The first thought that crosses our mind while investing money is the risk associated with it. While trading in shares is a risky proposition, fixed deposits and government securities on the other hand are considered relatively safer options. During this ongoing pandemic phase, a little-known instrument of investment has emerged as a new champion which has delivered double digit returns coupled with its safety standards. I am referring to what is known as Gilt funds, and today’s column explains all about it.
What are Gilt Funds?
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Gilt funds are debt funds that invest in central government securities. The nickname gilt comes from gilded edge certificates. As per SEBI norms, gilt funds have the mandate to invest at least 80% of their assets in government securities.
How do Gilt Funds Work?
If the Government of India is in need of funds (or loans), then it approaches the Reserve Bank of India (RBI). Apart from being the apex bank, the RBI also acts as a banker to the government. The RBI lends money to the government after borrowing from other entities such as insurance companies and banks. In exchange for the loan, the RBI issues government securities with fixed tenure, to which the fund manager of a gilt fund subscribes. Upon maturity, this gilt fund returns the government securities and receives money in return. These funds generate returns through interest rate risk. Since the government backs it, the credit risk is almost zero. Interest rates and prices of government securities are inversely related. In other words, when interest rates rise, prices of government securities fall. It has a direct impact on its performance.
Who Should Invest in Gilt Funds?
Gilt funds only invest in government securities ranging from medium to long-term horizons. So, these funds satisfy the security needs of investors. They are not the same as bond funds because the latter may allocate a part of the assets in corporate bonds, which can be risky. Gilt funds invest in low-risk debt instruments such as the government securities, which ensures the preservation of capital along with moderate returns. When compared with a typical equity fund, a gilt fund offers better asset quality despite the relatively lower return it offers. It is often considered an ideal investment haven for those investors who are risk-averse and want to invest in government securities.
Things to consider as an Investor:
. Risk Factor: Unlike corporate bond funds, gilt funds are the most liquid instruments as they do not carry credit risk. The reason being the government will always try its best in fulfilling its obligations. However, gilt funds primarily suffer from an interest rate risk. The net asset value (NAV) of the fund drops sharply during times of an increasing interest rate regime.
. Returns: Gilt funds can generate returns as high as 12%. However, returns from gilt funds are not guaranteed and highly variable with the changes in the overall interest rates. Hence, it would be beneficial to invest in Gilt funds when the interest rates are falling. Also, when the economy faces a slump, Gilt funds are still expected to deliver higher returns than even equity funds.
. Investment horizon: Gilt funds invest in government securities, which have medium to long-term maturity periods. The average maturity of a gilt fund portfolio varies between three years to five years. If you are thinking of investing in gilt funds, then you need to have an investment horizon of at least three to five years.
. Financial goals: If wealth accumulation over a medium-term is your goal, then you may consider investing in gilt funds to ride on the interest rate volatility. In other situation when the overall capital markets are going downwards, and you are looking for safer havens to earn short-term returns, then gilt funds could be the right choice.
.Tax treatment: Taxation of Gilt funds is similar to that of debt mutual funds. The rate of taxation is based on your holding period, i.e. how long you stay invested in a gilt fund. A capital gain made during less than three years is known as the short-term capital gain (STCG). A capital gain made over three years or more is known as the long-term capital gains (LTCG). Investors that receive the STCG from gilt funds, pay tax according to the investor’s income tax slab. LTCG tax, on the other hand, is a flat 20% with indexation benefits.
Both 2019 and 2020 have been favourable years for gilt funds in India due to the falling interest rate regime. This explains the double-digit returns from these mutual funds in India. However, interest rate movements are not unidirectional. There are chances of negative returns as they are highly volatile. One must proceed with caution as the interest rate cuts are subject to macro-economic conditions prevailing in the country from time to time.
