Rate Cut and Debt Funds: Should You Rethink Your Fixed-Income Strategy?

The Reserve Bank of India recently cut the repo rate by 50 basis points to 5.5%, while also slashing the Cash Reserve Ratio by 100 basis points. That’s a big move—injecting ₹2.5 lakh crore into the system and making borrowing cheaper across the board.

Great news for loan borrowers. However, for fixed-income investors, this shift poses a tough question: should you stick with your long-term debt funds or shift gears?

Let’s see what this rate cut means for your debt funds and fixed-income strategy.

Impact of Rate Cuts on Debt Funds

When the RBI announces a rate cut, it’s important to understand how it affects debt funds before adjusting your investment strategy:

• Capital Gains Potential

When interest rates fall, bond prices rise. Long-term debt funds benefit more from this inverse relationship because their holdings, longer-duration bonds, are more sensitive to interest rate changes. A one per cent rate cut, for example, can lead to significantly higher mark-to-market gains on 10-year bonds than on 2-year ones, boosting Net Asset Values (NAVs). This sensitivity makes long-term funds especially attractive at the early stages of a rate-cut cycle. However, timing is crucial, as most of the re-pricing happens quickly once cuts are anticipated.

• Reinvestment Risk

As yields fall, the interest earned on future reinvestments also reduces. Long-term funds are less exposed to this risk since they hold bonds for longer periods and do not need to reinvest frequently. Short-term funds, on the other hand, mature more quickly and need to deploy funds again at lower prevailing rates. This reinvestment risk erodes overall returns over time. For investors seeking stable income, this makes long-term debt funds more suitable during a falling interest rate cycle, provided they can lock in yields early.

• Credit Risks

Investors often mistake interest rate risk for credit risk. Even if the RBI lowers rates, it does not improve the creditworthiness of the issuer. Long-term funds that hold lower-rated securities can still be exposed to default risk. Therefore, the focus should not only be on duration but also the credit quality of the portfolio. Investors must review the credit profile of the fund, especially in a volatile economic environment where lower-rated companies may face refinancing pressures.

• Yield Compression

When investors enter long-term funds after multiple rate cuts have already taken place, they often face yield compression. This means the current yield to maturity (YTM) of the fund becomes less attractive due to already inflated bond prices. While existing investors benefit from NAV appreciation, new investors buy at higher levels and receive lower returns from now on. This situation is more pronounced in long-term funds because of their greater sensitivity to interest rate changes.

• Liquidity Management

Short-term debt funds invest in high-liquidity instruments, such as Certificates of Deposit, Treasury Bills, and Commercial Papers. These funds face lower interest rate risk and are ideal for meeting short-term goals. In contrast, long-term funds can sometimes hold papers with lower daily tradability. During periods of market volatility or redemption pressure, long-term funds may struggle to sell these instruments without incurring losses. For investors with liquidity needs in the next 12 to 18 months, short-term debt funds are better.

Alternatives to Debt Funds During Repo Rate Cuts

If you want to shift your investment from debt funds to other instruments during a repo rate cut, here are your options:

• Equity Mutual Funds

These funds invest primarily in shares of listed companies. When rates fall, companies can borrow more affordably, improving profits and fuelling growth. This boosts equity markets. Sectors, such as banking, real estate, and consumer goods, may especially benefit, pushing equity fund returns higher.

• Real Estate Investment Trusts (REITs)

REITs invest in income-generating commercial real estate, such as office parks, malls, and warehouses. During rate cuts, real estate borrowing costs decrease while profitability improves, leading to increased property valuations. This may enhance distribution yields and capital appreciation for REIT investors. In India, listed REITs provide exposure to large-scale properties with relatively stable rental income and offer liquidity along with quarterly income distribution.

Gold and Sovereign Gold Bonds (SGBs)

Gold offers protection against inflation and economic instability, proving a suitable option when interest rates fall. SGBs are government-issued securities linked to gold prices and provide an additional 2.5% annual interest on the invested amount. During periods of RBI rate cuts, real returns on fixed-income products may fall, making SGBs attractive. They combine capital appreciation from rising gold prices with fixed-interest income. Also, SGBs are exempt from capital gains tax if held till maturity (8 years).

Conclusion

A repo rate cut by the RBI can boost long-term debt funds in the short term, but it also brings risks such as reinvestment and credit issues. While these funds may offer good returns early in a rate-cut cycle, timing and credit quality matter. If you’re unsure, short-term debt funds offer better liquidity, and alternatives like equity funds, REITs, or SGBs can also be considered. Always match your investment with your goal, time horizon, and risk appetite.