Govt borrowing may spike yields, dent gilt fund returns due to MTM impact

In April, gilt funds were among the few debt categories to receive positive net flows. The category garnered Rs 2,515 crore of net inflows in April | Photo: Shutterstock
The spike in domestic yields on 10-year government securities (G-secs) is likely to dent returns on gilt funds, which have been gaining traction amid expectations of lower yields, driven by the accommodative monetary policy stance taken by the Reserve Bank of India (RBI).

On Monday, the yields on 10-year G-secs saw a spike of 20 basis points (bps), following the government’s move to raise its borrowing estimate for FY21 to Rs 12 trillion from the earlier estimate of Rs 7.8 trillion.

Gilt funds can tend to run longer durations and as yields move up, there is a negative mark-to-market impact on bond prices. For instance, on a modified duration of six years, a 25-bps upward move on the yields will translate into a mark-to-market impact of negative 1.5 per cent on a gilt fund portfolio,” said Kaustubh Belapurkar, director (fund research), Morningstar.

Gilt funds had gained traction in the past few months as the softening of yields and lower interest rates led to robust returns for the category.

At the end of April this year, the assets managed in gilt funds stood at Rs 12,014 crore, 59 per cent more than last April’s asset base of Rs 7,545 crore.  In April, gilt funds were among the few debt categories to receive positive net flows of  Rs 2,515 crore.

“Investors need to be aware that gilt funds carry significant interest rate risks, which surface when interest rates move. Such funds should ideally be a smaller part of an investors’ overall portfolio as the timing of entry and exit becomes crucial in such

investments,” Belapurkar said.

In the past year, yields on 10-year g-secs have softened from 7.4 per cent to 6.15 per cent. Gilt funds have delivered returns — with 15.6 per cent returns, they comprised the top-performing MF category.

Some market participants say there is still room for upside for long-duration products. “We have flagged before two drivers for long duration: One, valuation is very attractive when compared on the bases of both term spread and expected nominal growth for the year ahead. Two, dynamics between known expansion in deficit and somewhat unknown quantum of financing of this by the central bank is important,” said Suyash Choudhary, head-fixed income, IDFC Mutual Fund.

“We have seen the expansion in deficit, but market yields are reacting to the absence of any absorption plan so far from the central bank of this excess duration supply. The base case here remains that such a plan is coming sooner rather than later.”

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