Are falling interest rates turning debt mutual funds a smarter choice?

Why debt funds stand to gain as prices fall
Mutual funds benefit directly from falling interest rates as the value of bonds and interest rates are inversely proportional. When the central bank reduces policy rates, the yield on new issues falls, and existing bonds with higher interest rates gain value. The Net Asset Value (NAV) of the funds that hold them rises. Long-duration funds benefit the most, followed by smaller but regular gains by short-duration funds.

Which funds are to benefit
Gilt and long-term funds are most sensitive to rate falls and can give rich returns as rates decline. For balanced investors, medium-term funds are the choice, making profits without being too exposed to volatility. For investors who want stability and liquidity, ultra-short and liquid funds are still to be relied upon, though their potential for capital increase is limited.

Why fixed deposits are losing popularity
Lowering of interest rates has also resulted in decreased returns on fixed deposits, where most banks today are offering less than 7 percent on best-of-class rates. In contrast, debt mutual funds are providing more attractive returns with the benefit of flexibility. This phenomenon is attracting investors away from traditional deposit products to market-linked debt products.

Change in fund strategies
Since bond yields are settling down, the fund managers are moving towards high-quality corporate paper and shorter-duration instruments. This accrual-based approach helps them generate consistent returns as the margin for capital gain from falling yields becomes narrower. Shorter-maturity corporate paper is particularly drawing inattention because they provide safety along with better spreads compared to government paper.

Risks that investors should keep in mind
As enticing as they seem, debt funds are not risk-free. Longer-term funds are still sensitive to surprise fluctuations in interest rates and thus more risky. The initial NAV lift after rate cuts is temporary, and subsequent reinvestment can be at lower yields, limiting future yields. Hybrid funds, mixing debt and equity, can yield good returns but also add equity-like volatility that investors must be comfortable with.

Who can consider debt funds now
Debt mutual funds are suitable for investors with a medium- to long-term outlook who would like to benefit from a declining rate cycle. For investors with a five- to ten-year outlook, medium- or long-duration funds can prove to be a suitable option. Investors with short perspectives or liquidity requirements would be better served by liquid and money market funds. High-quality corporate bond funds provide a very interesting option for stable income-seeking investors.

The bottom line
Slumping interest rates have made debt mutual funds a profitable bet over aged fixed deposits. But the choice of fund category must be appropriate to the investor's time horizon, risk profile and income goal. With judicious selection, debt funds can provide stability as well as flexibility in the current context.