Debt funds outlook post Budget: Focus bulk of portfolio on 2-4-yr maturity

They offer the sweet spot of reasonably attractive yields without excessive interest-rate risk

The higher-than-expected gross market borrowing announced in the Union Budget has disappointed debt market participants. The 10-year government security (G-Sec) yield has been rising: from a low of 6.2 per cent in May 2022, it is currently above 6.7 per cent. Debt mutual fund investors need to recalibrate their strategy for the current environment.

 

Positives: Fiscal consolidation continues

 

The Budget maintained the focus on fiscal consolidation. “The fiscal deficit for financial year 2026–27 (FY27) was budgeted at 4.3 per cent of GDP, lower than FY26 (revised estimate), and there was a clear shift towards managing debt-to-GDP with a target of 50 per cent by FY31,” says Devang Shah, head – fixed income, Axis Mutual Fund.

 

“The commitment to reduce the fiscal deficit supports the long-term interest rate environment and enhances confidence in India’s macro stability,” says Abhishek Bisen, head – fixed income, Kotak Mahindra Asset Management Company (AMC).

 

The Budget also announced steps to deepen the corporate bond market, which could improve liquidity, participation and pricing efficiency over time, if implemented well.

 

Another non-Budget-related development that augurs well for debt markets is that pension funds were changing their asset allocations, which affected demand this year. “That has now normalised. Demand from pension funds should increase meaningfully in FY27,” says Anurag Mittal, senior executive vice president and head – fixed income, UTI AMC.

 

Negative: Higher gross market borrowing

 

The Budget projected gross market borrowing of ₹17.2 lakh crore for FY27, above market expectations of ₹16–16.5 lakh crore. “The elevated gross number increases near-term supply pressure, especially when combined with heavy state development loans (SDLs) issuance, and has kept upward pressure on yields in the 10-year segment,” says Shah.

 

Some fund managers, however, remain optimistic about the final borrowing outcome. “There is potential upside on stronger-than-expected revenue collections as well as dividend payment from the Reserve Bank of India. The government has also projected a marginal increase in small savings collection. This could also surprise on the higher side,” says Mittal. Actual borrowing could still end up lower than what markets anticipate.

 

Why 10-year G-Sec yield has hardened

 

Geopolitical tensions have raised global uncertainty. “Tariffs imposed on India have put pressure on the rupee. The combination of elevated uncertainty and currency depreciation has weakened demand for Indian bonds, pushing yields higher even though the macroeconomic fundamentals remain stable,” says Bisen.

 

“Markets have priced in a larger FY27 borrowing programme and sustained SDL supply, keeping term premia elevated,” says Shah.

 

Mittal expects the 10-year benchmark yield to trade between 6.70 and 6.90 per cent.

 

Long-duration funds could see volatility

 

The higher FY27 gross borrowing has added pressure on bond yields. “The 10-year G-Sec at around 6.7–6.75 per cent reflects a supply-heavy environment. This can last longer than expected and create prolonged volatility in long-duration funds,” says Feroze Azeez, joint chief executive officer (CEO), Anand Rathi Wealth.

 

“With limited visibility on meaningful rate cuts and the risk of interim volatility in long-term yields, retail investors should be cautious,” says Arihant Bardia, chief investment officer (CIO) and founder, Valtrust.

 

Harsh Vira, chief financial planner and founder, FinPro Wealth, says only investors with strong conviction and a long investment horizon should stay in this category at this point.

 

Medium-duration funds: Well positioned

 

Medium-duration funds are positioned between the stability of short-duration funds and the rate sensitivity of long-duration funds. “With yields moving higher post Budget, medium-duration funds benefit from improving accrual income, as maturing bonds are reinvested at higher rates,” says Azeez. He adds that the current yields of these funds in the 6.5–7.5 per cent range provide reasonable carry without excessive duration risk.

 

If the RBI continues rate cuts, these funds can also see price gains, while staying less volatile than long-duration options.

 

Shorter-duration funds: For stability

 

Shorter-duration debt funds can suit investors across market cycles. “In an environment of elevated yields, they benefit from stronger interest accrual while avoiding the mark-to-market swings seen in longer-duration categories,” says Azeez.

 

Ultra-short and liquid funds work well for parking emergency money or money needed in the near term. Investors can also use money market funds for goals that are less than one year away. “Keeping too much allocation here for extended periods would amount to leaving returns on the table,” says Vira.

 

Among other categories, some experts like the income plus arbitrage category. “It looks increasingly compelling because it is significantly more tax-efficient (taxed at 12.5 per cent after two years) while still delivering competitive post-tax returns,” says Bardia.

 

Structuring the portfolio

 

Investors should align debt fund selection to the investment horizon. Their horizon should at least match the fund portfolio’s average maturity.

 

“Investors should focus the bulk of their debt allocation on short- to medium-duration funds with portfolio maturity of around two to four years, which offers a sweet spot of reasonably attractive yields without excessive interest-rate risk,” says Vira. He suggests categories such as corporate bond funds and banking and public sector undertaking (PSU) debt funds, which can offer good risk-adjusted returns.

 

Mistakes to avoid

 

Investors should avoid chasing past returns. “Extrapolating past performance into the future can be dangerous in debt markets where the environment can shift quickly,” says Vira.

 

Investors should also not ignore duration risk. They should also avoid going down the credit curve in search of higher yields. Finally, they should not over-allocate to a single category and should diversify across categories, while matching funds to their horizon.