What Is a Gilt Fund and How Does It Work?

Gilt funds are a type of mutual fund that invests primarily in government securities. These funds appeal to investors seeking low-risk options, as they are backed by the government’s creditworthiness. While they carry no default risk, their returns fluctuate based on interest rate movements.

Composition and Portfolio Requirements

Gilt funds invest exclusively in government-issued debt instruments, ensuring a high degree of safety. Fund managers structure portfolios based on the duration and maturity of these securities, which range from short-term treasury bills to long-term government bonds. Longer-duration bonds are more sensitive to interest rate changes, making them riskier when rates rise but more rewarding when rates decline.

Regulations set by the Securities and Exchange Board of India (SEBI) require gilt funds to allocate at least 80% of their assets to government securities, minimizing exposure to corporate debt. As a result, returns are closely tied to government borrowing costs and monetary policy decisions.

Fund managers adjust portfolios based on macroeconomic indicators such as inflation, fiscal deficits, and central bank policies. If inflation is expected to decline, they may increase exposure to long-term bonds to benefit from potential price appreciation. In a rising interest rate environment, they may shift toward shorter-duration securities to limit volatility.

Types of Gilt Securities

Government securities in gilt funds vary by structure and tenure. Fixed-rate government bonds, the most common type, offer a set interest rate throughout their tenure, providing predictable cash flows. Floating-rate bonds, by contrast, have interest payments that adjust periodically based on a benchmark rate, such as the central bank’s repo rate, making them less sensitive to price fluctuations.

Zero-coupon government securities do not pay periodic interest. Instead, they are issued at a discount and mature at face value, with the difference representing the investor’s return. These instruments are highly sensitive to interest rate movements since their entire return is realized at maturity. Treasury bills, which mature within a year, fall into this category and are often used for short-term liquidity management.

State Development Loans (SDLs) are another category of government-backed securities that gilt funds may hold. Issued by state governments to finance infrastructure projects and other expenditures, SDLs offer slightly higher yields than central government bonds while remaining low-risk due to state backing.

Calculating Returns and Distributions

Gilt fund returns come from interest income from government bonds and capital appreciation when bond prices rise. Government bonds pay periodic interest, known as coupon payments, which gilt funds either reinvest or distribute as dividends. Some funds provide monthly or quarterly payouts, while others retain earnings to boost the fund’s net asset value (NAV).

Market conditions directly impact capital appreciation. When interest rates fall, bond prices rise, leading to capital gains. Conversely, rising rates reduce bond prices, potentially causing capital losses. Longer-term bonds experience more pronounced price movements, making them more volatile in changing rate environments.

A key metric for evaluating returns is the yield-to-maturity (YTM) of the portfolio, which represents the expected annualized return if the bonds are held until maturity. Investors also compare a fund’s performance against benchmark indices like the Nifty G-Sec Index to assess whether it is outperforming or underperforming the broader government bond market.

Taxation Guidelines

Gilt funds are subject to capital gains tax, which depends on the holding period. If units are sold within three years, gains are classified as short-term capital gains (STCG) and taxed at the investor’s applicable income tax slab rate. Holdings exceeding three years qualify for long-term capital gains (LTCG) tax at 20%, with the benefit of indexation.

Indexation adjusts the purchase price for inflation, reducing taxable gains. For example, if an investor buys gilt fund units for ₹1,00,000 and sells them after five years for ₹1,50,000, indexation may increase the cost base to ₹1,20,000, reducing the taxable gain to ₹30,000 instead of ₹50,000. This adjustment lowers tax liability compared to investments taxed without indexation.

Dividend distributions from gilt funds are taxed at the investor’s income tax slab rate. This differs from the earlier system where dividends were subject to Dividend Distribution Tax (DDT) at the fund level. Investors in higher tax brackets may find growth options more tax-efficient than dividend plans since they can defer taxation until redemption.

Redemption Process

Redeeming units from a gilt fund involves selling holdings at the prevailing net asset value (NAV). Investors can initiate redemption through their fund house’s online portal, a registered distributor, or a stock exchange platform if the fund is listed. The NAV applicable to the redemption depends on the time of request submission. If placed before the cut-off time, typically 3:00 PM for most mutual funds in India, the same day’s NAV applies; otherwise, the next business day’s NAV is used.

Exit loads may apply if units are redeemed within a specified period, usually between 15 days and six months, depending on the fund’s policy. These charges, often between 0.25% and 1%, discourage short-term trading. Once processed, redemption proceeds are credited to the investor’s registered bank account, typically within one to three business days. Investors should consider market conditions before redeeming, as interest rate movements affect NAV and overall returns.