US credit downgrade: What it means for Indian investors in US bonds

Indian funds with exposure to US debt may experience short-term mark-to-market volatility.

Investments in US bonds, especially by Indian investors, has gained traction in recent years, thanks to global diversification, currency hedging and relatively attractive risk-adjusted returns.

At present, there are five mutual fund schemes focussed on US bonds – Bandhan US Treasury Bond 0-1 year Fund of Fund (FoF), Aditya Birla Sun Life US Treasury 1-3 year Bond ETFs FoF, Aditya Birla Sun Life US Treasury 3-10 year Bond ETFs FoF, Axis US Treasury Dynamic Bond ETF FoF and DSP US Treasury FoF.

Due to RBI/SEBI restrictions on overseas investments by Indian mutual funds, these funds are not accepting fresh investments.

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Notably, US Treasury yields have been on the move ever since Moody’s downgraded the US’ credit rating last week.

US bond yields surged on May 21 with the 30-year yield hitting 5.089 percent — its highest since October 2023 — after a weak 20-year auction and Japan’s bond sell-off. The 10-year US yield rose to 4.595 percent. While higher yields attract investors, they also hurt existing bond values, as yields and prices move inversely.

How is this going to impact Indian investors betting on US bonds?

Credit rating cut

Moody’s on May 16 downgraded the US rating from top-notch AAA to AA1, citing “the increase over more than a decade in government debt and interest payment ratios to levels that are significantly higher than similarly rated sovereigns.”

With this downgrade, the US has lost its last AAA rating by all major ratings agencies, following downgrades by Fitch in 2023 and Standard & Poor's in 2011.

“Given that the markets have already broadly priced the worsening fiscal outlook, and the other two rating agencies have already downgraded the US from a top-notch rating, we see the rating downgrade as a lagged indicator and expect market reaction to be muted. However, bond market sentiments have soured a bit given the new tax cut proposals by the US government, and the rating actions will add to that negative sentiment,” said Kaustubh Gupta, Co-Head Fixed Income, Aditya Birla Sun Life AMC.

Impact on Indian funds

According to experts, the recent US credit rating downgrade is symbolically significant but has limited practical impact.
“Historically, such downgrades have led to short-term volatility, but long-term demand for Treasuries has remained strong. However, yields could stay elevated due to fiscal concerns and high interest rates, impacting global borrowing costs,” said Viram Shah, Co-founder and CEO, Vested Finance.

It is expected that Indian funds with exposure to US debt may experience short-term mark-to-market volatility.

“However, over the medium term, the impact is likely to be muted. If yields rise, these funds could offer better entry points for investors seeking stable, dollar-denominated returns. Currency fluctuations and Fed policy will remain more influential than the downgrade itself,” added Shah.

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According to Mayank Misra, Vice President–Product Management, Mutual Funds at INDmoney, while such a downgrade can trigger short-term volatility in US Treasuries, potentially impacting the NAVs of Indian mutual funds investing in them, these funds are generally well-positioned to deliver stable returns over the medium to long term.

Importance of US bonds in a portfolio

US bonds provide useful portfolio diversification given that the US Treasury has historically been the classic safe haven asset with deep liquid markets and strong institutional framework and the US dollar as the default reserve currency.

Even while downgrading the US from the AAA rating, Moody’s has reaffirmed US’ exceptional credit strengths such as the size, resilience and dynamism of its economy and the role of the US dollar as global reserve currency and long history of very effective monetary policy led by an independent Federal Reserve.

“US bond funds thus not only provide diversification against sharp global shocks, when US yields would most likely decline, but also against sharp domestic shock given that these bond funds have underlying assets denominated in the US dollar and would protect investors against large domestic currency fluctuations,” said Aditya Birla Sun Life AMC’s Gupta.

Therefore, US bond funds provide both geographic and currency diversification. They can reduce correlation to domestic Indian markets and act as a stabiliser in times of equity volatility.

Especially for Indian investors with future dollar liabilities, like education, travel, or property, these funds can act as a natural hedge.

"While concerns about rising US debt levels and fiscal deficits are valid, the resulting sell-off in US bonds has created attractive entry points. We look beyond near-term volatility, recognising that current higher yields present value, especially as the Fed is likely to implement rate cuts over the next two years in response to slowing growth. For global investors seeking both yield and safety, US bonds now offer an appealing combination of income potential and long-term stability," said Kunal Valia, Founding Partner, StatLane.

Alternatives to US bond mutual funds

With domestic US bond feeder funds temporarily closed for fresh subscriptions due to SEBI regulations, investors can still gain exposure through direct international investments.

Under the Liberalised Remittance Scheme (LRS), individuals can invest up to $250,000 annually in overseas assets.

Platforms such as INDmoney, Vested Finance and Winvesta facilitate such investments in US Exchange-Traded Funds (ETFs) that hold US Treasuries, investment-grade corporates, and short-duration instruments.

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“For investors looking at lower volatility and high yield returns, US bonds offer a good proposition. Through direct investing in US bond ETFs, one can ensure a periodic coupon payment. The returns expectation can be up to 7 percent (in high-yield corporate bonds) per annum in dollar denomination. Plus, there can be a 3-4 percent rupee depreciation annually, which can take the annual yield to around 9-10 percent,” said Swastik Nigam, Founder and CEO, Winvesta.

Another advantage is the favourable tax treatment that overseas investments receive. The long-term capital gain (LTCG) tax on overseas funds and securities is 12.5 percent after a minimum holding period of two years, whereas domestic bond funds are taxed at the slab rate, irrespective of the holding period.

“However, keep in mind that in case of direct investing in US bonds, there might be a slightly higher upfront cost of investing because of the rupee to dollar conversion. Additionally, there will also be a tax on dividends from US bonds, which may attract a 25 percent withholding tax for Indian residents,” said Nigam.

Funds to pick

According to INDmoney’s Misra, while specific recommendations depend on interest rate outlook and risk appetite, investors may consider sticking to relatively safer instruments such as US Treasury Bonds and Treasury Inflation-Protected Securities (TIPS).

These instruments offer strong credit quality and are better suited for conservative investors, especially in uncertain macroeconomic environments.

“For higher risk appetite, given the current rate cycle and potential Fed pivot, long-duration US Treasuries offer strong capital appreciation potential if interest rates fall. Overall, the most balanced bet today is intermediate to long-duration Treasuries,” he said.

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Vested Finance’s Shah feels that for long-term investors, laddered exposure to US Treasuries and investment-grade corporate bonds offers a good risk-reward balance in the current high-rate environment.

“Short-duration bond funds may suit conservative investors, while longer-duration funds could benefit when interest rates begin to decline. High-yield bonds should be approached with caution given the elevated credit risk in a tightening environment,” Shah said.

Returns expectations

According to experts, returns from US bonds will depend on the duration and interest rate trajectory.

“Currently, yields on US Treasuries and investment-grade corporates are at multi-year highs — offering 4-6 percent depending on the maturity and credit quality. For Indian investors, there’s also a potential currency gain if the rupee depreciates moderately over time, adding to overall returns,” said Shah.

While returns may vary year to year, these funds continue to be a viable option for diversification and stable income.
“US bond funds typically offer annual returns in the range of 7–8 percent in INR terms, depending on the type of bonds held, interest rate movement, and currency fluctuations,” said Misra.

US bonds can be a good strategic asset for Indian investors, but only if the risks are understood and managed. They're ideal for diversification, capital preservation, and dollar exposure, but should be used as part of a balanced portfolio with proper currency, interest rate, and tax planning.

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