NEW DELHI: The common wisdom in debt markets is that there is no better time to buy into a gilt fund than when interest rates are decreasing. With the Reserve Bank of India continuing to make repo rate cuts over the past several quarters and risks for other categories of funds rising, many investors may be tempted to buy into a gilt fund--where returns rise as interest rates fall.But, these are also highly volatile investments which may not be best suited to the average retail investor, experts note.
An essential requirement before investing in these instruments is to understand how returns are generated for gilt funds. Gilt funds exclusively invest in government bonds or G-secs. These bonds are effectively loans the purchaser gives to the issuer--and the latter promises to pay a certain fixed interest (this is the yield for the bond purchaser).
However, bond prices, which determine returns for gilt funds, move inversely to prevailing interest rates. When interest rates fall, bonds which offer fixed rates become more attractive and their prices rise. When interest rates rise, the inverse happens—prices fall because there are new bonds with higher yields.
“These are great for people who are looking to time the markets, get in when rates are low and out when they are high,” says Krishna Kumar, a financial planner from Chennai. “But, short term volatility is very high because they have very high interest rate risk”. Some swing as high as 7-8 per cent one week, but take a loss of 8-9 per cent in another. “Since interest rates are falling, one-year gilt fund returns are in double digits. But, high volatility in the short and even medium term is a real possibility,” added a debt MF executive, “it is best for retail investors to stay invested for 5-7 years”.