Debt funds in a volatile rate cycle: opportunity or trap?

Market volatility in bond markets, which has been caused by the ups and downs in the oil markets and stubborn inflation, is changing the game for debt mutual fund investors. Here are ways in which you can make hay from volatility without being caught short.

The year was meant to bring debt funds back into focus after a long time. Having watched equity markets bask in the sun for a while now, high interest rates were expected to give debt funds some traction. And then, oil came into the picture. Next, it was inflation. Last but not least was a change in the monetary policy stance of banks.

For those retail investors who bought into debt mutual funds expecting stable profits, it has been quite disconcerting. But for those who know the ropes of the business, it has been something else altogether.

The shockwaves: oil, inflation, and the bond market's rude awakening

Global bond markets began the year 2025 assuming a gradual path towards disinflation, one that allows for interest rate reductions without any fear. However, such a thesis had soon been shattered by two elements that acted cumulatively on each other.

The first element is that of crude oil prices. Crude oil prices remained high because of geopolitical tension in the Middle East, as well as OPEC+ managing their supplies strategically. For oil-importing countries such as India, this means a higher current account deficit, depreciation pressure on the rupee, as well as a high level of imported inflation, which cannot be curbed by monetary measures in the country. The Reserve Bank of India is now faced with a dilemma whether to lower interest rates for stimulating growth or to retain the rates at a high level for defending the rupee from depreciation pressures.

Inflation itself remains sticky across critical sectors such as food, fuels, as well as service sector. Core inflation levels tracked by RBI have not seen any decrease that could bring down bond yields.

What happens to your debt fund when yields rise?

And this is when most investors get surprised. The NAV of your debt fund falls when the interest rates or the yields of bonds increase. And the higher the duration of the fund (weighted average time taken for cash flows), the greater is the impact.

If you invest in a gilt fund having a long duration, that is, investing in 20-year government bonds, then there can be a downfall in its NAV by 8–12% when interest rates rise suddenly. But for liquid funds and overnight funds, it hardly makes any difference. It is not a defect in the product, but it is just simple math.

In the current scenario, such an outcome is exactly what we have seen: some funds have been growing at 7–8%, whereas others have been fluctuating due to inflation or crude oil prices.

The opportunity hiding in plain sight: short-to-medium duration

Let’s see what this story of volatility is hiding. RBI has been on hold for quite some time now, and yield on the short-end of the curve (one-year-three-year maturity) has priced in a substantial risk premium, which may never come into fruition. In simple terms, yields on short-term debt fund investments are giving handsome returns for the risks taken by them.

The money market fund and short-duration segments are yielding 7.2% to 7.8% per annum in gross yield, and this comes with no volatility in the net asset value. For individuals who were sitting idle in their savings account yielding 3-4% or their FDs locking up capital, such investments give an added edge with risk-adjusted return.

Similarly, corporate bond funds in the 2-4 years duration bracket also make for attractive instruments, provided they have portfolio ratings of AA and above. The spread between corporate bonds and government bonds gives a substantial return without having to take any undue risks.

The trap: duration risk disguised as a rate-cut bet

The dangerous instrument being used in this scenario is the long-duration fund that promises to work in favour of the investor through what the market calls "the rate cut play". The reasoning goes as follows: the RBI will reduce interest rates, the prices of bonds will increase, and you will generate capital gains as well as yield.

The problem, however, is that with such high oil price volatility, any move in these parameters can shift the rate cut date by a period of half a year or more, thus keeping the yields high. Long-duration fund investors will continue suffering NAV losses until the event materialises, which seems to be taking longer than expected.

The concept of dynamic bond funds, where duration could be adjusted based on what the fund manager believes about the rate cycle, has been found not very successful when dealing with volatility cycles. Rate cycle timing is one of the most challenging things to do; investors who pay someone to make a judgment in their stead would be paying for a mistake.

Credit risk funds: the other minefield

In a low-volatility environment, credit risk funds — those that invest in lower-rated paper to earn a higher yield — can look attractive. In a volatile macro environment, they are a different matter entirely.

High inflation and elevated oil prices compress corporate margins. They also tighten liquidity conditions, making it harder for leveraged companies to roll over debt. The very issuers whose paper credit risk funds hold are under pressure precisely when the macro environment is most uncertain. A wave of downgrades or defaults, even in a handful of holdings, can cause NAV damage that takes years to recover from — as multiple fund implosions from 2019 to 2022 demonstrated.

Unless you have a high risk tolerance, a long investment horizon, and a genuine conviction in your fund manager's credit analysis process, credit risk funds deserve caution in this environment.

The tax dimension no one talks about enough

The first change in structure that had an impact on debt fund investment was the elimination of indexation benefit on returns from debt funds in 2023. Return from such investments is now charged as per the individual's tax slab rate, taking away one of the major reasons why debt funds were preferred over bank FDs by those paying a higher income tax.

Such a shift makes comparisons between the two a little more interesting. With an interest of 7.5% on bank FD and 7.8% on debt funds, both have very little difference in terms of post-tax value for an investor paying 30%, particularly if fund expenses are considered. Liquidity continues to be a strong factor, but the tax advantage that used to make sense previously is no longer valid.

In fact, target maturity funds, which invest in bonds until they mature and hence offer better certainty of returns, have seen a rising popularity on account of such a change. The predictable returns coupled with the low management expense ratio of passively managed products make them a decent choice for FD replacements.

Conclusion

Debt funds are not universally a good thing or a bad thing at this stage of the rate cycle. It all depends on what type of fund you have, why you have it, and whether your time frame for investment matches the fund’s risk profile. If you have a short-duration or a liquid fund, you have something that truly delivers in the present context – true yield, true liquidity, and true stability. If you have a long-duration fund, then it is a macro play, and if you are correct and there is a clean rate cut cycle, you stand to make a killing – but with the volatility in oil prices and inflation, it is a toss-up with a really long wait period. The fundamental principle in investing in fixed-income instruments has always been matching the duration with the time horizon of your goal. With the rate cycle being volatile and unpredictable due to supply-side shocks, this principle assumes even greater significance today.