Gilt mutual funds have been in focus recently, with investors booking losses after the Reserve Bank of India signalled that further interest rate cuts are unlikely. Adding to the pressure, the recent GST rate cuts raised concerns over higher government borrowing, weighing on the performance of these funds. Here’s a look at what gilt funds are and how they work.

WHAT ARE GILT FUNDS?
Gilt funds are debt mutual funds that invest mainly in government bonds. Since these bonds are backed by the government, they are very low-risk, making gilt funds a safer option for conservative investors. The portfolio of these schemes is a mix of government securities with different maturities.

HOW DO GILT MUTUAL FUNDS WORK?
To meet its borrowing needs, the central and state governments raise money by issuing government securities (G-Secs) through the Reserve Bank of India (RBI). Gilt mutual funds invest in these G-Secs. The government pays interest during the tenure of the security, and when it matures, the fund receives the principal back.

HOW DO THESE FUNDS MAKE GAINS FOR INVESTORS?
Gilt funds earn returns in two ways. First, they receive interest income from the government on the securities they hold. Second, gilt funds can make capital gains by actively buying and selling government securities. Since bond prices and interest rates move in opposite directions, funds benefit when interest rates fall. That’s when bond prices move up, resulting in capital gains.

WHAT ARE THE RISKS?
When interest rates go up, bond prices fall, which can lower returns or even cause losses if the fund sells the securities before maturity. Recently, yields on the 10-year benchmark government bond moved up from 6.3% to 6.6% as expectations of interest rate cuts faded. This resulted in a fall in prices of government bonds, resulting in mark-to-market losses in gilt funds. There are, however, no default risks in gilt funds because of the sovereign guarantee.

WHO SHOULD INVEST IN GILT FUNDS?
Aggressive fixed-income investors who believe interest rates have peaked and may fall over the next 9-12 months can consider accumulating gilt funds in their portfolio. A decline in interest rates typically pushes up the NAV of long-duration gilt funds, leading to capital appreciation.

HOW ARE GILT FUNDS TAXED?
Gilt funds are treated like other debt mutual funds for tax purposes. If you choose the growth option, tax is levied only when you redeem your investment. For investments made on or after April 1, 2023, any gains are added to your income and taxed as per your applicable income tax slab.