Expect 25 bps rate cut: How will debt funds react to potential RBI cut?

With several economists forecasting a potential 0.25% (25 basis points) cut in the Reserve Bank of India's (RBI) repo rate, from 6.5% to 6.25% today, the financial market is closely watching how this move will affect debt funds. A reduction in interest rates typically has a significant impact on debt funds, particularly in terms of bond prices, yields, and the overall returns they generate for investors.

 

"RBI is expected to cut the repo rate by 25 basis points to 6.25% from the current rate of 6.50% in the Monetary policy meeting on February 7. The last rate cut was in May 2020 of 40 basis points to revive the economic growth affected by the pandemic. The cut in the repo rate means that the RBI will lend the money to the banks at a lower rate which in turn provides a benefit to the banks to charge lower interest rates from borrowers. This increases the money supply in the economy, strengthens liquidity, encourages borrowing, and boosts consumer demand. 

 

 

The main reason why RBI will likely cut the key rate this time is the expectation of an easing of CPI to 4.5% - 4.7% in January 2025 from 5.2% in December 2024. For FY25, the real GDP growth is estimated at 6.4% which is the lowest growth rate in the last four years. Also, the GDP is expected to grow between 6.3% to 6.8% in FY26. To accelerate the GDP growth, there is an anticipation that the RBI will take the rate-cut route," said Ajay Garg, CEO, SMC Global Securities.

 

How Falling Interest Rates Affect Debt Funds

When interest rates decline, bonds held by debt funds—especially those with higher coupon rates—become more valuable. This happens because these bonds continue to offer higher interest rates than newly issued bonds at the lower rates. As a result, the price of these bonds rises, which in turn boosts the Net Asset Value (NAV) of the debt fund, as per a Value Research analysis.  For instance, if a debt fund holds a long-term bond with a 7% coupon rate and interest rates drop, the bond's value increases because it continues to offer a higher return compared to newly issued bonds offering lower yields.

 

This effect is particularly pronounced in long-duration debt funds. The longer the maturity of the bonds in the fund, the greater the benefit when interest rates fall. Long-term debt funds hold bonds that pay higher interest rates for a longer period, and when rates drop, these bonds become even more attractive, causing their prices to rise and increasing the NAV of the fund.

 

For example, consider a long-term debt fund that holds a 10-year bond with a 7% coupon rate. If interest rates fall by 0.25%, the price of the bond will rise because it is locked in at a higher yield compared to newly issued bonds. This price increase leads to a corresponding rise in the fund's NAV, benefiting investors.

 

Rising Interest Rates and Debt Funds

On the flip side, when interest rates rise, the opposite happens. Newly issued bonds offer higher yields, making existing bonds (which were issued at lower rates) less attractive. As a result, the prices of older bonds fall, and the NAV of the debt fund declines. For instance, if the RBI decides to increase interest rates, a debt fund holding bonds with lower coupon rates will see the prices of these bonds fall, leading to a decrease in the NAV of the fund. 

"Apart from this immediate price impact, debt funds also generate returns through interest income, which is received periodically (annually, semi-annually, or quarterly) based on the bonds they hold. As interest rates fluctuate, the yield on reinvested funds also changes, affecting the fund's overall returns," said Value Research in a note.

   

In essence,  debt funds experience a two-fold impact from interest rate changes. Initially, a shift in rates has a one-time effect on bond prices, which either increases or decreases the NAV of the fund. Over time, the ongoing effect is felt through changes in reinvestment yields, which influence the fund's long-term returns.