These debt funds may thrive, thanks to rate cuts

The wait is over. After months of 'When's the cut coming?', the US Federal Reserve finally slashed interest rates by half a percentage point (50 basis points) on September 17, 2024.

What does this mean for the Indian market?

Given that the RBI (Reserve Bank of India) has followed in the Fed's footsteps in the past, rate cuts by the latter may make the former consider a similar move. And if the RBI does announce rate cuts are announced in its forthcoming monetary policy meeting in October, it may signal potential benefits for longer-duration debt mutual fund .

Why longer-duration debt funds may benefit from rate cuts

Before we delve into the 'why', it's important first to understand the relationship between bond maturity and interest rates.

You see, bond prices and interest rates move in opposite directions. Simply put, when interest rates head south, the prices of bonds with higher interest rates go up. Thus, when funds with longer maturities hold more of such bonds, they are likely to see a bigger boost. These include long-duration funds , with a median average maturity of 29 years, followed by gilt funds (18 years), dynamic bond funds (14 years) and medium to long-duration funds (11 years).

Of these, dynamic bond funds stand out. Unlike other debt funds, which have a fixed duration, dynamic bond funds have the flexibility to adjust their maturities depending on the direction in which interest rates are headed.

When rate cuts are anticipated, dynamic bond funds can increase their portfolio's maturity to maximise gains, as seen in the graph. These funds have been steadily extending their average maturity for the last year in the hopes of rate cuts by the Fed. Subsequently, the average maturity period of these funds has nearly tripled, from five years in early 2023 to 14 years in August 2024.

Taking the long view

Currently, nine out of 24 dynamic bond funds have average maturities exceeding the category median (14 years). This is a significant change from a year ago when the category's median maturity was around six years, with some funds even having maturities below the median.

Yet, certain dynamic bond funds are avoiding jumping on the long-maturity bandwagon. Notable ones include 360 One , Mirae Asset and Nippon India Dynamic Bond Fund . These funds have maintained maturities of less than seven years, with some even trimming them in the last one year.

Our take

Capital preservation is key if you are keen on investing in fixed-income securities. While debt funds with longer maturities may seem attractive right now, they also expose investors to increased volatility, owing to the uncertainty of rate cuts in the future.

Hence, when investing in debt funds, opt for those with lower volatility and stable returns (such as short-duration funds ). Avoid making longer-duration debt funds the core of your fixed-income portfolio due to their higher volatility. At best, they can be a supplementary component to help you benefit from interest rate movements, without risking your fixed-income allocation.

Also read: Are dynamic bond funds worth the hype?