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

Gilt funds are back in focus among investors with interest rates rising and bond yields across the world moving up sharply, as reported by ETBureau.

Gilt funds are debt mutual fund schemes that invest in government securities issued by the central and state governments. Long-duration gilt funds generally hold government bonds with maturities of 10 years or more. Since these securities are backed by the government, they carry very low credit risk, with the likelihood of default being minimal. However, their returns can fluctuate significantly with changes in interest rates, particularly because of their longer duration.

Gilt funds generally invest in government securities with longer maturities, making their returns more sensitive to changes in bond yields. When yields rise or fall, the prices of these bonds can move sharply, leading to greater fluctuations in fund returns. In contrast, short-term debt funds invest in bonds and money-market instruments with shorter maturities, making them relatively less sensitive to interest-rate changes and typically resulting in lower price volatility.

While gilt funds carry very low credit risk, they are not entirely risk-free. Their primary risk stems from fluctuations in bond prices, which can affect returns. These prices are influenced by several factors, including RBI interest-rate decisions, inflation, government borrowing, liquidity conditions, US Treasury yields, Federal Reserve policy, crude oil prices, foreign investor flows and geopolitical developments. Changes in any of these factors can trigger movements in bond yields and, in turn, affect gilt fund returns.

Gilt funds tend to perform well when bond yields decline, as bond prices move in the opposite direction to yields. Investors often consider them when interest rates and yields are near their peak, since falling yields can push bond prices up and boost gilt fund returns.

Gilt funds earn returns through interest on government bonds and changes in their prices. When bond yields fall, prices rise, allowing fund managers to book capital gains. Conversely, rising yields push bond prices down, hurting fund returns.

“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.