Why Gilt Funds Are Not Risk-Free

Are gilt funds risk-free?

Lakshmi moved part of her retirement corpus into a gilt fund because somebody explained that it lends only to the government, and a government does not default on money it borrows in its own currency. That is correct, and it is a genuine advantage rather than a marketing claim.

The fund had also produced excellent returns over the preceding few years, which is why it appeared on the list she was shown. Both facts were true and neither of them described what she was actually buying.

Lending money carries two main dangers: the borrower may not repay, and interest rates may move against you while you wait. A gilt fund removes the first entirely. It leaves the second untouched — and government bonds are frequently long-dated, which makes them among the most rate-sensitive instruments available.

So the honest description is that a gilt fund removes credit risk and concentrates interest-rate risk. Calling it risk-free swaps one for the other and produces exactly the wrong expectation.

Why do gilt funds rise and fall?

The mechanism is the ordinary bond mechanism, amplified.

When prevailing rates rise, an existing bond paying a fixed coupon becomes less attractive, and its price falls until a buyer would earn the going rate. How far it falls depends on how long the buyer is committed to that below-market coupon, which is duration.

Gilt funds frequently hold long-dated government paper, so their duration is often high — a fund with a duration of seven or eight moves roughly seven or eight per cent for each percentage point of rate change. That is equity-like movement in a product many people hold precisely to avoid equity-like movement.

And it works in both directions, which is how the misunderstanding takes root. During a period of falling rates, gilt funds produce excellent returns, attract money from people looking at those returns, and then behave very differently when the rate cycle turns.

What pattern catches gilt fund investors out?

It is worth stating explicitly, because it repeats and because Lakshmi is standing in the middle of it.

Rates fall over a period. Gilt funds post strong returns. Those returns appear in league tables and recommendations, and investors — often conservative ones, attracted by the word "government" — move money in, frequently money that was meant to be the safe part of their portfolio.

Then rates stop falling, or rise. The funds decline, sometimes sharply and for an extended period. The investor, who believed they had bought safety, discovers they had bought a bet on interest rates.

Nobody misled anybody. The fund did exactly what it says it does. The mismatch was between the word "government" and the assumption of stability.

How much have gilt fund values actually moved?

Until now this page could describe the mechanism and not show it. It can now show it.

Below are two government bond indices. Both carry no default risk of any kind — the borrower is the government in both cases. The only material difference between them is how long the money is committed for.

Over the same period	Lending for ten years	Lending for five years
Return a year	+6.45%	+8.02%
Worst fall from a high point	-11.73%	-7.16%
Time from that high to regaining it	17 months	8 months
Share of days below an earlier high	82.7%	69.1%
Worst twelve months	-5.10%	-0.56%
Share of twelve-month periods that lost money	14.0%	0.1%

Read the second row first. An instrument with no credit risk whatever fell 11.73% from a high point, between 27 May 2013 and 19 August 2013. Counting from that high, it took 17 months to be level again — and over the whole period it lost money across 14.0% of all twelve-month stretches.

Nobody defaulted. Nothing went wrong. That is simply what interest-rate risk looks like.

Now compare the columns. The shorter commitment fell 7.16% where the longer one fell 11.73%, was level again in 8 months against 17 months, and lost money in 0.1% of twelve-month stretches against 14.0%. Duration is why a given move in yields hits the longer bond harder — the same shock produces a bigger price swing the longer the commitment runs, which is the mechanism this table demonstrates. That is a statement about sensitivity, not a claim that duration alone accounts for every part of the two columns' difference over this specific stretch, which also reflects the particular path yields took and how the shape of the curve changed along the way.

There is a further result in that table which deserves care, because it is easy to over-read. Over this period the shorter commitment also returned more — +8.02% a year against +6.45% — while falling less. That is a fact about these 15.7 particular years and this particular pair of tenors, not a law, and it resists a one-line explanation: the ten-year yield this table's own record starts and ends on was actually lower at the end than the start, so "rates rose over the period" is not what happened either — what decided the outcome was the path in between and how the curve's shape moved, not a simple rise or fall from one endpoint to the other. Over a different stretch, with a different path, the longer commitment could win on return and still be the more volatile one throughout. What does generalise is the risk side: a longer commitment moves more for a given change in yield, which follows from the arithmetic of duration and holds regardless of which way rates go next.

