Outlook for debt funds improves, but avoid chasing long-duration gains

Keep the core allocation in short- to medium-duration funds; match fund maturity with financial goals

The 10-year Indian government bond yield, which stood at 6.66 per cent when the US-Iran conflict began, rose to a peak of 7.14 per cent before retreating to around 6.77 per cent.

 

With the backdrop turning more favourable, longer-duration debt funds have benefited the most from the rally. Experts, however, caution against taking an outsized exposure to them and suggest keeping the bulk of one's debt allocation in short- to medium-duration funds.

 

Macro backdrop turns supportive

 

India's macro environment has changed significantly over the past fortnight and has become more supportive for debt funds. Brent crude rose from around $70 at the start of the conflict to an intraday peak of $126. It has now retreated to around $72-73 per barrel.

 

Lower crude prices should reduce India's import bill and ease concerns around the current account deficit. If the truce holds, inflation expectations should also moderate.

 

Measures by the Reserve Bank of India (RBI) have also improved the environment for debt funds. "Steps to attract foreign flows through foreign currency non-resident (FCNR) deposits and external commercial borrowings (ECBs) by public sector undertaking (PSU) lenders should support inflows," says Devang Shah, head of fixed income, Axis Mutual Fund.

 

"RBI has fully subsidised forex hedging costs for banks raising FCNR deposits in the three- to five-year category. It has also introduced concessional ECB swap facilities for public sector undertakings," says Amit Modani, senior fund manager, Shriram Asset Management Company.

 

Government measures have also helped. "The removal of taxes levied on foreign investors' capital gains and interest income from government securities is a positive step," says Modani. Shah says that following the tax changes, foreign portfolio investors (FPIs) have invested around ₹40,000 crore in government bonds.

 

There is also a strong possibility of Indian bonds being added to the Bloomberg Global Aggregate Index. "Such inclusion could bring another $20-25 billion of flows," says Shah.

 

Bond markets have rallied. "Yields have fallen by about 40 to 50 basis points or more across the curve, reversing a large part of the rise caused by the Middle East conflict and higher crude prices," says Shah.

 

Inflation pressure and expectations of a sharp rise in interest rates have eased. "The tone of the RBI and the Monetary Policy Committee members suggests they are not in a hurry to raise rates," says Shah.

 

Risks persist

 

The truce is uneasy and the situation in West Asia remains uncertain. "Investors should wait for about two months for greater clarity," says Vishal Dhawan, founder and chief executive officer (CEO), Plan Ahead Wealth Advisors.

 

Inflation-related risks remain. "These include possible supply chain disruptions in West Asia. The RBI has flagged the possibility of a deficient monsoon," says Modani. The RBI expects consumer price index (CPI)-based inflation to rise to 5.9 per cent in the third quarter and to average 5.1 per cent for the financial year 2026-27.

 

"Around 90 per cent of the positive impact of the truce appears to be already priced in," says Joydeep Sen, corporate trainer and author.

 

Avoid chasing gains in long-duration funds

 

Long-duration debt funds have gained the most from the decline in yields. However, as Sen points out, they have already benefited from the fall. "Incremental returns from here may not be significant," he says. According to him, there is no compelling rate-cycle argument for entering long-duration funds at this stage.

 

Other experts concur. Modani is of the view that large single-directional bets should be avoided at present. "If inflation risk materialises, rate-hike expectations could build faster than expected. In that case, long-duration funds should be added in a tactical and phased manner," he says.

 

Sen suggests that investors should only consider long-duration funds if their investment horizon matches the fund's maturity. Modani adds that investors entering these funds should have a high risk tolerance and be able to handle interim volatility.

 

Short- to medium-duration funds: Build core allocation

 

Experts are of the view that high-quality short- to medium-duration funds offer a more balanced risk-reward profile in the current environment.

 

"RBI measures should bring a deluge of liquidity into the system over the next few months. A large liquidity surplus would be positive for the short- to medium-term part of the bond curve," says Shah.

 

Shorter-duration funds are also less vulnerable to interest-rate risk than longer-duration funds. "The two- to five-year corporate bond segment offers attractive spreads compared to matching government securities," says Modani. Shah is of the view that investors should build the core portfolio with funds that invest in the one- to five-year segment.

 

"Investors with a horizon of more than two years may consider allocating a portion to an income-plus-arbitrage fund of funds as this category can also offer tax efficiency," says Shah.

 

Credit risk funds: Higher accrual, higher risk

 

Credit risk funds may offer higher accrual than quality debt funds. "While a quality debt fund may have a yield to maturity of around 7 per cent, a credit risk fund may offer around 8 to 9 per cent," says Sen.

 

The case for this category is also supported by improved corporate health. "Rating agencies' credit ratios have stayed above one since FY22, indicating that upgrades have exceeded downgrades," says Sen.

 

These funds, however, carry additional credit and illiquidity risk. "They are suitable only for investors who understand and are comfortable with higher credit risk," says Dhawan. Investors who expect their fixed-income portfolio to be low risk should avoid this category.

 

Match fund maturity with goals

 

Investors should build their debt portfolio according to their risk profile and investment horizon. "Money required for short-term goals should be kept in liquid and overnight funds," says Dhawan.

 

Investors can place the bulk of the debt allocation in short- and medium-duration debt strategies, which may account for around 50 to 70 per cent of the portfolio. Dhawan suggests limiting the allocation to long-duration funds to around 20 to 30 per cent of the debt portfolio.