Bond/gilt markets have already factored in a interest rate hike, which is more than apparent in the shorter term gilt prices. That's not good news for gilt funds.

It does not take an Einstein to figure out the likely interest rate scenario in the shorter term i.e. 6-12 months. The Reserve Bank of India's (RBI) predicament is understandable, given the weakening rupee and inflationary concerns. So now its more a question of when rather than if. What does that mean for gilt fund managers? It does not take an Einstein to figure that out either. A hike in gilt yields will suppress net asset values (NAVs) of gilt funds, making them very unattractive. But first gilt yields. As the table below indicates gilt yields have declined over the past few months.

Yields on Govt. Sec. (Gilts)

Maturity	Minimum YTM (%)
	(Indicative)
	4-Feb-00	9-Jun-00
2000-01	7.46	9.05
2001-02	9.68	9.26
2002-03	9.89	9.59

Source: RBI's Weekly Statistical Supplement

The rise in gilt yields (2000-01) in the short term is an indicator of the negative sentiment on the interest rate scenario. There seems to be some kind of a consensus on an interest rate hike. However, a decline in gilt yields on longer term securities (2001-02, 2002-03) underlines a positive sentiment as far as interest rates are concerned, as dealers do not expect the hike in interest rates to be sustained over that period.

This makes gilt funds unattractive at current levels, and this more than reflected in the returns of most gilt funds over the last few months. However, regardless of the returns, nothing can compare to gilt funds as far as credit risk is concerned, even if the interest rate risk suppresses returns (as is apparent currently). However, investors looking to combine the high returns of a bond fund with the credit risk profile of a gilt fund can target bond funds with a relatively higher exposure to gilts.

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