Will Debt Mutual Fund Returns Improve After RBI's Latest Bi-Monthly Monetary Policy

The stance of the monetary policy is kept 'neutral' to remain unambiguously focussed on a durable alignment of inflation with the target while supporting growth.

The decision was taken considering that Consumer Price Index (CPI) inflation softened sequentially in November-December 2024 from its recent peak of 6.2% in October 2024. The fact that CPI was well within the target range was a comforting factor.

The decision was in consonance with the objective of achieving the medium-term target for Consumer Price Index (CPI) inflation of 4.00% within a band of +/-2.00%, while supporting growth.

What Does It Mean for Debt Mutual Funds Investors?

Well, it means that going forward, debt mutual fund returns are likely to be more attractive. This is because interest rates and bond yields share an inverse relation with bond prices. Simply put, when interest rates and yields fall, the price of bonds goes up and vice versa.

The longer end of the yield curve particularly benefits. In other words, debt mutual funds holding longer maturity papers stand to gain more from a rate cut action.

That being said, the inflation trends also need to be closely monitored so as to ascertain the scope of further rate cuts by the RBI, which would be beneficial for bond prices.

The RBI has observed that excessive volatility in global financial markets and continued uncertainties about global trade policies coupled with adverse weather events pose risks to the growth and inflation outlook.

Therefore, the MPC has decided to remain watchful and voted in favour of a neutral stance, which will provide flexibility to respond to the evolving macroeconomic environment.

So, much depends on the CPI inflation trajectory as regards policy rates are concerned.

If CPI inflation softens further and remains within the RBI's target range, the RBI may cut the policy rates further to support growth, which will be a decisive turn in the interest rate cycle.

On the other hand, if inflation increases due to higher tariffs being imposed, weak Indian Rupee (INR), weather events, and supply chain being disrupted among other factors, then it would limit the scope for the RBI to cut rates further.

Currently, the INR has dropped to a life low of 87.95 against the U.S. Dollar (USD) owing to the risk of higher tariffs being imposed by the U.S.

Debt Mutual Fund Returns May Improve, but Devising a Sensible Strategy Is Essential

While the policy interest rate has been cut, the rate cycle seems to have turned, and debt fund returns are likely to improve, you cannot be investing in an ad hoc manner in any debt mutual fund out there. Devising a strategy that aligns with your risk profile, investment objective, and liquidity needs is important.

At present, you need to have exposure to debt mutual funds tactically. It ought to be done very thoughtfully whereby an optimal return can be clocked with the risk being minimised.

Note that debt mutual funds are not risk-free and may be subject to interest rate risk, credit risk, default risk, etc.

Typically, debt mutual funds that carry longer maturity papers may witness higher volatility in the interim when interest rate fluctuates. On the other hand, funds that invest in the short maturity segment witness minimal mark-to-market impact when interest rates fall.

Currently, it is difficult to estimate whether policy rates would move down consistently even in the ensuing meetings, given that there are risks to the inflation trajectory.

Against the above backdrop, allocate your hard-earned money sensibly to appropriate categories of debt mutual funds.

[Read: Best Debt Mutual Fund Categories for 2025]

Medium-to-Long Duration Debt Mutual Funds:

To take exposure to slightly longer maturity papers, you may consider investing in Medium-to-Long Duration Debt Mutual Funds. But make sure that the maturity profile of the scheme you zero in on is up to 5 years or so with G-secs making up around 30%.

Remember, Medium-to-Long Duration Debt Funds are moderate-to-high-risk contenders. This is due to the interest rate sensitivity of these funds, as well as the fact that there is a slight credit risk.

Thus, it is important to evaluate the qualitative aspects such as the portfolio characteristics, risk ratios, investment processes & systems, risk management framework, and ideologies followed by the fund house and not focus only on the historical returns.

You may allocate around 25% of your debt mutual fund portfolio to some of the best Medium-to-Long Duration Debt Funds, keeping an investment horizon of 3 to 5 years.

Over a period of 3 to 5 years, Medium-to-Long Duration Funds could reward you, the investor well, provided a prudent selection is made.

[Read: 3 Best Medium to Long Duration Debt Funds for 2025]

Dynamic Bond Funds:

If you wish to play the interest rate cycle and have an exposure dynamically to short and medium-to-long maturity debt papers, some of the best Dynamic Bond Funds can be a meaningful choice, provided you have an investment horizon of 3 to 5 years.

Regardless of the direction in which interest rates move, Dynamic Bond Funds are capable of taking advantage of dynamic market conditions and can invest accordingly to create an all-season portfolio that generates optimal returns.

The performance of Dynamic Bond Funds largely depends on the fund manager's judgement of the interest rate movement. If the manager fails to gauge the movement of interest rates accurately or is unable to time the investment correctly, you may be at risk. The level of risk depends on the kind of underlying securities held in the portfolio.

It is critical to invest in Dynamic Bond Funds that hold a robust portfolio of securities across maturities and high-quality debt & money market instruments. Around 25% of your debt mutual fund portfolio could be allocated to some of the best Dynamic Bond Funds.

[Read: 3 Best Dynamic Bond Funds for 2025]

Banking & PSU Debt Funds:

These can be a good alternative to park money into a bank fixed deposit. Banking & PSU Debt Funds are mandated to invest predominantly (80% of their assets) in top-rated corporate debt instruments issued by Banks, Public Sector Undertaking (PSUs), Public Financial Institutions (PFIs), Municipal bonds, and other such securities.

These entities are recognised for their robust credibility and liquidity compared to those from private issuers, making them a relatively safer investment option.

Usually, Banking & PSU Debt Funds have exposure to debt papers across the yield curve. Nevertheless, a majority of Banking & PSU Debt Funds usually maintain a duration of 2 to 5 years in their portfolio. The decision is based on the evaluation of various micro and macroeconomic factors, including the interest rate cycle.

For an investment horizon of 2 to 3 years, you may consider investing in some of the best Banking & PSU Debt Funds. At present, around 30% of your debt mutual fund portfolio could be allocated to these funds.

[Read: 3 Best Banking & PSU Debt Funds for 2025]

Liquid Funds:

For a shorter investment horizon, of up to a year or so, it would be better to stick to some of the best Liquid Funds having the least or no exposure to private issuers.

At a time when geopolitical tensions are simmering in many parts of the world and may have ramifications on the global economy, it would be worthwhile to hold some money in Liquid Funds. Even legendary equity investor Warren Buffett strategically allocates a portion of the portfolio to short-term U.S. treasuries.

Investing in some of the best Liquid Funds is a sensible way to hold some money safe, whereby it can offer you liquidity, help address unforeseen circumstances, and meet short-term financial goals, while the risk-on asset classes are expected to be volatile.

To conclude:

Make sure you hold a sensible and reasonably diversified portfolio of worthy debt funds considering your risk profile, investment objective, and investment horizon rather than chasing returns. This shall help you earn optimal risk-adjusted returns. When investing in debt funds, returns should be secondary, and how the scheme manages risk is paramount.

Be a thoughtful investor.

Happy Investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.