Mutual Fund Unlocked: Short-term and long-term gilt funds

Gilt funds are debt mutual fund schemes which invest predominantly in the government bonds, that is, government-issued bonds and securities of various maturities. The types of gilt funds are further divided into two types, that is, long-term gilt funds and short-term gilt funds. Long-term gilts funds are the gilt funds which invest into the long-dated government bonds, having maturities greater than 5 years up to 30 years, whereas short-term gilt funds invest in government bonds having short-term maturities. Long-term gilt funds seem to be more popular among institutional investors as these are most sensitive to interest rate changes and therefore allow such investors to bet on interest rate cycles.

These funds generate returns mostly through interest rate risk. We know that interest rate risk and credit risk are the major risks that affect bonds, but in the case of gilt funds, the credit risk involved is nearly zero as these funds entirely consist of government bonds. Also, these bonds are backed by the government, so the possibility of default is nil given the sovereign guarantee.

These funds predominantly generate returns by taking the duration calls and by trading in the underlying instruments. Fund managers of these funds usually tend to invest in the bonds with the varying maturities according to the interest rate outlook.

That is, here the fund manager takes a view on the future movement of interest rates in the economy and invest either in short or long duration government bonds. When the manager anticipates interest rates fall, a major part of the portfolio will be loaded with gilts with a longer maturity. This is because when interest rates are expected to fall, the price of the existing long-term bond tends to rise.

In short, these funds generate returns mostly from the capital appreciation arising from the rate movements.

On the taxation front, dividends from these funds are taxed at 28.84 per cent and investments of more than 3 years attract LTCG (Long term capital gain) tax of 20 per cent and before 3 year, the returns are taxed as per the investor's respective tax slab.