What are Gilt Funds and How Interest Rates Decide Their Returns
- Bhanu Kiran
- 7 days ago
- 5 min read
Updated: 6 days ago
You might have noticed how government bond yields make headlines whenever the RBI changes interest rates. For many investors, it feels distant as if it matters only to economists or large institutions. But those movements influence how a category of mutual funds behaves every single day. Gilt Funds sit at the intersection of public finance and personal investing, translating government borrowing and policy signals into real-world returns. They remind us that the stability of our portfolios often begins with the stability of the nation’s finances.
What Are Gilt Funds And How Do They Work
Gilt Funds are mutual funds that invest primarily in government securities such as Union government bonds and state development loans. Since these securities are backed by the Government of India, they carry minimal credit risk, making them one of the most stable categories within debt mutual funds.
Key facts about how they work:
They invest at least 80% of their portfolio in government securities, as per SEBI’s mutual fund classification norms.
Their returns depend on movements in interest rates (Bond prices rise when rates fall and vice versa)
They are managed by fund houses registered and regulated under SEBI, ensuring strict investment discipline.
They carry no default risk but are highly sensitive to interest rate movements.
In essence, Gilt Funds channel government borrowing into investable instruments for individuals by offering a transparent view of how fiscal policy and market dynamics intersect.
Types Of Gilt Funds And Their Risk Profiles
Gilt Funds are broadly classified into two types under SEBI guidelines. Both invest in government securities but differ in how they manage maturity and respond to changes in interest rates.
Standard Gilt Funds These funds invest across short-, medium-, and long-term government securities. The fund manager actively adjusts the maturity mix (duration) depending on the interest rate outlook. Their NAVs fluctuate moderately, as exposure is spread across different durations, balancing risk and return potential.
Gilt Funds With Constant Maturity (10-Year) These funds primarily hold 10-year government securities to maintain a fixed maturity profile. Because of their long duration, they react sharply to interest rate changes—rising more when rates fall and dropping more when rates rise. This makes them more volatile compared to standard gilt funds.
While both types carry minimal credit risk, their performance can vary widely based on interest rate cycles. Understanding how duration affects sensitivity to rates is key to interpreting gilt fund behavior.
When Gilt Funds Perform Well (And When They Don’t)
Gilt Funds move in sync with interest rate cycles. Their performance depends largely on the direction of rates, inflation expectations, and the Reserve Bank of India’s monetary stance.
When They Can Perform Well:
Falling Interest Rates: Bond prices rise as yields drop, boosting fund NAVs.
Dovish Monetary Policy: RBI signals lower rates or injects liquidity into the system.
Stable or Declining Inflation: Improves real returns from fixed-income instruments.
Favorable Global Environment: Lower global yields attract capital flows into Indian bonds.
When They May Not Perform Well:
Rising Interest Rates: Bond prices fall, pulling down fund NAVs.
Hawkish Policy Actions: Tightening liquidity or rate hikes by the RBI.
Fiscal Concerns: Higher government borrowing pushes yields upward.
Global Yield Spike: Increases domestic bond yields, impacting valuations.
In short, gilt funds thrive when interest rates fall and struggle when they rise. Recognizing these macro cues helps interpret their short-term performance without mistaking it for mismanagement.
Who Should Invest In Gilt Funds
Gilt Funds attract investors who value safety from default but can handle the ups and downs that come with interest rate changes. Since they invest only in government securities, the risk shifts from credit quality to duration and rate sensitivity.
Typically suited for:
Investors seeking safety from credit defaults while accepting interest rate volatility
Individuals with a medium-to-long investment horizon, usually three years or more
NRIs and resident investors aiming to diversify away from corporate or credit-heavy instruments
Those who understand how macroeconomic and policy shifts impact bond yields
Not suitable for:
Investors expecting steady, short-term returns
Anyone uncomfortable with NAV fluctuations driven by changing interest rates
Taxation Of Gilt Funds In India
From 1 April 2023, gains on investments in gilt funds (and other debt-oriented mutual funds) are taxed purely as per the investor’s income-tax slab rate, regardless of how long the units are held.
Dividend income from gilt funds is added to the investor’s total income and taxed according to the applicable slab rate.
For NRIs, capital gains and dividend payments from gilt funds are subject to tax-deducted-at-source (TDS) as prescribed under Indian tax law; the slab-rate treatment applies equally to such gains.
Gilt Funds Vs Fixed Deposits Vs Bonds
Gilt funds link directly to government securities and market yields, while fixed deposits offer fixed returns backed by banks. Bonds, depending on whether they’re government or corporate, balance safety with yield potential.
Feature | Gilt Funds | Fixed Deposits | Bonds (Govt/Corporate) |
Safety | High (sovereign guarantee) | Very high (bank guarantee) | High for government bonds; varies for corporate bonds |
Returns | Market-linked, can be volatile | Fixed, low to moderate | Fixed or market-linked depending on issue |
Liquidity | High (mutual fund redemption) | Medium to High (premature withdrawal penalty) | Varies; listed bonds offer higher liquidity |
Taxation (since Apr 2023) | Taxed at slab rate, no indexation | Taxed at slab rate, no indexation | Taxed at slab rate, no indexation |
Interest Rate Sensitivity | High | Low | None |
Minimum Investment | Low (₹500–₹1,000) | Moderate (₹5,000–₹10,000) | Varies by issue |
Suitable For | Medium-to-long-term investors | Conservative savers | Savers with moderate to high risk appetite |
Before concluding, we invite you to speak with a SEBI-registered mutual fund advisor to gain informed insights into mutual fund investments.
Conclusion
Gilt funds remind us that even the safest investments move with the rhythm of the economy. Their performance reflects changes in inflation, policy, and interest rates, the same forces that shape equities, real estate, and every other market. For investors, understanding gilt funds is not just about learning a debt product but about seeing how money responds to broader economic shifts. If you are unsure how they fit into your portfolio, a Mutual Fund Advisor can help align them with your financial goals and risk profile.
FAQs
Are Gilt Funds better than bonds?
It depends. Gilt funds pool government bonds for easy liquidity and professional duration management. Individual government bonds offer fixed maturity cashflows and known yields. Choose based on need for liquidity, control over holding period, and willingness to bear mark to market volatility.
Are Gilt Funds Tax-Free?
No. Since April 1, 2023, gains from gilt funds are taxed at the investor’s income slab. Dividends are added to taxable income and taxed accordingly.
What are the risks of Gilt Funds?
Primary risk is interest rate or duration risk, which can cause large NAV swings. Secondary risks include liquidity strain during stress and reinvestment timing risk. There is negligible credit risk for sovereign securities.
Are Gilt Funds better than FDs?
Not universally. Fixed deposits give predictable nominal returns and capital stability. Gilt funds offer market-linked returns, higher liquidity, and sensitivity to rate cycles. Investment horizon and risk appetite determine which is preferable.
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