What are Gilt Funds: Definition, Risk, And Returns

While equity funds offer the potential for relatively higher returns, they also carry a higher level of risk than debt funds. Some investors may prioritise less volatility on capital invested over a higher potential return on investment is lower. Other may seek a steady stream of income from their investment at a relatively lower level of risk than equity-based investment instruments.

For such investors, gilt funds can be a suitable choice.

• Table of contents

1. What are gilt funds?
2. Types of Gilt Funds
3. How do Gilt Mutual Funds work?
4. Tax implications of gilt fund investments
5. Who should invest in gilt mutual funds?
6. What are the advantages of investing in gilt funds?
7. Advantages of investing in gilt funds
8. Factors to Consider Before Investing in Gilt Mutual Funds

What are gilt funds?

Gilt funds are a type of debt mutual funds that invest primarily in government securities issued by the central and state governments of India, and the Reserve Bank of India (RBI). These debt instruments may have different maturity profiles, coupon rates, and yields. According to the Securities and Exchange Board of India (SEBI) mandate, gilt mutual funds must invest at least 80% of their money in debt instruments issued by the Indian government.

Types of gilt funds

Gilt funds are primarily of two types. The first type (simply called gilt funds) invests in government securities across various maturities, providing diversification in maturity periods. The second type (gilt fund with 10 year constant duration) predominantly invests in assets that have a portfolio Macaulay duration of 10 years. Macaulay duration is a measure of how long, on average, it takes to get back the money invested in a bond, considering all the payments (interest and principal) the bond makes. It’s expressed in years and helps bond investors understand interest rate risk. The higher the duration, the more the bond's price is likely to change with interest rates.

How do gilt mutual funds work?

Gilt mutual funds pool money from investors to invest in government securities with varying maturities. Returns are generated through interest income. Additionally, interest rate changes also influence the fund’s Net Asset Value on a given day. Rising rates lower the market value of existing bonds, while falling rates increase their market value (due to the inverse relationship between bond prices and interest rates).

Fund managers play a key role in selecting securities to optimise the return potential while mitigating risk. Since gilt funds are backed by the government, they offer relative stability and low default risk, but are subject to interest rate fluctuations.

Investments of gilt funds

Gilt funds are invested in:

• Central government bonds
• State government bonds
• Treasury bills
• State development loans
• RBI fixed rate bonds
• RBI floating rate bonds
• Inflation-indexed bonds

The actual investment portfolio of gilt funds may differ. It is important to note here that gilt funds may also invest up to 20% in debt and money market securities other than government securities. You can find this information in the Scheme Information Document (SID).

Tax implications of gilt fund investments

The tax implications of gilt fund investments depend on recent changes in tax laws. For investments made after April 1, 2023, all capital gains are treated as short-term and taxed as per the investor's income tax slab rate, regardless of the holding period. Previously, long-term capital gains (LTCG) were taxed at 20% with indexation benefits for holdings over three years, but this benefit is no longer available for newer investments.

Who should invest in gilt mutual funds?

You can consider investing in gilt funds if:

• You are a conservative investor and averse to investments that carry a relatively higher level of credit risk.
• You have a short to medium investment horizon.
• You want to diversify your equity-heavy investment portfolio.
• You are looking for a stable return potential through periodic interest payments received by the scheme.
• You are a retiree who wants to generate a predictable income stream in the form of periodic Income Distribution cum capital withdrawal (IDCW).

Advantages of investing in gilt funds

Now that you understand the gilt funds meaning, you need to know about the benefits of investing in them:

• Relatively lower risk: Government securities held by gilt funds are backed by the sovereign guarantee of the central and state governments of India and RBI. This makes them one of the most stable mutual fund investment options available with minimal credit risk.
• Regular stream of income: Gilt funds can provide a stable return potential by investing in government securities with fixed coupon rates and maturity dates. Investors seeking predictable income streams in the form of IDCW may find this particularly desirable. However, investors must note that after payment of IDCW, NAV will fall to the extent of payout and statutory levy.
• Portfolio diversification: Investors can use gilt funds to balance out a portfolio heavily invested in equity-based investments and align its risk profile with their unique risk appetite.

Factors to Consider Before Investing in Gilt Mutual Funds

Gilt funds may be suitable for the objective of capital preservation and accessing a reasonable return potential over the medium to long-term. However, it is advisable to carry out due diligence before making an investment.

First, evaluate interest rate risk, as gilt funds are highly sensitive to changes in interest rates. Falling interest rates can lead to capital appreciation, while rising rates may diminish returns.

Second, assess your investment horizon; gilt funds are better suited for medium to long-term investors who can withstand potential short-term volatility caused by rate fluctuations. Additionally, consider the fund's performance history, the expertise of the fund manager, and the expense ratio, as these factors directly impact net returns.

Gilt funds can be suitable for conservative investors seeking a stable return potential with minimal credit risk since they invest in government-backed securities. However, they are not completely risk-free due to their sensitivity to economic conditions.

Lastly, analyse the macroeconomic environment, including inflation trends and expected interest rate movements, as these influence gilt fund performance.

Diversification benefits also make gilt funds attractive, but they should complement your overall portfolio strategy rather than serve as a standalone investment.

To conclude, gilt funds offer investors the opportunity to invest in securities issued by the central and state governments and RBI. Investors stand a chance to get a stable return potential with gilt funds while diversifying their portfolio and prioritising less volatility on capital invested. It is recommended to evaluate their interest rate, expense ratio, and credit quality before adding them to your investment portfolio.

FAQs:

Where are gilt funds invested in?

Gilt funds are invested in central and state government securities across different maturities, issuers, and types. These may include central government bonds, treasury bills, state government bonds, state development loans, RBI fixed-rate bonds, and so on.

How long should I hold my investment in gilt funds?

Gilt funds are suitable for short to medium investment horizons. However, it is imperative that investors consult a financial advisor before making any investment decisions.

How are gilt funds affected by interest rate changes?

When interest rates rise, the bond prices fall. When the interest rates fall, the bond prices rise. Since gilt funds are essentially government bond funds, interest rate changes affect their Net Asset Value (NAV) as well.

What are the risks involved in gilt debt fund investments?

Gilt debt funds are primarily exposed to interest rate risk, where rising interest rates can lead to a decline in bond prices and thereby, the net asset value of the fund. They also face inflation risk and occasional liquidity risk. They may also face credit risk. However, that is quite low as they invest in government-backed securities.

Who should invest in gilt funds?

Gilt funds can be suitable for risk-averse investors seeking relative stability of capital and moderate return potential over a medium to long-term horizon. They may also be considered by those looking to diversify equity-heavy portfolios or generate the potential for income through government securities.

Is investing in gilt funds safe?

No mutual fund is safe. However, gilt funds can be considered relatively stable because they invest in government bonds, which are not as volatile as stocks and carry minimal credit risk. However, they are not risk-free as they remain vulnerable to interest rate fluctuations and market conditions.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.