Five minutes to understanding a Gilt Fund

What is a gilt fund?
A gilt fund is a special kind of a debt fund that invests only in government securities. We know already that a debt fund invests only in interest bearing paper, that is, in government, corporate, municipal and institutional bonds and debentures. A gilt fund is a debt fund that buys only government securities and treasury bills – instruments on which repayment of principal and periodic payment of interest are assured by the government. These bonds are issued by the Government of India and are equivalent of US Treasury Securities and are considered the highest quality bonds because the government backs them. Therefore the payment upon maturity is guaranteed. In exchange for this very high margin of credit safety, these instruments have the lowest yields. The name ‘gilt’ comes from the original British government certifications that had gilded edges, signifying a very high degree of safety of the money lent to the government.

Is this a zero risk product?
There are many kinds of risk that a financial product carries. A gilt fund has zero credit risk but does carry an interest rate risk. In English, a zero credit risk means that these funds do not have the risk of default on their investments, the government will always pay its debt (interest and principal), making them very secure long term investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.

But these bonds do carry an interest-rate risk. We know that when interest rates rise, bond prices fall and the opposite is also true. Gilt funds carry the risk of the bond prices changing due to changes in the interest rates. If interest rates rise during the tenure of the bond, then its prices will fall, making for a capital loss. This risk also depends on the maturity and duration of the bonds and generally, the longer a fund’s duration or average maturity, the higher its interest-rate risk, making for a higher degree of risk in the product. The NAV of the fund will be more sensitive to changes in interest rates. One can reduce the interest rate risk by choosing a bond fund with a shorter duration or average maturity.

Who should buy it?
Gilt funds allow an individual investor to take advantage of the interest rate cycles. They are suited to the investor who wants a total return, both income and capital rather than a high regular income. Gilt funds, due to their high safety, are ideal investments for the pension and provident fund investments. Those looking for very high safety of the principal, though lower returns should look at a gilt fund for investment.