How do gilt funds react to changing interest rates?

Gilt funds, which primarily invest in government securities, react to changes in interest rates based on the duration and maturity of the bonds they hold. Here's an explanation of how gilt funds react to changing interest rates:

Effect of Rising Interest Rates on Gilt Funds

When interest rates rise, the price of existing bonds generally falls. This happens because new bonds will offer higher yields, making older bonds less attractive. Gilt funds that hold long-term government bonds are more likely to experience a decline in the value of their portfolio as interest rates rise.

Impact: Rising interest rates can lead to a decrease in the Net Asset Value (NAV) of gilt funds, resulting in short-term losses. This is particularly true for gilt funds that invest in long-duration bonds.

Effect of Falling Interest Rates on Gilt Funds

When interest rates fall, the price of existing bonds rises because they offer a higher yield compared to new bonds issued at lower rates. Gilt funds holding long-duration government bonds can benefit from this rise in bond prices.

Impact: Falling interest rates can increase the NAV of gilt funds and potentially lead to capital gains for investors. The longer the maturity of the bonds, the more significant the price increase is likely to be in a falling rate environment.

Duration and Sensitivity to Interest Rates

The duration of the bonds in a gilt fund plays a significant role in determining the sensitivity of the fund to interest rate changes:

• Short-Duration Bonds: Gilt funds focusing on short-term government securities are less sensitive to interest rate changes, resulting in more stable returns.
• Long-Duration Bonds: Gilt funds holding long-term government bonds are more sensitive to interest rate fluctuations, which means their prices can change more significantly with rate movements.

Yield Curve and Gilt Fund Performance

The yield curve represents the relationship between bond yields and maturities. Gilt funds that invest in bonds with varying maturities may react differently to shifts in the yield curve:

• Flattening Yield Curve: A flattening yield curve may indicate a slowdown in economic growth, which could negatively impact gilt fund returns.
• Steepening Yield Curve: A steepening yield curve, where long-term rates rise faster than short-term rates, can benefit gilt funds holding long-duration bonds, as they may offer higher yields.

Active Management of Interest Rate Risk

Fund managers of gilt funds may actively adjust the portfolio to respond to interest rate expectations. This can include:

• Interest Rate Hedging: Using derivatives like interest rate swaps to hedge against rising interest rates.
• Duration Adjustment: Changing the average duration of the fund's portfolio based on market expectations of future rate movements.

Gilt funds are sensitive to interest rate changes, with rising rates typically resulting in price declines and falling rates leading to price increases. Understanding these dynamics and adjusting the portfolio’s duration can help mitigate the effects of interest rate fluctuations on the fund’s performance.