What risks remain in a gilt fund?

Interest-rate risk is the main one, as above. Reinvestment risk follows from it: if rates fall, the income the fund receives gets reinvested at lower rates, so future returns decline even while current values rise.

Inflation risk is quieter and can matter more over long holdings, since a fixed coupon buys less over time and that erosion never appears as a loss on a statement.

Liquidity in stress is worth naming even though government securities are generally the most liquid rupee bonds available — that is a genuine strength, and liquidity is still a matter of degree, with even government bond markets trading at wide spreads under severe conditions.

And there is a risk specific to how these funds are run. Many gilt funds actively vary their duration according to a view on rates, which means Lakshmi is exposed both to rate moves and to whether the manager positioned for them correctly. That is a second risk dressed as risk management, and it is covered in its own page.

What is a gilt fund genuinely good for?

This is not an argument against them, because used for the right job they are excellent and the reasons are specific.

They offer credit-risk-free exposure to interest rates — the combination a long-horizon liability requires when certainty of repayment matters more than stability of the interim value. Government bonds are also the asset most likely to hold up or gain when equities fall in a growth scare, unlike corporate credit, which tends to fall alongside equities at the same moment. And they behave predictably given a rate move, which makes them straightforward to reason about once duration is understood.

Money with a short horizon in a long-duration fund carries a horizon mismatch: the mark-down that is temporary with fifteen years to wait is a realised loss when the money is needed in one. The credit certainty and the duration volatility are both real — neither cancels the other.

What determines how a gilt fund behaves?

Duration is the single number that determines behaviour, and it is on the factsheet. Translating it into rupees — the value at stake on a one-point rate move — makes the abstract concrete before a position is taken rather than after.

The comparison against how long the money can be left alone tells you what a rate move means in practice: if the holding period exceeds the duration, a rise is a temporary mark-down. If it does not, the mark-down is a realised loss at the moment the money is needed. Past returns describe the rate cycle that has just occurred rather than what comes next, which matters more in this category than in most.

Government exposure and long duration are separable: the credit certainty comes from the sovereign borrower, and the volatility comes from how long the commitment runs. A shorter-duration government option carries the credit property without the same price movement. In a fund whose entire return may be a few per cent, the expense ratio takes a significant share of it, and the spread between funds is narrow enough that costs affect the outcome meaningfully.

What can the gilt index history not tell you?

These are indices, not funds. A fund holding government paper charges a fee, holds some cash, and in many cases varies its duration according to somebody's view on rates. Its outcome will differ from the table above, and the last of those adds a risk the table does not contain at all: whether the manager positioned correctly. That is dynamic bond fund risk.

Two benchmarks are not the whole curve. The table shows five years against ten. A fund holding longer paper would have moved more than either column, and this record has no thirty-year index in it to show you.

The longer series covers one and a half decades, containing one large rate shock rather than several full cycles. It establishes that a fall of this size happens. It cannot tell you how often.

The two columns don't quite trade on the same calendar. Over the shared window, the ten-year series has a small number of dates the five-year series lacks, and vice versa — a difference small enough to leave the return figures intact but large enough that a percentage built from counting days, like how often either column was underwater, is against a slightly different number of days on each side.

And the figures are before inflation. A period in which a bond returns a little and prices rise by more is a loss in what the money buys, which never appears as a negative number on a statement — nominal return, real return and purchasing power.

What to take away

A gilt fund removes default risk and keeps interest-rate risk, often in a concentrated form because government paper tends to be long-dated. "Government backed" describes who repays you, not how steady the value will be along the way.

Duration determines behaviour; translating it into rupees makes a one-point rate move concrete. A horizon longer than the duration makes a rate rise temporary. A horizon shorter than it makes the same move a realised loss.

The tendency to hold up during equity falls gives gilt funds value as portfolio ballast — and that value disappears if the fund has to be sold at a moment when the money is needed rather than when rates have settled.