Gilt funds are debt funds that invest in government securities. The government bonds used to be issued in golden-edged certificates. The nickname gilt comes from gilded edge certificates. As per Sebi norms, gilt funds have the mandate to invest at least 80% of their assets in government securities.
There are two kinds of gilt funds. One, gilt funds that invest mostly in government securities across maturities. Two, gilt funds with constant maturity of 10 years – these funds must invest at least 80% of their assets in government securities with a maturity of 10 years.
Investors should keep in mind that since these schemes invest in government securities, they have zero default risk. However, they have very high interest rate risk. In fact, government securities set the tone for interest rates in the money market and economy. The mostly traded 10-year government security is considered the benchmark. Its yield movement sets the tone for trading in the bond market. For example, traders look for trading opportunities based on the spread or interest rate difference between government bonds and corporate bonds or between the 10-year bond and other government bonds.
Most mutual fund managers do not recommend gilt funds to their regular clients. They believe that only investors with high awareness about the money market or bond market should invest in these schemes. It is extremely important to time the entry and exit in these schemes because they are extremely sensitive to interest rate movements. They do very well in a falling interest rate regime, but they suffer and start giving negative returns one the rates start hardening.
When RBI starts reducing rates, the demand for government securities issued earlier goes up because they carry a higher interest rate. When the demand goes up, their price goes up and yields fall. This is called the inverse relationship between the price and yield of bonds. However, when RBI pauses on rates or starts hiking policy rates, the opposite trend happens. Since the new bonds will carry a higher interest rate, demand for older bonds drops or traders sell them. This results in their prices dropping and yields going up.
As said earlier, a falling interest rate regime is great news for gilt funds. In tandem with the price of bonds, the NAV of these schemes also goes up. This is the reason why gilt schemes have been performing well in the last one year, ever since RBI started reducing the rates.
Finally, invest in gilt funds only if you can keep track of the interest rate movements and time your entry and exit in these schemes. Always remember that their extreme sensitivity to interest rate movements in the economy. This means gilt schemes may start going up or down, depending on the interest rate outlook. The RBI action might come later.