What are gilt mutual funds and who should invest in them

Credit risk and interest rate risk should be considered when it comes to gilt funds. Credit risk refers to the inability of the borrower to pay the dues. Popular belief is that gilt funds are free of credit risk because they are backed by the govt, which usually does not default on its debt obligations.

However, investors usually miss the point that although gilt funds run no credit risk, they are highly reactive to interest rate fluctuations. Interest rate risk refers to the change in price due to change in interest rates and for the NAV of a gilt fund scheme, this relation is negative or inverse. A rise or fall in interest rates leads to a consequential fall or rise in the NAV, thus causing fluctuations in returns. Such extreme volatility has made gilt funds the riskiest investment class in the debt category. Going by this logic, a falling interest rate environment would be favourable for gilt funds and consequently, to invest in them.

Historically, gilt funds have provided a positive return to investors over the past ten years. 2-year performance paints an even better picture, with funds returning as much as 14%. On this front, they clearly score over bank FDs. The falling interest rate scenario proved fruitful for investors.

However, one must remember that even though the repayment obligation is guaranteed, returns from gilt funds are not. They are highly volatile due to movements in interest rates. Gilt funds are expected to deliver tremendous returns during economic turmoil and slowdown but rising interest rates will certainly provide lower to negative returns on investment.

Gilt funds have a long-term investment horizon. Most gilt funds in India are currently running at an average maturity of over 7 years. Thus, investors should take a long-term view of financing requirements while investing. If you want to include these in your debt portfolio, make sure your financial goals and aspirations are in line with the investment considerations.

Gilt funds charge an annual fee to cover the fund manager's fees and other expenses. The upper cap on this expense ratio is 2.25% of the asset under management. However, the actual expense ratio may vary across funds. Investors should take into account the impact of expense ratio on the expected return of the fund.

Capital gains on investment in gilt funds are fully taxable. If the fund is held up to 36 months, the gains would be charged as short-term, STCG tax would be applicable as per the individual's slab rate. If the fund is held for longer, the gains would be deemed long-term and LTCG tax at 20% (with indexation benefits) would apply.

The exit options are similar to those in case of other mutual funds. Exit depends on whether the fund is open-ended or closed-ended. For an open-ended fund, the available exit routes are- sale in the secondary market, redemption post the lock-in period but before maturity, redemption on maturity, switch-ins and systematic withdrawals. For a closed-ended fund, these include- sale in secondary market and redemption on maturity.

Investment in gilt mutual funds would be suitable to investors who possess technical knowledge and can constantly monitor movements in interest rates or have access to professional investment managers to keep track of the same. Further, these suit investors who only want to go for securities low on credit risk. Investors seeking to diversify their debt portfolio can include gilt securities but should remember that these are longer in duration. Finally, potential investors or those who have decided to invest in gilt funds must not neglect the role that the economic environment plays. This is especially important now at the time of the coronavirus pandemic and its impact on economies.