Debt MF outlook: Divide portfolio between long- and low-duration funds

Two significant events—the Union Budget of 2025 and the Reserve Bank of India’s (RBI) monetary policy review—have taken place. Let’s examine the outlook for debt mutual funds in their aftermath.

 

Twin boosts: Fiscal consolidation, rate cut

 

The key positive from the Budget is fiscal consolidation by the government. The revised fiscal deficit estimate for 2024-25 stands at 4.8 per cent of gross domestic product (GDP), while the fiscal deficit for 2025-26 is estimated at 4.4 per cent of GDP.

 

“The government has significantly reduced the fiscal deficit in line with its guidance. It has also committed to reducing the debt-to-GDP ratio going forward,” says Mahendra Kumar Jajoo, chief investment officer–fixed income, Mirae Asset Investment Managers (India).

 

“The fiscal deficit estimate for next year of 4.4 per cent aligns with the glide path mentioned earlier during Covid when the deficit had increased,” says Joydeep Sen, corporate trainer and author.

 

The monetary policy turned dovish with the first rate cut in nearly five years. “More rate cuts are likely going forward,” says Pankaj Pathak, fund manager–fixed income, Quantum Asset Management Company (AMC).

 

Higher inflation in US could play spoilsport

 

One issue to watch out for is the RBI’s stance. “While the RBI cut the repo rate, it maintained a neutral stance,” says Jajoo.

 

The Indian economy requires rate cuts and a supportive monetary policy to sustain growth, which is slowing. “However, global uncertainty due to Trump’s tariffs, geopolitical conflicts, etc could lead to higher inflation and a higher fiscal deficit in the US. The RBI may be forced to respond to global developments,” says Jajoo.

 

Pathak also notes that Trump’s tariffs and immigration policies could be inflationary for the US and could affect its monetary policy. This would, in turn, have global implications.

 

According to experts, the government’s income tax collection estimate appears aggressive, given the personal income tax giveaways.

 

“While the government is committed to maintaining the fiscal deficit, further fiscal support may be needed if the economy does not revive,” says Jajoo. 

 

Rate cut expectations

 

Most experts are of the view that this will be a shallow rate-cut cycle. “If inflation falls to the RBI’s projected average level of 4 per cent for FY26, there would be a significant gap compared to the repo rate of 6.25 per cent. This suggests a possibility of another 50–75 basis points of rate cuts in the next one year,” says Jajoo.

 

Since the current repo rate is close to the long-term average, Pathak anticipates one more cut of 25 basis points. “However, if GDP growth recovery remains sluggish, more cuts, up to 100 basis points, are possible this year,” he says.

 

Sen expects one or, at most, two incremental rate cuts, each of 25 basis points.

 

Long-duration funds could rally

 

If rates are cut by another 50–75 basis points, longer-duration bonds and funds could rally further. Jajoo believes there is momentum left in these funds.

 

Pathak also sees longer-end yields falling further due to positive demand-supply dynamics for government bonds. “The net supply of government bonds for FY26 is flat, but demand from insurance companies, pension funds, and banks has been growing. Demand from foreign investors could also increase due to India’s inclusion in global bond indices,” says Pathak.

 

Low-duration funds attractive

 

Some fund managers find the low-duration category appealing. “Today, the three-year corporate bond yield is higher than the five-year and 10-year yields. If the RBI injects adequate liquidity and credit momentum slows, the corporate bond yield curve could normalise,” says Jajoo. He suggests diversifying between long-duration and low-duration funds.

 

Other managers favour dynamic bond funds. “Dynamic bond funds are a good bet if you can stay invested for two to three years. Accrual levels are good in short- to medium-duration AAA bonds,” says Pathak.

 

Sen recommends corporate bond funds. “The spread corporate bonds offer over G-Secs is attractive,” he says.

 

Do’s and don’ts

 

Pathak cautions investors against basing decisions solely on past returns. “Align your investment horizon with the maturity profile of the fund,” he says. If investing in long-duration or dynamic bond funds, he says a longer holding period is necessary to ride out interim volatility.

 

Sen says after the rate cuts, accruals will reduce, so investors need to moderate their return expectations.

 

For those wishing to lock in current accruals, target maturity funds are an option. However, these funds will not offer the benefit of capital gains. To get this benefit, investors must take exposure to longer-duration funds.