Why fund managers are mixed on gilt funds

In India, yield on the benchmark 10-year government security (g-sec) stood at 7.47% on 23 October, up from around 6.76% in mid-August and about 6.54% a year ago. The yield is at its highest level in three-and-a-half years. Rising US yields, higher crude oil prices and monetary tightening at home have all contributed to the pressure.

For investors, rising yields cut both ways. Higher yields can make government bonds more attractive to new investors, but they also push down the prices of existing bonds, inflicting mark-to-market losses on debt funds that hold them. Gilt funds, which invest predominantly in government securities, can be particularly sensitive to these moves when their portfolios have longer durations.

On average, gilt funds’ net asset values (NAVs) have fallen about 2.5% since mid-August. Some fund managers see the correction as an opportunity to build positions gradually. Others believe yields could rise further, making patience the better strategy.

The case for gilt funds

The argument for investing now rests on the view that yields are already attractive and that much of the expected monetary tightening may be reflected in bond prices.

“Yields at close to 7.45-7.5% are a good entry point. But investors should enter in a staggered manner and not put the entire sum in at one go, as oil is rising and yields are elevated globally. We don’t know where the top will be,” said Puneet Pal, head of fixed income at PGIM India Mutual Fund.

Joydeep Sen, corporate trainer and author, pointed to the gap between bond yields and the policy rate as a reason to believe that further increases in the 10-year yield could be limited.

“Over the last 25 years, the average spread between the repo rate and the 10-year g-sec yield has been about one percentage point. Today, it is almost double that. So even if the RBI (Reserve Bank of India) hikes further, the 10-year yield may not move up as much, since it is already in an elevated zone,” he said. He too favours a staggered approach.

On 7 October, the RBI raised the repo rate by 25 basis points (bps) to 5.5% and changed its stance to “calibrated tightening”.

Bond prices and yields move inversely. When yields rise, existing bonds with lower coupons become less valuable, leading to mark-to-market losses for debt funds. Longer-duration portfolios are more exposed to such losses because their bond prices are more sensitive to interest-rate changes.

“Staying invested for a period close to a fund’s duration, typically over a seven-to-nine-year horizon can help to reduce the impact of volatility. When your holding period is longer, the effects of interest rate movements largely cancel out. If yields rise, the fund’s NAV falls in the short term, but the fund reinvests its interest income and maturing bonds at the higher yields, which makes up for that loss over time. So, your return ends up close to the yield at which you entered. And if yield levels normalize, you also stand to benefit from capital appreciation. Yield of close to 7.5% is a good level to lock-in for investors with a longer investment horizon,” said Ashish Chadha, a registered investment advisor.

Historical returns offer some support for the long-term case. A Mint analysis of gilt funds since 2005 showed that no five-year holding period or longer delivered a negative return. The minimum return rose to 3.3% over seven years and 4.5% over 10 years, while average returns remained between 7.2% and 7.8% across holding periods ranging from one year to 10 years. The maximum return was 11.9% over seven years and 10.4% over 10 years.

“We find the entire basket of debt funds attractive due to higher yields and duration opportunities. Accordingly, we recommend the long-duration g-secs and state government securities for duration, and we suggest the 2-5 year corporate bond space for capturing accruals,” ICICI Prudential Mutual Fund said in its outlook note.

“With the RBI changing its stance to calibrated tightening, we expect three more 25-bps-hikes from hereon, taking the repo rate to about 6.25%. A large part of this rate hike cycle is already built into the current ten-year yield. Yields may remain in a narrow corridor of 15-20 basis points and not move too much either way from here,” he said.

The case for caution

Not everyone believes the current yield is an attractive enough entry point. Some fund managers expect yields to rise further before stabilising, potentially giving investors a better opportunity to invest.

“Yields have gone up quickly. You may see a retracement if at all of 10-15 bps to 7.30%, but it may not sustain there. A lot of issues need to be sorted out before yields can come down meaningfully,” said Shantanu Godambe, fund manager at DSP Mutual Fund.

“The capex cycle in India is strong and rates are high globally. A foreign investor earning 5% in the US will not come here for 7.25-7.5%, if you factor in rupee depreciation of another 3%,” he said.

He added that currency-market volatility has prompted companies that might otherwise have borrowed overseas to raise money in the domestic market, keeping liquidity tight. He expects the RBI to take the repo rate to about 6%, with inflation staying above 5% and the Eighth Pay Commission adding to demand.

“It is better to be at the short end and earn the 8% accrual available there,” he said.

“Issuance of state development loans (SDLs), corporate bond issuances, together with the central government borrowing, there is more supply than the market has demand for, which will add to the upward pressure on yields,” he said.

“A mean reversion in credit growth to more manageable levels will bring back some demand into bonds,” he said.

He put current credit growth at 17-18% and said it could be temporary, reflecting specific factors such as higher working capital requirements related to supply-side and oil-price pressures.

For Godambe, the timing of an investment in long-duration bonds depends on how much further monetary tightening the market has to absorb.

“The rate hike cycle has just begun. Once we are about 50 basis points further into it and people start wondering whether another 25 or 50 bps is coming, that is when you can start investing, because markets would have priced in a lot of the negativity by then. Right now, it’s a hope trade that the dollar and US yields will come down,” he said.

What investors should do

Gilt funds carry negligible credit risk because they invest in government securities, which carry a sovereign guarantee. But they are exposed to interest-rate risk, and longer-duration funds can see short-term losses when yields rise.

For example, a 50-bps increase in yields on a portfolio with a modified duration of six can translate into an approximately 3% negative impact. Modified duration measures a bond or portfolio’s sensitivity to interest-rate changes. The higher the modified duration, the greater the potential price movement for a given change in yields.

Both sides agree that a further rise in yields cannot be ruled out, although the extent of any increase remains uncertain. Some gilt funds are actively managed, allowing fund managers to reduce portfolio duration defensively or increase it to take on more interest-rate risk.

For investors, the choice comes down to risk appetite and investment horizon. Gilt funds may suit those who can withstand near- to medium-term volatility and remain invested through interest-rate cycles. Those seeking greater stability should keep the bulk of their debt allocation in shorter-duration categories, which are less sensitive to changes in yields.

“Gilt funds should only be considered by investors who understand interest rate risk and can stomach near-to-medium-term volatility as there are still a lot of variables,” said Surya Bhatia, financial adviser at Asset Managers.

Jash Kriplani

Jash Kriplani is a seasoned journalist based in Mumbai with more than 15 years of experience across some of India’s leading publications, covering personal finance and investments. Over the years, he has developed a strong reputation for breaking down several complex financial concepts into clear, accessible insights for everyday investors, with a particular focus on helping individuals make informed decisions about their money.Jash has consistently written with a reader-first approach, blending storytelling with practical guidance. His work often reflects a deep understanding of investor behaviour, market cycles, and the evolving financial landscape in India, while staying grounded in data-driven insights and the real-world context.He is also a Certified Financial Planner (CFP), having earned the credential from the Financial Planning Standards Board Ltd, USA. This professional training complements his journalistic work, allowing him to bring a deeper perspective to his writing. Through his work, he aims to bridge the gap between financial theory and real-world application for Indian investors, empowering them to build sustainable, long-term wealth.In his free time, he likes to read and spend time with family.