Explained: What the RBI rate cut means for fixed income investors

Short-term debt funds still a good option for investors with a short-term investment horizon.

The 25 bps rate cut by the central bank is expected to boost fixed income instruments further, with bond yields expected to ease in the coming months.

Soon after the MPC announcement, the 10-year benchmark 6.79 percent 2034 bond yield rose to 6.6958 percent, compared to 6.6449 percent at the open. This rise of 5 basis points (bps) came amid the absence of any additional liquidity measure in the monetary policy decisions.

Shriram Ramanathan, CIO - Fixed Income, HSBC Mutual Fund said that while the initial reaction in the bond market has been one of disappointment, he believes interest rates will continue to soften over the next few months.

More Rate Cuts to Follow?

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Indranil Pan, Chief Economist, Yes Bank cited a study by the RBI that indicated that the ideal real interest rate for the economy should be 100-150 bps. The real interest rate refers to the nominal interest rate adjusted for inflation.

For an those looking to invest, it makes sense to subtract the inflation rate from the rate of return on, say, a fixed deposit. If the result is negative, then the investment is not worth it.

Given the expectation of a muted economic growth in FY26, Yes Bank's Indranil Pan thinks RBI could be content with keeping the real interest rate at 150 bps, rather than at 100 bps.

“With inflation forecast for FY26 at 4.2 percent, a 150-bps real rate means that the repo rate can go down to 5.75 percent,” Indranil Pan said.

For FY26, RBI's inflation target has been pegged at 4.2 percent and GDP growth at 6.7 percent.

“As the policy was on expected line with no immediate measure on the liquidity front, the 10-year G-sec has reacted by moving around 4-5 bps higher post the announcement. We continue to expect incremental 25 bps rate cut till June 2025,” said Deepak Agrawal, CIO - Debt, Kotak Mahindra AMC.

How the MPC Impacts Fixed Income Investment

Bond yields usually move in anticipation of interest rate changes and have an inverse relationship with bond prices. When yields fall, the prices of bonds typically rise. Since debt mutual funds hold a portfolio of bonds, the net asset value (NAV) of the fund usually increases as bond prices go up.

According to experts, the overall situation remains bond-positive, with a clear expectation of further rate cut and a favourable demand-supply mix. Sandeep Bagla, CEO, TRUST Mutual Fund believes the short-term debt funds are likely to perform better.

“Long end of the curve will move lower once the inflation battle is won, which is some time away. There is pressure on currency as well, which will make interest rates volatile, though within a range," he said.

Suresh Darak, Founder, Bondbazaar believes that bond market appears to have bottomed out, potentially remaining steady, or experiencing a slight uptick.

What Should Debt Fund Investors Do?

Experts see 10-year benchmark heading towards 6.55 percent in a couple of weeks as the inflation is expected to ease, and Open Market Operation (OMO) purchase from the central bank is expected to drive down the bond yields.

Deepak Panjwani, Head - Debt Markets, GEPL Capital said that the short-term debt funds may see a drop in returns due to the decline in yields. However, they are still a good option for investors with a shorter term investment horizon.

For long-term debt funds, Panjwani sees them benefitting from the rate cut, as prices of existing bonds with higher coupon rates looks set to rise. However, they come with higher volatility.

“Further, corporate bond funds and PSU bond funds are expected to see some benefit from the rate cut, with high creditworthiness and average maturity duration of 1-3 years. Also, gilt funds may see significant gains from the rate cut, but they are highly sensitive to interest rate changes,” said GEPL's Panjwani.

Industry-watchers believe the RBI is unlikely to effect deeper rate cuts going forward. "The MPC still retained its neutral stance and did not over commit on liquidity. The RBI also continues to remain comfortable on the domestic growth outlook. This indicates a shallow rate cut cycle ahead. Hence, we continue to prefer short-to-medium duration products, given the favourable risk reward," Anurag Mittal, Head of Fixed Income at UTI AMC said.

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