Gilt funds

Over the past few years, The Reserve Bank of India (RBI) has consistently lowered interest rates. Consider this, The RBI has lowered its Repo Rate (i.e. the rate at which RBI lends to commercial banks) from a high of 8% in 2015 to its current rate of 4%. Falling interest rates have resulted in a significant reduction in Fixed Deposit (FD) returns and has made investors look to other tax efficient instruments like GILT funds, which can potentially generate a higher return and are far more tax efficient than a bank FD.

GILT Funds as a category of Debt Mutual Funds

At the outset, investors should understand that debt mutual funds are fundamentally different from an FD (Click to read about types of debt mutual funds). Choosing a wrong fund may deliver higher return compared to an FD but will surely not be aligned to your goal of earning a ‘higher return with a high level of safety’.

When you buy a credit risk debt fund for example, there is a risk of default and of losing a part of your principal. At the same time, you are also likely to earn a much higher rate of return over an FD. This is because credit risk funds invest at least 65% of their corpus in companies with less than AA rating (i.e. to not-so-highly rated companies which pay out a high interest on their debt). On the other hand, when you buy GILT Funds (i.e. a government securities fund), there is no credit risk even though these funds may deliver negative returns if RBI increases interest rates. There is no credit risk because GILT Funds typically invest in sovereign rated instruments. Over the past two years, as economic environment deteriorated, credit risk funds earnt a bad name for delivering negative returns on account of corporate defaults.

While investment in debt funds is suitable for investors who want to earn higher post tax return compared to an FD; all Debt funds should not be compared to FDs.

Debt funds vary based on duration, safety and interest rate of instruments held by the fund.

When choosing a debt fund over a fixed deposit, the key criterion is to find something nearly as safe as a fixed deposit offering a higher post tax return. The way investors have been achieving this with a high degree of certainty is by choosing a debt fund which invests in long term government bonds (i.e. sovereign or SOV rated bonds) and follows a roll down strategy.

SOV VS Other Ratings in Debt Funds

While investing in bonds, investors must consider the issuer of the bonds. Bonds issued by corporations inherently carry more risk than bonds issued by the government. In a situation where a recession hits us, the issuer of the bond may go out of business and may default on the debt. The risk of default in GILT Funds is minimal, although it can still happen.

Role of Credit Rating and Its Importance

In simple terms, credit ratings are representations of the creditworthiness of corporate or government bonds. It provides the insights of the bond issuer’s financial strength and its repayment capacity.

Credit rating Rating description
AAA Highest safety
AA High safety
A Adequate safety
Below A* Moderate/inadequate safety or high risk of default

*includes B, BB, BBB, C and D rated companies.

Sovereign rating

KEEP IN MIND, the Sovereign rating – SOV, MEANS government instruments. A sovereign credit rating indicates the creditworthiness of a country and helps the investors to know the level of risk associated with investing in the debt of a country, including any political risk. As of 8th May, 2020, S&P and Fitch have assigned BBB- sovereign rating to India with a negative outlook. This credit rating measures the ability of a country to pay back its debt. So if an SOV rated bond defaults, it is akin to the country defaulting on its debt obligation. It is this virtue which puts SOV as the highest rating for a bond paper. 

Roll Down Strategy

A Roll down strategy exploits the concept that – yield and price of bonds move in opposite directions. As interest rates decrease, bond prices increase. A roll-down strategy involves buying long term bonds and selling them before their maturity date to maximize return. Typically, here, a bond is sold before maturity when it is valued at lower yields but a higher price.

Below is a comparison of  a roll down GILT strategy (Nippon India Nivesh Lakshya Fund) with other funds holding primarily GILT securities.

Parameters Nippon India Nivesh Lakshya Fund SBI Dynamic Fund Axis Dynamic Bond Fund
One Year Return 12.87% 11.36% 13.52%
Yield to Maturity ~6.63% ~6.18% ~6.78%
Average Maturity 24.44 years 13.60 years 8.7 years
Modified Duration 11.27 years 8.30 years 6 years

As of 8 November 2020


Yield To Maturity (YTM): YTM is the total rate of return an investor earns if he/she holds the bond till maturity including all the coupon payments.

Average Maturity: A debt fund portfolio comprises several bonds with varying maturity dates. Average maturity is the weighted average of maturity for all bonds in the fund portfolio.

Modified Duration: Modified duration is the sensitivity of a debt fund’s portfolio to changes in interest rate. For example, if modified duration of a bond is said to be 4.50 years, it indicates that the price of the bond will decrease by 4.50% with a 1% (100 basis point, or bps) increase in interest rates.


Returns generated by the top performing roll down strategy fund Vs. Traditional Bank Fixed Deposit.

Parameters Long Term FDs Axis Dynamic Bond Fund
Yield 5.70% 6.78%
Post-Tax Yield 3.99% 5.90 – 6.10%
Investment Horizon Max 10 years 7-9 years
Liquidity High (penalty charged on early withdrawal) Very high (redeemed at prevailing NAV)
Credit Quality / Safety Depends on the issuer’s rating Highest Safety
Tax Efficiency Low (Taxed at income tax rate) High (Indexation benefit available)


  • 5.9-6.1% yield is based on current portfolio and after accounting for fund management expense.
  • The above calculation assumes an income tax rate of 30%

Debt funds also benefit from favorable taxation structure. While FD interest is taxed every year based on an investor’s tax slab; profit from debt funds are taxed only at the time of redemption. Further, they are taxed at a lower rate of 20% with indexation benefit if held for more than three years. This makes debt funds, particularly long term debt funds, a very good option for long term wealth creation.

What About Regular Interest Income like from Fixed Deposits?

Is there an opportunity for investors to earn regular interest income by investing in GILT funds?  Take the example of the above fund. While it is most suitable for long term wealth creation, it will be equally advantageous for an investor who can forego receiving interest pay-outs for the first 3 years. Upon completion of 3 years, accumulated returns are taxed at 20% and get the benefit of indexation.

At this time (after holding for 3 years) investors can set up a Systematic Withdrawal Plan which will make the fund work exactly like an interest-bearing FD and pay a much higher post tax return.

Systematic Withdrawal Plan (SWP)

SWP is a facility that allows an investor to withdraw a fixed amount of money from a fund at predetermined intervals. SWP in debt funds can prove to be an attractive option for people looking for regular income.

Consider the example below:

Mr. A invests Rs. 1 Crore in a GILT fund. This amount grows at ~ 8% p.a. to reach Rs. 1.24 Crore at the end of 3 years. Since the investment has completed 3 years, the gain of Rs. 24 lakhs is now taxed at 20% after indexation making this gain virtually tax free (at current rate of indexation).

At the end of 3 years, Mr. A can set an SWP at 8% per year. With this he will be able to withdraw Rs. 8 Lakh per year (i.e. Rs. 66,700 / month). The frequency of SWP can be set at monthly, quarterly, or yearly basis. Effectively the fund value grows for the first 3 years. Thereafter, Mr A withdraws an amount equal to fund’s annual appreciation going forward, in an extremely tax efficient way.

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