FAQ on gilt mutual funds: essentials investors should know

Published: April 15, 2021 at 10:07 am

We answer a set of questions on gilt mutual funds asked by investors. Interest in gilt mutual funds has increased for two reasons: credit events in debt funds and a gradual reduction in PPF interest rate. We wanted to write an article on selecting gilt mutual funds but realised that before we get into the technical aspect of selection, it would be better to answer some common questions. This is part one.

A quick introduction. Gilt mutual funds predominantly invest in govt. Bonds (aka gilts because historically govt bonds were printed on gilt/gold-edged paper ). Although the credit risk in such funds is minimal (govt bonds cannot be rated for a resident investor!), the NAV of such funds will fluctuate wildly!

The longer the duration (date until maturity) of the bonds in the portfolio, the more the NAV fluctuations. This because of demand-supply fluctuations in the bond market.  In many gilt funds (and dynamic bond funds), the fund manager will change the duration of bonds held in the portfolio as per present bond market conditions and their reading of the future. Let us refer to this as “managing duration risk”.

There two types of gilts funds” the constant maturity gilts funds that predominantly hold 10-year bonds and the “plain” gilt funds.  The constant maturity funds will have an average portfolio maturity of close to 10 years at all times. Hence the volatility will be higher, but since the fund manager will indulge in managing duration risk, the fund is like an (expensive) index fund.

The plain gilt variety will typically have funds that will try and manage duration risk. Some will do this activity, and some in a rule-based manner. We shall look at the technical differences between these two categories in the next article on selecting a gilt fund.


In this article, I would like to first answer the questions posed by members of the Facebook group Asan Ideas for Wealth. Here are some basic resources for investors to get started. Those who need more information than the responses given below may consult these.

Q1: I’m looking for gilt funds for long term and short term debt portion. As interest rates are reduced in bank/ppf. Q2:  Gilt fund, which can be used to replace ppf/epf. How to identify if it is time to exit?

A: Let us be clear about this right away. Gilt funds are not an alternative to PPF to get better returns. Yes, “over the long term,” a gilt fund has enough potential to beat PPF. However, investors should not get into gilt funds with this “alternative” mindset.

This typically means they would expect the gilt fund to perform from day one and get disappointed when they realise that the bond market can crash like the equity market, and gilt funds will always be hit the hardest. That gilt funds can go years without beating even an SB account.

If equity investing is similar to drinking Vodka, gilt investing is similar to drinking beer (a lot of it!). Many readers at this point may be thinking, “not for me. I do not want to take any risks in the debt part of my portfolio”.

The sad news is, “not taking any risk” is also a risk. If fixed income returns do not fluctuate, they will head south over the long term: Can I use liquid funds for long-term goals with equity MFs?

We recommend interested investors add a small exposure to gilt funds in their portfolios and get used to the volatility. Gilt funds should be viewed as an accompaniment to PPF and not a replacement.

For short-term needs, use open-ended target maturity gilt funds or ETFs (if the maturity date falls before your need). See, for example, IDFC Gilt Index Funds 2027, 2028 Review. For long-term needs, use only open-ended gilts funds and not open-ended ETFs.

Q: How to time the entry & exit based on interest rate hike & rate cut in gilt funds.
GILT investment in NPS TIER II is equally good? How to reduce the volatility in gilt funds.

A: This is in principle possible but not necessary. We recommend most investors invest in gilt funds normally, each month manually or via SIP. As regards Tier II, the lesser the exposure to NPS, the better, ideally zero. Also, see: Can I use NPS Tier II as a low-cost index fund?

Q: If interest rates start inching up, will it not hurt gilt funds? A: Of course! If a gilt fund can give 15% or 20% annual returns, then we must be ready for commensurate annual losses too!

Q: What about volatility in gilt funds and the impact of interest rates and demonstration of modified duration with respect to change in interest rates. Is the change indicated by modified duration is similar to the change in NAV due to a change in interest rates?

A: We must understand that the Indian bond market has significantly deepened over the last decade. This means lot more players, a lot more opinions and a lot more speculation. So gilt fund NAVs will not react in step to interest rate changes like all those theoretical discussions on gilt funds would suggest.

Just as the stock market tends to price in future growth today, the bond market prices in future interest rate movement well ahead of time, this means the demand vs supply in the bond market will fluctuate quite a bit due to speculative trades. Since this happens continuously, one cannot do a one to one correlation with interest rate movements or modified duration (this is a measure of much NAV will fall if rates fall by 1%).

So all debt fund investors must shift their outlook from interest rate risk to duration risk or demand-supply risk. A one-to-one correlation with stock prices and profits is not possible in real-time. The same is true in the bond market as well.

Q: 10Y Constant Maturity Gilt Funds – if one starts their SIPS now, assuming interest rates rise in 2022 (their NAV goes down), approx in how many years the cycle of low-interest rates/high NAVs reappears? A: If we can predict these things, a gilt fund would resemble a fixed deposit. It is the unknown that drives risk and reward in the markets.

Q: How to invest in Gilt funds- Monthly fixed amount or Variably on some indicators
How to redeem from Gilt funds(shifting to liquid or money market fund). Suppose for a 12-year goal – in the 10th & 11th year or gradually before few years?

A: Monthly via SIP will work. The key point to note is, for long term goals, equity funds and gilts funds should be managed in tandem. A big surge in a gilt fund can be taken advantage of. One can either redeem from gilt and invest into equity or redeem from gilt and invest in safer debt.

The opposite also holds true. So redemption is not just before the goal deadline. It is a continuous process. Yes, exposure to gilts should be gradually decreased, and exposure to, say, a liquid fund or FD increased as the deadline approaches.

Q: Does the term “Gilt Funds” always mean those which are not the 10Y-ConstantMaturity, or does this term include all Gilt Funds? Appears a bit confusing to newbies.

A: There are two official categories: “Gilt Funds” and “Gilt Fund with 10-year constant duration”. Both of these invest 80% of their assets in govt bonds/gilts and are referred to as gilt funds. There is, however, a big difference.

The constant duration category will only invest in 10-year gilts (or thereabouts) at all times. All other gilts funds can do as they please. Some of them react every month to demand-supply changes in the market, and some, not at all or at least not visibly.

Investors should appreciate that fund belonging to the “gilt fund” category can be dynamic bond funds, and this increases the underlying risk—more about this in the next article.

Q: Should NRI’s invest in gilt funds? A: In principle, yes, but it depends on their asset allocation, the taxation rule in their country of residence; If they can invest via resident parents, spouse etc.

Q: Does it makes sense to stagger our investments in Gilt to take advantage of volatility? A: No, but it makes sense to stagger our redemptions as mentioned above along with annual rebalancing.

Q: When to enter, time frame, when to exit.. approximate ROI etc.. correlation with the interest rate?

A: The correlation with interest rate is only approximate, as mentioned above. It is reasonable to expect a gilt fund to beat bank FD rates and PPF over 10 years. Obviously, this is not a guarantee, but prudent portfolio management during the journey can make it possible. We recommend investors normally invest via SIP in gilt funds. But also systematically manage risk via rebalancing.

To be continued …

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