IAS Economy Practice Question . 18

Consider the following statements about the Gilt Funds in India:
1. They are a kind of mutual funds
2. They invest in Government securities
3. They are risk free
Which among the above is/ are correct?
[A]Only 1
[B]Only 1 & 3
[C]Only 1 & 2
[D]Only 2 & 3

Answer: Only 1 & 2
Gilt funds are those mutual fund schemes that dedicatedly invest in government securities. These government securities include dated central government securities, state government securities and treasury bills. By investing in these gilt funds, investors are not exposed to credit risk since the securities are guaranteed by the central government. These funds invest in long-term government security papers which usually have a longer duration. In its attempt to broaden the market for the government securities, RBI extends several facilities to bring in more liquidity and consequently buyers’ interest in these funds. RBI extends reverse repurchase facility to gilt funds investing in government securities. The quantum of liquidity support on any day is up to20% of the outstanding stock of government securities, including treasury bills, held by the gilt funds as at the end of the previous working day. The central bank also provides one subsidiary general ledger account and a current account for the gilt funds’ transaction. The gilt funds are given the facility of transfer of funds from one centre to another under the remittance facility scheme of the Reserve Bank of India. Gilt funds are also allowed to access the call market as lenders. Please note that Gilt funds are not entirely risk-free. Investments in gilt funds are sensitive to interest rates risk though. Bond prices are inversely proportional to interest rates. Thus, these bonds would not do well, when interest rates are set to rise. Another risk that gilt funds entail is the risk of liquidity. A security is liquid, if it can be bought and sold easily and there are almost equal number of buyers and sellers. It is generally considered that higher the liquidity, lower is the risk. A gilt fund can be invested in a G-Sec paper which isn’t actively traded or is illiquid and if in such a situation, the fund manager is forced to make a distress sale, on redemption pressure, it is bound to adversely affect the fund’s performance. The popularity and the investors’
interest depend on the interest rate regime. These gilt funds do not perform well in a rising interest rate regime, since the government bond yields would be northward bound in such a scenario, and hence, the falling bond prices.

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