What Is A Gilt Fund? Features, Advantages, Risks, And Who Should Invest

What Is A Gilt Fund?

Someone in their late 20s may prefer to invest in high-risk, high-growth investments like equities and equity-oriented mutual funds. They can afford to take more risks, since they have time on their side.

However, someone risk-averse, or closer to retirement, may prefer something more stable and low risk when choosing their investment options. Debt mutual funds, such as gilt funds, may be an appealing choice for those looking for stable and low credit risk investments.

Gilt Fund Meaning

A gilt fund full form: Government Securities Fund, falls under the umbrella of debt mutual funds, which is a category of mutual funds that invest primarily in fixed-income securities.

Gilt mutual funds invest solely in bonds or interest-bearing securities that have been issued by the state or the central government. These investments are made in instruments with varying maturities, and since the money is invested with the government, these funds tend to carry minimal risk. This feature of low risk makes gilt mutual funds one of the most stable investment options for conservative and long-term investors.

How Do Gilt Funds Work?

Here is how gilt mutual funds typically work: The government requires funds for various short-term and long-term needs. To raise the funds required by the government, the Reserve Bank of India (RBI) acts as the government’s banker and issues government bonds or securities. The RBI gathers money from institutions such as banks and insurance companies and then uses it to lend to the government.

In exchange, the RBI issues these government securities to the market. The mutual fund houses will then invest in these government securities on behalf of investors. The investor can then purchase units of these gilt mutual funds through various fund houses. The Net Asset Value (NAV) of these fund units will vary depending on the fluctuations in interest rates. When interest rates fall, bond prices rise, and the NAV goes up, and vice versa.

Types Of Gilt Funds

As per SEBI classification, gilt funds can be split into two types depending on their investment structure and portfolio duration.

Gilt Funds

Under this category, the fund invests at least 80% of the total assets in government securities across different maturities. These are open-ended debt schemes where, depending on prevailing market conditions and interest rate scenarios, the fund manager can adjust the maturity profile of the portfolio.

Imagine a scenario where the market conditions suggest that the RBI will reduce interest rates soon. Here, to take advantage of the falling rates, the fund manager may decide to switch to government securities with longer maturities.

The opposite holds as well; if rates rise, bond prices fall. Hence, the fund manager may focus on government securities with shorter maturities to cushion the impact on the fund's NAV.

10-Year Constant Maturity Gilt Funds

This type of gilt fund also invests a minimum of 80% of the assets in government securities. However, what sets it apart from the previous category is the portfolio duration. This fund must maintain a Macaulay duration of approximately 10 years at all times, and the fund manager cannot shift to shorter maturities like regular gilt funds. This feature makes the 10-year constant maturity gilt fund more exposed to short-term changes in NAVs due to increased sensitivity to interest rate changes.

Features Of Gilt Funds

Here are some of the key features of gilt mutual funds:

No Credit Risk

Gilt mutual funds are often seen as a safer investment pick. The reason is simple. They invest in government-backed securities, which typically means that the chances of default or credit risk are low to none.

Interest Rate Sensitivity

Bond price and interest rates are inversely related. Gilt mutual funds are very sensitive to the fluctuations in interest rates. A fall in interest rates pushes bond prices higher, which can translate into capital gains. But when rates climb, bond prices slip, and losses may follow.

Suitable for Conservative Investors

As investors’ funds are deployed in government securities, they carry minimal credit risk, making gilt mutual funds a relatively safer option for investors who prioritise stability and lower risk over higher returns compared to other debt mutual funds.

Advantages Of Gilt Funds

There are certain benefits that gilt funds provide, which are useful to know before investing in them. Here are a few listed below:

High Safety (Government-Backed)

As gilt mutual funds are open-ended debt schemes that invest at least 80% of their total assets in government securities across various maturities, they carry relatively low credit risk as compared to other debt funds. This provides investors with a higher sense of safety.

Liquidity

Gilt mutual funds tend to stay highly liquid since they invest in open-ended government securities. Investors have the flexibility to enter or exit the fund at any moment.

Potential For Capital Gains

Since gilt funds have an inverse relation to interest rates, when the central bank cuts interest rates, the prices of existing government bonds in the market go up. Because current funds hold these bonds, a drop in interest rates can lead to a higher NAV, providing the investors with attractive capital gains.

Risks Of Gilt Funds

Though gilt funds provide various benefits, investors should also be aware of the risks inherent in investing in them.

Interest Rate Risk

Gilt funds are mostly exposed to interest rate risk. When the central bank hikes rates, the fund’s NAV can fall fast. Most gilt funds also invest in long-duration bonds with higher maturities. That matters because the longer the bond maturity, the steeper the potential drop in the fund’s price.

Price Volatility

A gilt fund's NAV changes daily based on secondary market bond trading. Additionally, economic data, inflation spikes, as well as fiscal deficit worries can trigger sudden price swings. Exiting the fund during the period of market downturns may cause capital loss.

Lower Returns in a Rising Rate Environment

Gilt funds are highly sensitive to capital losses in a rising interest rate environment. This is because of the strict inverse relationship between bond yield and bond prices. When the central bank raises interest rates, yields go up, which forces the prices of existing lower-yielding government bonds to fall. That drop eventually drags down the fund’s NAV, too.

Who Should Invest In Gilt Funds?

Gilt funds may not be suitable for every investor. Gilt funds are most suited to :

• Conservative or risk-averse investors seeking low credit risk investment options

• Investors prepared to hold their investments for 3 to 5 years or longer

• Investors who want to benefit from capital appreciation by investing in a falling interest rate scenario

• Investors seeking exposure to debt instruments, along with stability and diversification in their portfolio

Gilt Funds Taxation

Gilt mutual funds are subject to capital gain taxes:

• Your returns on the funds are taxed as Short Term Capital Gains (STCG) if you purchased them after 1 April 2023. Your holding period does not change the tax treatment; they are taxed according to your income slab.

• If you purchased the units before 1 April 2023 and hold them for more than 24 months, the gains from such investment are treated as Long Term Capital Gains (LTCG) and taxed at 12.5% without any indexation benefit.

Conclusion

To wrap up, gilt funds go beyond being just government-backed debt mutual funds. They provide stability, diversification of portfolio and considerably lower default risk for investors. Gilt funds provide investors with various benefits; however, investors should still keep in mind the inherent risks, such as sensitivity to interest rates, inflation and macroeconomic risks, before making any decisions.