Gilt Mutual Funds

Gilt Funds or Government Sector Mutual Funds are a popular choice for investors looking to invest in government securities. Known for their low-risk, steady returns, these funds make a great choice for investors looking to diversify their portfolios. Let’s look at the best-gilt funds in India and how you can choose one for yourself.

What are Gilt Mutual Funds?

Government sector mutual funds or GILT mutual funds invest in government securities. These securities are issued by the Reserve Bank of India on behalf of the central or state government and are called ‘gilt securities’.

When you invest in these securities, you put your money in some central or state government project, which is why safety is foremost. These are medium-to-long-term securities, with maturity ranging from 8 to 10 years.

SEBI (Securities and Exchange Board of India) has issued guidelines where these Government Sector Funds are required to invest at least 80% of their funds in Government Securities and State Development Loans and the balance in cash and cash equivalents.

Best Gilt Mutual Funds

List of the top-performing gilt mutual funds sorted by returns with their AUM and Expense Ratio.

Why are they called Gilt funds?

Gilt funds are issued in India and other Commonwealth countries. The term ‘gilt’ originates from the time when the British government issued bonds with gold-coated edges.

These certificates served as a symbol of reliability that the government would not default on these securities. While physical certificates are a thing of the past, the term ‘gilt’ remains in use today, representing low-risk investments backed by the government. They are considered free from any credit risk.

How do Gilt Funds work?

Gilt funds are a type of debt mutual fund.  Whenever the Central and State Governments have fund requirements, either for a new infrastructure project or socio-economic development they reach out to the Reserve Bank of India (RBI) for these funds. You can think of RBI as the Government’s bank for this purpose. They issue ‘gilt securities’. These securities have a pre-defined maturity date and interest rates. Mutual fund houses then offer schemes that invest specifically in these ‘gilt securities’. 

For example, if you invest ₹10,000 in a gilt fund with a 10-year maturity and a 7% interest rate, your money is deployed into these gilt securities. Over time, the government pays 7% interest to bondholders, and when the bond matures, it repays the principal amount. As an investor, you benefit from regular interest payments and potential capital appreciation of the bonds.

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. 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.

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.

What are the benefits of investing in Gilt Funds?

Let’s look at the advantages of investing in these government-backed securities:

Relatively Safer

Gilt funds primarily invest in government securities. The possibility of the government defaulting on these bonds is relatively much lower than that of any equity fund. These funds are best suited for conservative investors whose goal is capital preservation.

Diversified Portfolio

If you’re building a diversified mutual fund portfolio, government-backed securities can help balance risk, especially when paired with equities. For example, Rahul, a working professional, is a moderately aggressive investor. He is planning for his higher education and wants stability alongside growth for his investments. To balance market fluctuations, he allocates a portion to gilt funds, ensuring part of his savings remains secure.

Capital Appreciation

Government sector funds thrive when interest rates in the market fall. This is because, when the interest rate goes down, bond prices rise. Hence, someone invested in a gilt fund would not only benefit from interest income but also capital appreciation.

High Liquidity

Unlike fixed deposits or close-ended mutual funds, government sector funds are open-ended mutual funds; meaning investors can buy and sell their investment anytime. 

Who should invest in Gilt Funds?

Deciding if a particular investment is good for you or not is a tough choice. You can invest in a gilt mutual fund if you associate with the following investing traits:

1. You believe in capital preservation

If you prefer stable returns and capital preservation, government sector funds can be a good choice. Since these funds aren’t directly linked to the market, they experience fewer price fluctuations. For instance, if you're saving for a specific goal or need a steady income stream, investing in government bonds over equities ensures more stability and predictability in your returns.

2. You do not like risky investments

If you are a risk-averse investor and if price fluctuations in equity funds make you uncomfortable, debt funds are a better choice. Since the bonds in these funds are backed by the government, the possibility of credit risk is very low. 

3, You want to diversify your portfolio

If you're open to some risk but also want stability, diversifying with government bonds can help. By allocating a portion of your portfolio to low-risk investments, you ensure that part of your capital remains secure. In contrast, your equity or high-risk investments continue to drive growth.

What are the risks associated with Government Sector funds (Gilt Funds)?

While government sector funds are a relatively safe investment, there might still be certain risks associated with them:

1. Interest rate risk: Interest rates and bond prices have an inverse relationship. When interest rates rise, bond prices fall. If investors choose to liquidate their investments during this period, they might experience short-term losses.

2. Inflation risk: Gilt funds offer fixed returns. This means that if inflation is high and exceeds the fund yield, actual returns from the fund may turn negative. So say a fund offers 6% returns but inflation during the same time is 7%, which means your purchasing power has decreased, making the real return negative.

How do I pick a Gilt Fund for myself?

When you pick a fund to invest in, it should align with your financial goals. Consider these factors before you pick a gilt fund to invest in:

Expense Ratio

The expense ratio is a fee charged by a mutual fund house for managing your investment in the fund. Since the returns of these investments depend on the interest rates, the expense ratio plays a major factor. The lower the funds expense ratio , the more it will add to your returns.

Investment Horizon

Another aspect of picking a mutual fund is deciding on your investment horizon. How long do you plan on staying invested? Are you investing for the short-term or long-term? Choose a low-duration fund around 3 to 5 years for the short-term and opt for a long-duration fund to benefit from capital appreciation.

Historical Performance

Inspect the fund's past returns to see how the fund performed in the past. Look at the standard deviation, average maturity, yield to maturity and other key metrics. We have discussed choosing a debt mutual fund in further detail here.

What will be my tax implication from gains on Gilt Funds?

When you sell your investment in these government sector funds, any gain you make is called a ‘capital gain’ and is taxable. If you sell your investments within 36 months, the gain is called a short-term capital gain; if you sell after 36 months it's called a long-term capital gain. You can learn about how debt mutual funds are taxed in detail here.