Inflows into Gilt Funds have picked up.

A few things investor friends should keep in mind before getting excited...

Back to the basics. Debt funds have two kinds of risks.

The first is credit risk which we have heard a lot about. Yes, gilt funds do not have credit risk.

The second is duration risk, the risk of price movements due to interest rates. The longer the tenure of the fund the larger the duration risk. If rates go up sharply, a long duration fund will show negative returns. Go back to mid 2013 as an example.

Gilt funds have long durations - often 8 to 10 years. And hence they carry significant duration risks.

If it is difficult to time entry and exist into equity markets, timing interest rates is also very tough! Investors don’t get it right.

Gilt funds have delivered fabulous returns in the last year because of rates falling. You may see 12-18 percent returns. Do not buy them expecting this. You will be disappointed.

Do not also buy them as a substitute for a ultra short fund because you are chasing safety. To try and solve one problem you will create another one.

If you are really really terrified and want to park short term money, use the Overnight fund (1 day assets).

If you buy a gilt fund make sure you have a very long term horizon. My own belief, target maturity structures are better than gilt funds. Their duration starts at 3, 5, 10 etc and keeps falling over the life. That way if you hold to maturity you don’t have duration risk.

These funds exist - and with high quality credit. Bharat Bond, some corporate bond funds and some Bank PSU funds, have target maturity structures. They are called rolldowns also. You can just check the duration of them and match it to your investment goal tenure.

Also, today, the yields in quasi sovereign (AAA PSU) companies are at a significant premium (1 percent) to sovereign. Historically high premiums. As an investor, this may provide you a better risk return profile. My own view.

Finally full disclosure: I run a gilt fund and have no problem with it. I only worry when money flows into a category without understanding it fully, and then investors have a bad experience. The questions I got on social media inspired me to write this!

A little addition on duration risk, for those who have asked. Why do bonds change value when interest rates move?

Imagine if you had a bond of value 1000 rupees paying 5pc interest over 5 years. Annually. 50 rupees a year.

If you held the bond for 5 years (and assume it’s a government bond so no default risk) regardless of what happens to interest rates in 5 years you will get 1000 rupees back plus 5 installments of 50 rupees. So if you hold to maturity then no duration risk.

But now look at the short term. Interest rates move to 6pc. Isn’t your bond giving 5pc a lot less valuable now? Yes. And in the short term your bond price or bond fund value has fallen. If rates move to 4pc the reverse happens.

The impact is less for bonds maturing in 1-2 days, because there are less payments to receive and more for bonds maturing in 5-7 years. This is why bonds or bond funds with more duration have more sensitivity to interest rate risk.

Duration captures this. It’s not the same as maturity. But it tells you how much a bonds price will move for every 1 percent move in rates. For long duration funds of 8 years a 1 Pc fall in rates means 8 percent return. Now you know why gilt funds have made money in last year!