YOUR QUESTIONS: Government funds should perform well near the peak of the interest rate cycle
How should I consider investing in government funds? Can I expect stable returns over a five-year period?
Government funds are a category of fixed income funds with a mandate to invest at least 65% of total assets in government securities (G-sec) across maturities. These funds do not involve any credit risk as they invest in sovereign instruments and therefore offer a relatively lower return compared to a company of comparable duration. However, the underlying portfolio is more liquid since G-sec are generally relatively more liquid than corporate debt securities.
Since these funds have no duration restriction to maintain, this is a diversified category with funds having a modified duration in a wide range of 2 to 9 years (as of August 2021). Funds that maintain a higher duration are more volatile due to greater sensitivity to changes in interest rates and, therefore, subject investors to potentially higher interest rate risk. The prices of fixed income securities have an inverse relationship with interest rates.
Given the current steep yield curve, most funds currently maintain a longer duration to benefit from the higher yield offered. However, funds that maintain a longer duration could be negatively affected if interest rates rise amid concerns about additional supply and monetary tightening amid high inflation and a slowing US Fed.
The performance of these funds could be volatile over short periods of time and subject to management of interest rate fluctuations. However, over a reasonably long horizon (at least 5-6 years), these funds can be expected to produce decent returns along with indexing benefits available for holding periods of more than 3 years. Such funds are more likely to perform well near the top of the interest rate cycle, with the likelihood of a subsequent fall in interest rates leading to substantial capital gains. Investors might view these funds as part of their tactical asset allocation.
To gain exposure to funds with relatively stable returns, you may want to consider investing in funds with relatively low interest rate and credit risk, such as bank PSU funds, corporate bond funds. and ST Income Funds. You may also want to consider some exposure to floating rate funds, which generally perform well in a rising interest rate scenario.
The author is Director, Investment Advisory, Morningstar Investment Adviser (India). Send your questions to [email protected]