Time to benefit from gilt funds?

Falling interest rates can add a glint to their performance. But invest with caution.

Interest rate cut and gilt funds: An investment insight by RBI

Many experts believe that interest rates have peaked and may soon see a rate cut by the Reserve Bank of India (RBI). If that does happen, gilt funds are set to appear attractive.

Here's why: A change in interest rate has an inverse relationship with returns from debt funds, especially those that invest in bonds with a medium to long duration. When the RBI hikes interest rates, the returns of such funds tend to decrease, and when interest rates fall, their returns typically increase.

This happens because when the RBI lowers interest rates, the interest rate offered on new bonds will be lower. So, bonds that were issued earlier and pay more interest become more valuable. As a result, the price of these older bonds goes up, leading to an increase in the return of debt funds holding them.

And since gilt funds invest in government bonds, which are often of long duration, they are more susceptible to interest rate changes. For instance, when interest rates were cut in 2020 around the time of COVID, returns from gilt funds shot up to over 12 per cent, and when RBI upped the rates, gilt funds offered yields at three per cent only.

Now that investors are anticipating interest rates to tumble sometime this year, the question arises whether one should invest in gilt funds for quick gains.

Investment case for gilt funds

As mentioned above, government bonds are usually for longer durations, which is why gilt funds carry higher interest rate risk, especially when compared to short-duration funds.

Therefore, investors must not lose sight of the volatility gilt funds can present. One has to accurately predict the interest rate movements to profit from these funds. A wrong call can prove costly.

What you can do

Given gilt funds' heavy reliance on interest rates, they 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 also applies to investors who think they can anticipate the future movements of interest rates.

Our suggestion

For a fixed-income investor, preservation of capital is paramount. This is where high-quality short-duration debt funds come in handy. They should comprise the bulk of your fixed-income portfolio. Since short-duration funds are mandated to maintain a Macaulay duration of between one to three years, because of which most bonds in its portfolio are of a similar duration, these funds are relatively stable, as shown in the graph.

Taking risky calls with your debt investments defeats the entire purpose. If wealth creation is your purpose, we suggest you look at equity funds. But if it's safety that you crave, opt for debt funds that are high in quality and eliminate interest rate risks as much as possible.

Also read: Analysing business cycle funds

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