Are gilt funds a good bet amid rising interest rates? What investors should know

Gilt mutual funds are debt schemes that invest in government securities issued by India’s central and state governments. Their government backing means the likelihood of default is minimal, giving them very low credit risk. However, low credit risk does not mean stable returns.

Long-duration gilt funds often hold government bonds maturing in 10 years or more. For example, a fund may own several long-term government bonds and earn interest from them. If market yields fall, those bonds can become more valuable, allowing the fund to benefit from price gains. If yields rise, their prices can decline.

This makes gilt funds different from deposits or other investments whose values may not move as sharply. Their performance depends heavily on interest rates, inflation, government borrowing, liquidity, global yields and other market forces. Investors therefore need to consider both their safety from default and their sensitivity to changing rates.

Gilt funds have returned to investors’ focus as interest rates rise and bond yields across the world move sharply higher. This matters because gilt fund returns are closely linked to government-bond prices, especially when funds hold long-duration securities. Rising yields can hurt prices, but a later decline in yields can support them.

For example, investors may consider gilt funds when rates and yields appear close to their peak. If yields fall afterward, the prices of existing government bonds generally rise. Fund managers can then book capital gains, adding to the interest earned from those bonds. The reverse can happen if yields continue rising.

The article quotes Basant Bafna of Mirae Asset Mutual Fund, who sees an opportunity to gradually build exposure to long-duration government bonds. He says yields have risen sharply, while markets may be pricing more RBI rate hikes than the central bank ultimately delivers.

A gilt fund’s returns reflect both the interest paid by its government bonds and changes in those bonds’ market prices. Because long-duration gilt funds hold bonds that are more sensitive to rates, yield movements can have a pronounced effect on their value. The fund’s low credit risk does not remove this market risk.

Suppose a fund owns government bonds and market yields subsequently fall. Those existing bonds can rise in price, enabling the fund manager to book capital gains. If yields instead rise, the same bonds can lose value, which weighs on the fund’s returns. Interest income continues to matter, but price changes may dominate over shorter periods.

Yields respond to RBI decisions, inflation, government borrowing, liquidity, global Treasury yields, crude oil prices, investor flows and geopolitical developments. Therefore, gilt funds may perform well during falling-yield periods, but investors must accept potentially large fluctuations when rates and yields move higher.

Long-duration gilt funds generally invest in government bonds with maturities of 10 years or more. This long holding period matters because the prices of such bonds are more exposed to changes in market yields. Their returns can therefore fluctuate more than those of funds holding shorter-maturity securities.

For example, if yields rise after a fund buys a 10-year government bond, the bond’s price can fall significantly. If yields decline, its price can rise substantially. The fund manager may then book a capital gain. The same yield movement usually has a smaller price effect on a shorter-term bond.

This sensitivity creates both opportunity and risk. Investors may consider long-duration gilt funds when interest rates and yields are near their peak, because falling yields can lift prices. But if yields continue rising, the fund can face negative price movements despite holding government-backed securities with minimal default risk.

Government-bond yields can move because of many forces beyond RBI interest-rate decisions. The article lists inflation, government borrowing and liquidity conditions as domestic influences. It also identifies US Treasury yields, Federal Reserve policy, crude oil prices, foreign investor flows and geopolitical developments as important external or market forces.

For example, higher government borrowing can affect bond-market conditions, while changing inflation can alter expectations about future rates. A shift in Federal Reserve policy or US Treasury yields can influence global bond markets. Foreign investor buying or selling can also affect demand and yields. These forces can operate together rather than independently.

Their importance is practical for gilt-fund investors. Any factor that pushes yields higher can pressure government-bond prices and fund returns. A factor that helps yields decline can support prices and create capital gains. This is why gilt funds are not entirely risk-free, even though their default risk is very low.

Gilt funds generally invest in longer-maturity government securities, while short-term debt funds invest in shorter-maturity bonds and money-market instruments. This difference affects how strongly each fund responds to changes in interest rates and bond yields. Gilt funds have very low credit risk, but their market prices can move considerably.

For example, when yields rise, a long-term government bond held by a gilt fund may fall more sharply in price. A shorter-maturity security in a short-term debt fund usually experiences a smaller price reaction. When yields decline, the long-term gilt fund may also gain more from rising bond prices. The trade-off is greater fluctuation.

Short-term debt funds are therefore relatively less sensitive to interest-rate changes and typically show lower price volatility. Gilt funds may offer greater potential from falling yields, but they also carry greater interest-rate risk. Neither comparison makes gilt funds entirely risk-free, since price movements can affect returns.

A bond’s yield reflects the return investors demand from holding it, while its price is the amount they pay for the bond. When market yields fall, an existing bond with its stated interest payments becomes relatively more attractive. Investors may then pay a higher price for that bond. This is why prices generally rise as yields fall.

When market yields rise, newly available bonds offer more attractive returns. An older bond with unchanged interest payments becomes less appealing unless its price declines enough to provide a comparable yield. For example, a government bond bought before yields rise may lose market value, even though the government continues paying its interest.

This inverse relationship drives gilt-fund performance. Falling yields can raise the prices of the government bonds held by a fund and allow capital gains. Rising yields can push those prices down and hurt returns. The effect is usually stronger for long-duration bonds, which explains their greater volatility.