In the ninth article in our Scrapbook Series, gilt unit trust funds come under the spotlight. Charlene Clayton takes a look at exactly what gilt unit trusts are, who should invest in them, and what risks are attached to these funds.
What is a gilt unit trust?
A gilt unit trust invests money in the bond market. The bond market is also called the capital market or the debt market.
Bonds are certificates issued to an investor when a government, big institution, or company borrows large amounts of money.
Normally a gilt is issued by a government. It is regarded as a low risk investment because governments are unlikely to renege on repaying money that they owe investors.
Gilt unit trust funds invest in all the different types of bonds that are available. In South Africa there is a limited bond market because the only borrowers are the government, municipalities and what are called utilities, such as Eskom, Telkom, Transnet or the various Water Boards.
Very few companies in South Africa issue bonds because it is cheaper for them to raise money on the share market. Governments, on the other hand, cannot sell shares.
The main reason why a government issues a gilt is to raise money to finance the budget deficit the shortfall between revenue (taxes) and expenditure.
When you invest in a gilt fund, just like any other unit trust, your money is pooled with that of other small investors and the fund is professionally managed for you.
A unit trust fund allows you to gain a much wider spread of investments than would be possibly by buying individual shares or bonds.
In South Africa it is extremely difficult for individuals to buy bonds directly because they are issued at very high values of about R1 million. This makes gilt unit trusts an obvious option for the small investor.
The name gilts comes from when they were originally issued in Britain and the actual certificates used to have gold foil around the edges.
Management companies which trade in gilts are issued with a bond certificate when they buy them.
The certificate has a face value which reflects the size of the loan at which it was originally issued.
The certificate also has a coupon rate which shows the interest the government or parastatal agrees to pay the buyer on an annual basis. The maturity date is also shown.
The holder of a gilt may sell it at any point prior to the date of maturity in the actively traded bond market.
When the gilt is sold, the price is determined by discounting the future value of the money that the holder will receive on the maturity date and the income stream (interest), into present date value.
The price fluctuates on a daily basis because, for example, the markets' perception of future inflation and the direction of interest rates differ from day to day.
The yield (or return on the initial investment) of a gilt, which is quoted in newspapers, is used as a barometer to determine its price.
There is an inverse relationship between the yield of a gilt and its price. The price of a bond decreases as interest rates go up. This is because no one wants to lend money to the bond issuer or seller if they can get better returns elsewhere.
When bonds are in demand, however, the issuer can ask a higher price which means lower returns or yields for the investors.
Don't for one moment assume that an investment in bonds or gilt unit trusts is risk free.
Your capital can be at risk precisely because the value of a bond moves up and down just like interest rates do.
If you are a speculator it is a good investment to buy bonds or invest in gilt unit trusts when interest rates are high and then to sell them when interest rates come down. That way you make a capital profit.
Bond investments are often made to generate income because you receive income while you hold the bond through the coupon rate (interest rate) which is paid half yearly. The coupon rate remains fixed until the bond matures.
However, if your main aim for investing in unit trusts is the need for an income, it is better to invest in an income fund where the risk is actively managed by a professional fund manager. An income fund invests in more than just gilts, thereby spreading the risk.
To achieve the highest possible returns for unit trust investors, gilt fund managers manage the average duration of the fund (the average years to maturity of all the gilt holdings).
Interest rates on loans that will mature after a number of years (called long term rates) will often be different from short term rates.
The reasons for this are inflation expectations, the deficit funding programme of the government and the business cycle.
This means the composition of the long and short dated gilts in the portfolio will change depending on the portfolio manager's view of expected interest rate changes,
If a government borrows too much it places pressure on the available savings of individuals and corporates which means everyone has to pay higher interest. This is good news for people investing in bonds but bad news for borrowers.
The All Bond Index of the Johannesburg Stock Exchange (JSE) serves as a benchmark for this sector's performance.
Who should invest in a gilt fund?
Gilt funds are a medium risk unit trust investment which have investment opportunities comparable to general equity unit trusts which invest in markets like the JSE.
These funds are suitable for investors who want to capitalise on changes in interest rates, good capital growth as well as income from their investments.
Often the potential for good returns in bond funds is better than in the share market, but over the long term share market investments have out-performed bond market investments.
By investing in these funds, you get returns both from the growth in the fund and the interest which is paid on the interest bearing securities.
In South Africa it has been mostly institutions and retirement funds which invest in gilts.
In terms of what is known as the prudential investment guidelines (Pigs), retirement funds must hold at least 20 percent in bonds to reduce risk.
Fund managers believe that gilt unit trusts should form part of your overall investment portfolio.
There are tax consequences if you invest in bonds because the income that you receive is in the form of interest. The first R2 000 of any interest you earn is tax free, but over this, you are taxed at your marginal rate of tax.
How much does it cost?
As from last month unit trust management companies are no longer bound by regulated fees structures.
They are, however, obliged to provide details of their costs in their trust deeds and must give unit holders at least three months written notice of any changes to existing fees.
The regulated fees for gilt funds are:
* An annual management fee of about 0,855 percent;
* A once-off initial charge on the value of your investment amounting to 1,09 percent; and
* Compulsory charges every time you invest in gilt unit trusts.
The compulsory charge is made up of brokerage fees, marketable securities tax (MST) and stamp duty and is about 0,051 percent.
Always check on fees and compare not only performance but also the impact of costs on the performance before you invest.
Minimum investment?
You can buy gilt unit trusts with a lump sum or invest monthly by debit order.
The minimum lump sum investment you can make is R5 000 and the monthly minimum is R500.