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The emergence of gilt funds

Amid falling debt-fund returns, gilt funds have emerged as a high-yielding option, but be careful about the duration risk in these funds

The emergence of gilt funds

The emergence of gilt funds amid falling yields and their fascinating returns has been a topic of investor interest over the last one year. The new-found interest in gilt funds has been quite visible in the kind of flows they have been garnering and also the kind of investor queries we have been receiving. True that these funds are largely free from any credit or liquidity issues but the heightened interest in these funds is mostly due to the double-digit returns that they have given over the past year. As on 29th October, the category's one-year median return stood at around 12 per cent. This trend has essentially been driven by the rate cuts by the RBI. Currently, the repo rate stands at 4 per cent, the lowest since 2001.

Gilt funds invest in government bonds, which are often of long duration. As interest rates fall, the returns of these funds go up as their underlying bonds carry a higher coupon. Thus, the flows of these funds are often linked to the expectation of a rise or fall in interest rates (see the graph below).

What should investors do?
Investors must not lose sight of the volatility these safe funds can present. The graph 'Gilt-fund returns and G-sec yields' based on the median one-year rolling returns depicts the volatile nature of these funds, which is similar to the volatility in equity funds. These funds typically invest in government securities of medium to long duration, which are overly sensitive to interest-rate movements. If interest rates rise, their prices fall and vice versa. This is where gilt funds get their volatility from.

One needs to accurately predict the interest-rate movements to profit from these funds. A wrong call can prove costly. Thus, these funds are not meant to be the core of your portfolio. At best, you can have a tactical or a supplementary allocation to these funds. This should be the case even for those who think they can deftly anticipate interest rates. You can adopt a core-satellite approach here. For an investor's core fixed-income portfolio, safety and quality are of utmost importance. For the same, you can opt for high quality short-duration funds. Further, consider credit-risk and gilt funds as supplementary allocation and invest only a part of your fixed-income corpus in them. While these are avoidable, those who want to pursue higher returns can look at them as supplements. Please note that investing in them is purely a matter of choice and most investors can do without them.