Are debt mutual funds a smart bet during an interest rate cut cycle?

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Since the Reserve Bank of India (RBI) is likely to start reducing interest rates in subsequent quarters, several investors are thinking if now is the right time to look at debt mutual funds. These fixed-income products generally do well when rates decline—but not all segments fare equally well. Before moving your portfolio, learn about how debt funds respond to rate movements and which ones are designed for a rate reduction scenario.

Impact of rate cuts on debt fund yields

Debt mutual funds hold fixed income instruments like government securities, treasury bills and corporate debt. When interest rates fall, outstanding higher-yielding bonds are of higher market value and the net asset value (NAV) of debt funds rises. Particularly in gilt and long-term funds, holding longer-tenor debt instruments and extremely interest-rate-sensitive. Therefore, during a rate-cut cycle, such funds are capable of giving more capital appreciation.

Which debt schemes benefit most

Not every debt scheme responds similarly to falling rates. Long-duration schemes, gilt schemes, and dynamic bond schemes benefit most when rates decline. They usually carry longer tenor securities, usually with their price rising more sharply when rates fall. For short-duration funds or liquid funds, they are less exposed because they invest in papers of shorter durations that are not as sensitive to the movement of interest rates. Although safer, they may gain less in a declining rate cycle.

What do investors need to be wary of?

While even more is to be received in the way of returns, long-duration funds also bring with them more interest rate risk and volatility. Should declining rates be stopped or reversed on inflation or geopolitical grounds, these funds will trail. To this is added that abrupt monetary policy shifts or economic statistics reversal can flip the market around in an overnight fashion. Investors need to expect at least some degree of vacillation and not attempt to time it so exactly.

Debt fund role in portfolio strategy

For investors with long- to medium-term holding periods, investing in a portion of debt funds during the rate-cutting phase can prove to be an intelligent decision. They provide diversification, frequent income, and lower risk in relation to equities. However, the fund has to be selected on the risk category as well as the investment tenure as well. Conservative investors can also invest in corporate bond or short-duration funds to achieve safety along with return.

Rate cuts can offer an opportunity—but stay cautious

Reductions in interest rates tend to give a helping hand to longer-term debt mutual funds. But at the same time, they involve higher timing and volatility risks. If debt funds are on your mind now, invest in a staggered or systemic fashion and select fund categories wisely based on your risk tolerance and investment horizon. As always, take the advice of a financial planner before making drastic shifting of allocations.