InvestorQ : Why is the interest rate inversely proportional to returns on GILT funds?
Gauravi Patel made post

Why is the interest rate inversely proportional to returns on GILT funds?

Nitin Shah answered.
3 years ago
Gilt funds are debt funds that invest in government securities. As per SEBI norms, gilt funds have the mandate to invest at least 80% of their assets in government securities. Since these schemes invest in government securities, they have zero default risk. However, they have a very high-interest rate risk. Bond prices follow an inverse relation with yields. i.e. If yields go down, bond prices go up, and thus there is a positive mark-to-market impact on Gilt fund NAVs/returns. On the flip side, if yields start moving upwards, there will be a negative MTM impact on gilt fund NAV/returns.

Let us understand why this happens-

If you were to hold a bond that pays a coupon of 7%, and the interest rates are headed downwards to 6%, then a bond that pays 7% becomes more valuable, i.e. the bond price move upwards. The contrary holds too. When the Reserve Bank of India (RBI) starts reducing rates, the demand for government securities issued earlier goes up because they carry a higher interest rate. When the demand goes up, their price goes up and yields fall.

However, when RBI pauses on rates or starts hiking policy rates, the opposite trend happens. Since the new bonds will carry a higher interest rate, demand for older bonds drops, or traders sell them. This results in their prices dropping and yields going up.