Gilt Funds
In India, a Gilt Fund is a mutual fund scheme that invests primarily in government securities (G-Secs) issued by the central or state governments. These funds are considered among the safest mutual fund options due to minimal credit risk, as repayment is backed by the government.
Key Points: Gilt funds are not immune to volatility NAV can fluctuate sharply in response to rising or falling interest rates. Suitable for conservative investors but best understood as a tool for capital preservation and diversification, not aggressive wealth creation.
Returns and Suitability
- Returns: Typically moderate, reflecting G-Sec yields. Returns rise when interest rates fall and vice versa.
- Suitable for:
- Risk-averse investors
- Investors seeking diversification
- Medium- to long-term investors (3–5 years or more)
Features of Gilt Funds
- Investment Focus: Gilt funds invest at least 80% of their portfolio in government securities (G-secs)
issued by the central or state governments, including State Development Loans. - Low Credit Risk: Since these securities are backed by the government, gilt funds carry minimal to no credit/default risk, making them one of the safest debt fund categories.
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- Interest Rate Sensitivity: The NAV of gilt funds fluctuates inversely with interest rate changes. When interest rates fall, gilt fund NAVs tend to rise and vice versa. Thus, they are exposed to interest rate risk, which is their primary source of volatility despite negligible market or credit risk.
- Returns: Gilt funds generally provide moderate but relatively stable returns, often better than fixed deposits, especially during a falling interest rate regime. Returns can range typically from about 8% to 10% annually over the medium to long term, depending on interest rate trends.
- Portfolio Diversification: Due to their low correlation with equity markets, gilt funds are effective diversifiers within an investment portfolio.
- Investment Horizon: Suited for investors with a medium to long-term horizon (3 years or more), as interest rate volatility can cause short-term fluctuations in NAV.
- Taxation:
- For investments made on or after April 1, 2023, all capital gains—irrespective of holding period—are taxed at the investor’s income tax slab rates with no distinction between short-term or long-term gains and no indexation benefits.
- For investments made before April 1, 2023, long-term capital gains (held beyond 24 or 36 months depending on sale date) are taxed at a concessional rate of 12.5% without indexation, while short-term gains attract slab rates.
- Dividends (IDCW) from gilt funds are taxed as ordinary income at slab rates, and TDS at 10% may be applicable if dividend income exceeds ₹5,000 per year.
- Expense Ratio: Like other mutual funds, gilt funds charge an expense ratio, typically ranging from around 0.15% to 0.6%, which impacts net returns.
- Accessibility: Gilt funds provide retail investors access to government securities which are otherwise difficult to invest in directly.
- No Market Risk: As gilt funds do not invest in equities or corporate bonds, they are free from equity market volatility and credit risk associated with corporate debt.
How does Gilt fund work
A Gilt Fund is a type of debt mutual fund that invests at least 80% of its assets in government securities (G-secs) issued by the central and state governments. Here’s how it works in practice:
- Pooling Investor Money:The fund collects money from multiple investors, pooling their investments into a large corpus.
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2. Investment in Government Securities: The fund manager uses this corpus to buy government bonds and securities issued by the Reserve Bank of India (RBI) on behalf of the government. These government securities have fixed maturities and pay periodic interest (coupon).
3. Earning Returns: The government securities held by the fund pay regular interest, which generates income for the fund. The fund’s overall returns come from:
- Interest income earned on the government bonds.
- Capital appreciation or depreciation resulting from changes in interest rates. When interest rates fall, the market value of government bonds rises, increasing the net asset value (NAV) of the fund, and vice versa.
4. Managing Duration and Maturities: The fund manager actively manages the portfolio, selecting a blend of short, medium, and long-term government securities to optimize returns while managing interest rate risk.
5. NAV Movement: Since bond prices move inversely with interest rates, gilt funds’ NAV fluctuates accordingly. Investors who stay invested longer can potentially benefit from capital appreciation when interest rates decline.
6. Redemption: Investors can redeem their units at NAV prevailing at the time of redemption. Gains are realized when units are sold.
7. Safety and Risk: Because the underlying securities are backed by the government, credit risk/default risk is negligible, making gilt funds one of the safest debt mutual fund options. However, they carry interest rate risk, meaning the market value can fluctuate as interest rates change.
8. Taxation: Gains realized on redemption are taxed as per debt mutual fund rules. For investments made on or after April 1, 2023, all gains are taxed at your income tax slab rate without distinction of short or long term.
Simplified flow:
Government needs funds → RBI issues bonds → AMC of gilt fund buys these bonds → bonds pay interest and mature → fund’s NAV changes with interest rates → investor earns returns via NAV appreciation and/or dividends.
Pros and cons
Pros
- High Safety and Near Zero Credit Risk: Invest primarily in government securities backed by central/state government, virtually no default risk.
- Suitable for Conservative Investors: Ideal for those seeking capital preservation and stability during economic uncertainty or market volatility.
- Potential for Capital Gains: Bond prices rise when interest rates fall, offering capital appreciation alongside fixed interest income.
- Consistent Income Stream: Gilt funds distribute coupon interest from government bonds, providing predictable income, useful for retirees or income seekers.
- Portfolio Diversification: Low correlation with equities helps reduce overall portfolio risk.
- Access to Government Securities: Enables retail investors to invest in government bonds that are otherwise unavailable to individuals directly.
- Open-Ended and Flexible: Investors can enter or exit at NAV anytime; SIPs are possible to average out risk.
Cons
- Interest Rate Risk: Highly sensitive to interest rate changes; NAV falls when interest rates rise, causing volatility.
- Price Volatility: Longer maturity gilt funds experience larger NAV swings, unsuitable for short-term investment.
- Lower Returns Compared to Equity: Focus on capital protection leads to moderate returns, which can lag inflation and equity returns over long term.
- No Inflation Protection: Returns are not inflation-adjusted, so real returns may be negative in high inflation periods.
- Lower Liquidity: Government bonds may be less liquid than equities or other debt funds, possibly delaying quick redemption.
- Expense Ratios: Fund management fees (up to 2.25%) reduce net returns.
- Taxation: For investments on or after April 1, 2023, gains are taxed as short-term capital gains at slab rates regardless of holding period, limiting tax efficiency.
- Risk in Rising Interest Rate Environment: Rising rates can lead to losses, especially if redemption is required during such periods.
