Gilt Funds

Also known as Government Securities in India, Gilt Funds invest in government papers (named dated securities) having medium to long term maturity period. Issued by the Government of India, these investments have little credit risk (risk of default) and provide safety of principal to the investors. However, like all debt funds, gilt funds too are exposed to interest rate risk. Interest rates and prices of debt securities are inversely related and any change in the interest rates results in a change in the NAV of debt/gilt funds in an opposite direction.

For investors who are averse to taking risks in stock market and looking for safety as well as liquidity, gilt funds is just the right option. They may offer lower returns but are liquid and safe. In the last fiscal, gilt funds have delivered superior returns in comparison with debt funds and income funds because of falling interest rates.

Gilt funds predominantly invest in government securities of varying maturity and money market instruments. Government securities or gilts, are issued/guaranteed by the state/central government and guarantee timely payment of interest and principal.

The government securities run price risk like any other fixed income security. Generally when interest rates rise, prices of fixed income securities fall and when interest rates drop the prices increase. The extent of fall or rise in the prices is a function of the prevailing interest rates, days to maturity band the increase or decrease in the level of interest rates. The price risk is not unique to government securities. It exists for all fixed income securities.

Fixed income instruments usually carry three kinds of risk-default risk, interest rate risk and liquidity. Interest rate risk arises on account of changes in interest rate. For e.g. the market value of the fixed income instrument will go down in value if interest rates rise and vice versa. This would be a notional loss if such an instrument is held up to maturity. However, if the holder sells the instruments before maturity then there could be a loss on such investment on account of rise in interest rate.

Default risk is one wherein the issuer of the debt defaults or fails to meet its obligation on the payment of interest or principal or both. However, government securities are unique in the sense that their credit risk always remains zero. Gilts are also very liquid and can be traded with ease. Therefore gilt prices are influenced only by the movement in interest rates in the financial system.

The gilt funds have major portion of their investment in GOI securities and hence on an average have a maturity period of one year or more. However to maintain liquidity funds also invest in the money market. Funds with high maturity period and low money market exposure have high liquidity risk. In case of a fall in the interest rates, the NAVs of gilt funds gain sharply but also fall sharply when the interest rates rise. The longer the maturity period of gilt funds, the higher the loss or gain.

The minimum investment amount in gilt funds is Rs 5,000-10,000. Since gilt funds are open ended, the investor can exit or withdraw anytime subject to an exit load. Typically gilt funds offer investors two options, the growth option and dividend option. Under the dividend plan, the fund would declare dividends from the net income earned by way of interest and capital gains (appreciation in the prices of the government security when the interest rate falls). Under the growth plan, these payouts would be reinvested.

Most of the gilt plans offer two plans to the investor, short-term plan or the treasury plan and long term plan also called as investment plans. Treasury plan usually invests in gilts with a short maturity of 6 months to 2 years or in call money. They have a highly liquid portfolio, carry lower risk and at the same time deliver lower returns. These plans are suitable for investors with a short to medium term time horizon of 6 months to one year. In contrast, investment plans invest in gilts of maturity more than 2 years. Long-term gilt funds invest in papers with a maturity period as high as 25 years. Investment plans generate higher returns and are more susceptible to volatility arising due to interest rates. Such plans are suitable for investors with a longer investment horizon of more than 2 years.

Gilt funds are chargeable to tax from Financial Year 2002 unlike in the past when they were absolutely tax-free in the hands of the investor. The investor will have to pay tax on the dividend income received at the individual rates in case of dividend option. Tax @10% would be deducted at source only if the amount received from the company or the mutual fund exceeds Rs 1,000. An investor can also claim a deduction in respect of this income under section 80 L within the overall ceiling of Rs 9,000. In the case of growth option, the investor will pay long term capital gains tax of 20% if he stays invested in the scheme for more than a year.

The short-term gilt funds carry no credit risks as gilts have a sovereign backing and the likelihood of default is nil. Also, as these funds invest in shorter maturity gilts, the adverse change in interest rates has a limited impact on their NAV vis-à-vis long-term gilt funds. Thus they are less volatile than the long-term counterparts. While standard deviation for long-term gilt fund ranges between 1.39 and 1.75, in the case of short-term gilt funds it hovers around the 0.21-0.43-range.

That apart, short-term gilt funds also scores over medium-term debt funds, as the former comprises superior credit quality instruments in comparison to the latter, which invest in corporate bonds of different quality. However, softening interest rates has seen longer-tenure government securities make an entry into the medium-term debt portfolio. Apart from fetching good returns, this has also made medium-term debt funds more volatile.

The short-term gilt funds have proved to be cut above these funds. During highly volatile times such as in July 2000, September 2001 and May 2002, an average short-term debt fund displayed better resilience vis-à-vis an average medium-term debt fund.

Superior returns apart, gilt funds are yet to catch retail investors' interest in a big way. Recently, key stock exchanges kicked off trading in government securities, almost on the lines of stock trading, to increase retail participation. However, gilt funds will continue to enjoy an edge due to their professional management, diversification and, above all, ease of investing.