matures, the price movements along the way stop mattering. You receive the interest and then the repayment, and whatever the market did in between was noise. The certainty people associate with government paper comes from that: from holding to maturity.

A gilt scheme does not mature. It is an open-ended holding that keeps buying and selling securities as older ones approach maturity and money moves in and out. So there is no date on which your units convert to a known amount, and the price movements never stop mattering the way they would for a security you held yourself.

That is the whole difference. The scheme gives you a diversified, professionally managed and easily redeemable exposure, and gives up the one feature that made the underlying feel certain. Neither arrangement is better; they are answers to different questions.

Four checks, and the first is the one that matters most.

• When do you need the money? Under a couple of years and this is the wrong category regardless of anything else.
• What is the average maturity of the scheme holdings, and are you comfortable with what that implies?
• Do you accept that the value will move, sometimes noticeably, in both directions?
• Would a simpler answer serve? For most stable-side needs, it does.

We are distributors rather than investment advisers, we recommend no schemes, and we do not offer views on where interest rates are heading. If you want to work out where a particular pot of money belongs given when you need it, get in touch, and how to choose a mutual fund sets out the order of decisions.