Policy rates in India seem to have peaked, while rate cuts may still be six-seven months away. This seems to be the main takeaway from the monetary policy review last week.

But markets usually factor in events before they materialise. What’s more, Indian government bonds are set to be included in the JP Morgan GBI-EM global index from June this year. Higher foreign investor flows into government bonds will push government security (g-sec) prices up and their yields down in the market. So, if you are looking to gain from falling interest rates, the time to invest is now.

When interest rates decline, it pays to own long-duration bonds in your portfolio. Prices of long-duration bonds appreciate more than short-duration ones when rates fall. Today, there are long-duration debt mutual funds that allow you to own government bonds going up to 25- to 30-year maturity.

But such funds will be extremely sensitive to even small rate moves. G-secs are likely to turn much more volatile with higher foreign investor participation. Therefore, it may be better to play the falling rate opportunity with g-secs of slightly lower maturity. One option to do this is five- and 10-year constant maturity funds, which we have already recommended.

For investors who would like to leave the timing and maturity profile of g-secs to a fund manager, actively-managed gilt funds are a good choice. SBI Gilt Fund is a good option for investors to consider, given its strong long-term track record of navigating rate cycles.

Why this fund

Given that gilt funds perform only when rates are on a downtrend, their trailing and point-to-point returns are a poor way to gauge their performance. SBI Gilt Fund is no exception, with its annual returns for the last three years in the 3 to 7 per cent range. This was during a rising rate cycle.

A rolling return analysis of the fund over the last decade (January 2014 till date), to capture its performance across ups and downs in rates, shows that the fund has navigated cycles well.

Over the last 10 years, SBI Gilt Fund delivered a 1 per cent NAV loss in its worst year and gained 23 per cent in its best year. Its one-year returns average to 9.4 per cent, if all one-year rolling periods are taken into account.

In terms of distribution of returns, the fund scores with very few negative years (2 per cent of the time) and many double-digit years. It delivered over a 10 per cent annual return about 42 per cent of the time. The fund compares favourably to its peers both in terms of downside protection in bad times and the ability to deliver high returns in good times.

One of the main features of gilt funds, which put off investors, is their tendency to deliver losses when market conditions are adverse. The past decade has seen the gilt fund category deliver a 16 per cent gain in its best year (2014) and a 2 per cent gain in its worst year (2022). Over shorter periods such as a quarter, the category has delivered a 3-4 per cent loss in NAV. 

SBI Gilt has fared well on this aspect. The fund contained its downside better than the 10-year constant maturity fund in its worst year (1 per cent against 1.92 per cent) and did better than a constant maturity 10-year fund in its best year (23 per cent versus 19.5 per cent on constant maturity).  

Why invest
Very few negative years (2 per cent of the time)
Navigates rate cycles smartly
Recorded double-digit annual returns for a good part the past decade
Portfolio strategy

SBI Gilt Fund has been managing its portfolio maturity actively in the recent years. In January 2022, before RBI flagged off this rate hike cycle, the fund’s portfolio carried an average maturity of about six years. This was quickly reduced to 1.6 years by April 2022, when rate hikes commenced. By April 2023, when the RBI went into pause mode, the average maturity was elongated to 9.7 years. Since then, it has crept up further to 12.7 years and seems well positioned to capitalise on a rate reversal. The fund invests 75-85 per cent of its portfolio in g-secs and about 5-15 per cent in State Development Loans which offer slightly better yields.

Taking duration calls based on the future direction of rates requires an experienced manager at the helm. SBI Gilt has this in Rajeev Radhakrishnan, who has over two decades of experience. He is aided by co-manager Tejas Soman with nine years experience.  

Given that the yield gilt funds can offer is limited, a high expense ratio can substantially eat into returns. SBI Gilt Fund’s direct plan expense ratio at 0.46 per cent is among the lowest in the category. Its regular plan expenses of 0.94 are also in the bottom quartile.

A final caveat. Because their returns can swing wildly from year to year, gilt funds are not suitable for the typical income-seeking debt investor who dislikes volatility. Wrong calls on duration by the fund can also cause capital losses.