Long-duration, gilt mutual fund schemes lose shine as yields spike

Negatives largely priced in but outlook remains uncertain, say experts

The spike in government security (G-Sec) yields amid the West Asia crisis has eroded the near-term gains of long-duration and gilt mutual fund (MF) schemes, dragging their three-year and five-year returns below those of lower-risk short-duration funds. 

As of May 19, the average one-year return of gilt funds and long-duration funds were -1 per cent and -2.7 per cent, respectively, shows data from Value Research. The annualised three-year returns of the two categories that carry the highest duration risk stood at around 5.5 per cent, the lowest among all debt scheme categories. 

Typically, the two longer-duration funds are expected to outperform medium to long investment horizons, as their exposure to higher-duration papers enhances return potential. However, the recent surge in yields has eroded this advantage. 

The 10-year G-Sec yield has risen around 45 basis points (bps) since the US-Iran conflict began in February-end. The yield is currently at a 2-year high level. The 30-year G-Sec yield is up 36 bps in the same period and is currently at levels last seen in June 2022. 

A rise in yields is negative for bond investors. The longer-duration papers witness sharper mark-to-market losses due to their higher sensitivity to interest-rate movements. 

“Long-duration debt funds have faced pressure as long-term bond yields have remained elevated despite expectations of monetary easing. Unlike short-term debt, long-duration funds are highly sensitive to interest-rate movements, making them vulnerable to sticky inflation, large government borrowing, and global bond-market dynamics,” said Jiral Mehta, senior manager — research, FundsIndia. 

According to experts, while the bond market may have already priced in all the negatives, the global uncertainty calls for a cautious approach towards higher-risk debt funds. 

“Given the risks, we believe it will still be a volatile period for long-duration bonds. We think the conditions need to be closer to a rate-easing cycle for this to be attractive,” said Vivek Rajaraman, managing director — listed investments, Waterfield Advisors. 

Joydeep Sen, corporate trainer (financial markets) and author, said the higher-duration funds can be suitable for investors having a longer investment time frame (over three years). 

“The spread between the repo rate and the 10-year G-Sec yield is currently far above its long-term average, indicating that bond yields have already priced in many of the expected negatives such as inflation and higher issuances. While that limits the scope for a sharp further rise in yields, investors should still align fund duration with their investment horizon rather than try to time the market,” said Sen. 

For investors with a shorter investment time frame, shorter-duration schemes and hybrid funds are better suited currently, experts said.

 

“Shorter-duration bonds will be better placed at this juncture as they will have less mark-to-market impact if the yields go up from here. Income Plus Arbitrage funds are well placed from exposure, duration, and tax considerations," Rajaraman said.

 

"At FundsIndia, we prefer debt funds with high credit quality and short duration (one-three years)," said Mehta.