Are gilt funds a good bet amid rising interest rates?
WHAT ARE GILT FUNDS?
Gilt funds are debt mutual funds that invest in government securities issued by the central and state governments. Long-duration gilt funds typically invest in government bonds with maturities of 10 years or more. Since these securities are backed by the government, the credit risk is extremely low with the chances of default being minimal.
HOW ARE GILT FUNDS DIFFERENT FROM SHORT-TERM FUNDS?
Gilt funds typically invest in longer-duration government bonds. Returns from gilt funds that invest in long-term securities can fluctuate sharply when bond yields move up or down.
On the other hand, short-term debt funds invest in bonds and money-market instruments with shorter tenures. They tend to be less sensitive to interest-rate movements. As a result, they see lower fluctuations in returns.
BUT AREN’T INVESTMENTS IN GILT FUNDS RISK-FREE?
From a credit-risk perspective, that’s true. But that does not mean these funds are entirely risk-free. This is because the big risk comes from volatility in bond prices. There are a whole host of factors such as RBI rate decisions, inflation, government borrowing, liquidity conditions, US Treasury yields, Federal Reserve decisions, crude oil prices, foreign investor flows and geopolitical developments that influence bond prices. They affect gilt fund returns.
SO, WHEN IS IT FAVOURABLE TO INVEST IN GILT FUNDS?
Gilt funds tend to be most attractive when investors expect bond yields to decline. Investors often start looking at gilt funds when they feel interest rates and bond yields are at their peak, and the scope for further rate increases is limited. This is because bond prices and bond yields move in opposite directions. When yields fall, bond prices rise, benefiting gilt funds.
HOW DO BOND FUND MANAGERS GENERATE RETURNS FROM GILT FUNDS?
Fund managers generate returns in two ways. The first is the interest earned on the government bonds held by the fund.
The second is when bond prices change. When bond yields fall, bond prices rise, allowing fund managers to book profits by selling some bonds at higher prices. But if bond yields rise, bond prices fall, which in turn hurts returns.
IS THIS THE RIGHT TIME TO INVEST IN GILT FUNDS?
That depends largely on where investors believe bond yields could move from here.
Gilt funds tend to perform best when investors expect bond yields to decline. A section of market participants believes the bond yields have peaked.
“The current environment offers an opportunity to gradually build exposure to long-duration government bonds,” said Basant Bafna, Head of Fixed Income, Mirae Asset Mutual Fund.
According to him, bond yields have already risen sharply, and markets may be pricing in more RBI rate hikes than the central bank ultimately delivers.
However, others remain cautious. They say uncertainties such as the likelihood of further US rate hikes, inflation risks and weaker foreign flows could keep bond yields higher for longer periods.
So, investing in gilt funds requires investors to get the timing of bond yields right, which is easier said than done.
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