What are Gilt Mutual Funds?

The world of mutual fund investing is vast. Investors often base their investment decisions on their risk profile. Therefore, those seeking the safety of capital can consider gilt funds that invest primarily in government securities. The funds mobilised through gilt funds are utilised to finance the government’s infrastructure projects or other expenses. Let’s understand the basics of gilt mutual funds, the advantages of investing in them and how to pick the right one. 

What are Gilt Funds?

When lending money to someone, we want to pick the most trustworthy borrower who is unlikely to default on repayment. Undoubtedly, there isn’t a more credible borrower than the government. So, gilt funds give investors the opportunity to invest in bonds issued by the state or central government.

A gilt fund is a type of debt fund that invests in fixed-income government securities with different maturities. According to the guidelines by the market regulator SEBI, gilt funds have to invest at least 80% of their assets in government securities and the rest in cash or cash equivalents. 

Gilt mutual funds are suitable for investors who have a low-risk tolerance and seek capital preservation. They have minimal credit risk due to the government's backing, making them a safe investment option.

Types of Gilt Mutual Funds

There are two types of gilt funds in India:

• Gilt funds that invest in government securities that mature at different durations.
• Gilt funds that invest in government securities with a constant maturity of ten years. They are required to invest at least 80% of total assets in securities with 10-year maturity. Interestingly, these government securities serve as the benchmark for interest rates throughout the economy and the money market.

How Do Gilt Mutual Funds Work?

Now that we have understood what gilt funds are, let’s take a look at how they work.

State and central governments need funds for various purposes, such as to finance infrastructure projects, for socio-economic activities or to manage the fiscal deficit. The government approaches the Reserve Bank of India (RBI) to acquire these funds.

As the banker to the government, RBI issues government securities or gilts for a fixed tenure and interest rate.

Gilt mutual fund managers acquire these interest-bearing securities, effectively lending to the government. Upon maturity, the RBI repurchases the securities by paying back the principal amount along with the accrued interest.

While gilt mutual funds can offer substantial returns and carry minimal to no default risk, they face interest-rate risk.

Interest rates and gilt funds have an inverse relationship. When interest rates rise, the prices of existing government securities typically fall. This happens because new securities are issued with higher interest rates, making the older securities with lower rates less attractive. As a result, the value of the existing securities decreases, leading to a decline in the NAV (Net Asset Value) of gilt funds holding those securities.

Conversely, when interest rates fall, the prices of existing government securities usually rise. This occurs because the older securities with higher rates become more valuable compared to new securities with lower rates. Consequently, the NAV of gilt funds holding these securities increases.

Therefore, gilt funds benefit from falling interest rates and suffer from rising interest rates. 

Let’s understand this with an example.

Imagine a gilt fund holding government bonds with a fixed interest rate of 4%. 

Scenario 1: Rising Interest Rates

Suppose RBI increase the interest rates from 4% to 6%. New government bonds are now issued at a higher 6% rate. Investors will find these new bonds more attractive than the older 4% bonds. Consequently, the price of the existing 4% bonds will drop because their lower yield makes them less desirable. As a result, the NAV of the gilt fund, which holds these 4% bonds, will decrease.

Scenario 2: Falling Interest Rates

Suppose the central bank lowers interest rates from 4% to 2%. New government bonds are now issued at the lower 2% rate. The older bonds with the 4% rate become more attractive since they offer a higher return compared to the new ones. As a result, the price of the existing 4% bonds will rise, increasing the NAV of the gilt fund that holds these bonds.

Benefits of Investing in Gilt Funds

Investing in gilt funds has the following benefits:

Low credit risk: Gilt mutual funds carry minimal-to-no credit risk as they invest in government securities. The government is unlikely to default on its obligations, making them suitable for investors seeking low-risk investments.

Reasonable Returns: Gilt funds tend to offer reasonable returns to investors at virtually no risk. The returns offered by them are often more than fixed-income instruments like bank FDs or savings accounts. 

Access to Exclusive Investment Instruments: Few government securities are unavailable to retail investors but only to institutional investors. Therefore, investing in gilt funds gives investors access to such exclusive investment instruments. 

Risks of Investing in Gilt Funds

Gilt funds are exposed to the following risks:

Interest Rate Risk: When interest rates rise, the prices of existing bonds typically fall. This happens because new bonds are issued with higher interest rates, making the older ones with lower rates less attractive. This can hurt the NAV of the fund. Further, gilt funds with longer-duration securities are more vulnerable to interest rate fluctuations.

Lower returns: Generally, investments that carry higher risk offer higher returns. Given their low-risk nature, gilt funds offer lower returns than other equity and hybrid mutual funds.

Who Should Invest In Gilt Funds?

Risk-averse investors who want to invest in debt instruments with minimal credit risk can look to invest in gilt funds. Further, these funds are suitable for investors with an investment horizon of 3-5 years. Apart from this, gilt funds can also be opted by investors looking to diversify their portfolio with a low-risk investment option. 

Factors To Consider Before Investing In Gilt Funds

Before investing in a gilt mutual fund, investors should consider these parameters:

Risk: While gilt funds are one of the safest instruments as they don’t carry any default risk, they suffer from interest rate risk. When interest rates rise, their NAVs tend to take a hit. Mutual fund managers don’t generally recommend gilt funds as investing in them requires sufficient knowledge of interest rate movements. 

Return: Although gilt funds generally offer consistent returns, they are not guaranteed and can vary with interest rate changes. Investors should ideally invest in them when interest rates are lower. They often outperform equity funds during economic downturns as investors seek safer options.

Investment Horizon: Gilt mutual funds are suitable if you have an investment horizon of around 3-5 years as a gilt fund’s portfolio has an average maturity that varies between this duration.

Expense Ratio: The expense ratio is the fee charged by the fund house for managing the mutual fund. A lower expense ratio generally results in higher returns. Though SEBI has set the upper limit of a gilt fund’s expense ratio at 2.25%, its operating cost can vary depending on the fund manager’s strategy.

Taxation of Gilt Funds

If you have invested in gilt funds before April 1, 2023, then returns on units redeemed within 24 months are taxed as short-term capital gains (STCG) and after 24 months as long-term capital gains (LTCG). STCG tax is applied at your income tax slab rate while LTCG tax is applicable at 12.5% with no indexation.

However, returns on investments made on or after April 1, 2023, are taxed as per your income tax slab rate. 

How To Invest In Gilt Funds

You can invest in gilt mutual funds easily through the INDmoney app. Here's how

• Open the app and log in with your credentials.
• Navigate to the "Mutual Funds" section within the app.
• Use the filter to select "Gilt Mutual Funds" to view the available choices.
• Decide between a lump sum investment or a Systematic Investment Plan (SIP) for regular investments.
• Enter the desired investment amount and confirm the transaction.