YOUR QUERIES: Gilt funds likely to perform well near the peak of interest rate cycle

How should I look at investing in gilt funds? Can I expect to get stable returns over a period of five years?
—Bhaskar Pant
Gilt funds are a category of fixed-income funds with a mandate to invest at least 65% of total assets into government securities (G-secs) across maturities. These funds involve no credit risk as they invest into sovereign instruments and hence offer relatively lower yield relative to comparable duration corporate. However, the underlying portfolio is more liquid since G-secs are typically relatively more liquid than corporate debt securities.

Given these funds have no restriction on the duration to be maintained, this is a diverse category with funds having modified duration in the wide range of 2 to 9 years (as of August 2021). Funds maintaining a higher duration are more volatile due to higher sensitivity to changes in interest rates, and as a result subject investors to potentially higher interest rate risk. Prices of fixed-income securities have an inverse relation with interest rates.

Given the steep yield curve at present, most funds are currently maintaining higher duration to benefit from higher yield on offer. However, funds maintaining longer duration could be impacted adversely if interest rates move upwards on concerns over additional supply and monetary tightening amid high inflation and the U.S. Fed stimulus taper.

The performance of such funds could be volatile over short periods, and subject to the direction of interest rate movement. However, over a reasonably long horizon (at least 5 to 6 years), such funds can be expected to deliver decent returns along with indexation benefits available for holding periods of over 3 years. Such funds are more likely to perform well near the peak of the  interest rate cycle, with likelihood of a subsequent fall in interest rates which would lead to handsome capital gains. Investors could consider such funds as part of their tactical asset-allocation.

To gain exposure to funds with relatively stable returns, you could consider investing into funds with relatively low interest rate and credit risk such as Banking PSU Funds, Corporate Bond Funds and ST Income funds. You may also consider some exposure to floating rate funds, which typically do well in a rising interest rate scenario.

The writer is director, Investment Advisory, Morningstar Investment Adviser (India). Send your queries to fepersonalfinance@expressindia.com