Build debt fund portfolio diversified across duration, watch volatility

Take limited exposure to longer-duration debt funds; match horizon with fund's portfolio duration

Debt mutual funds turned in a strong performance in 2024, with longer-duration funds leading the way. While rate cuts may begin in 2025, the cycle is likely to be a truncated one. Experts, therefore, suggest not going overboard on longer-duration funds. Instead, they suggest building a diversified portfolio and selecting debt fund categories based on the investment horizon.

 

Drivers of performance in 2024

 

Both dropping bond yields and high accruals contributed to performance. “The yield of the 10-year benchmark government security (G-Sec) dropped from 7.35 per cent to 6.78 per cent, creating market gains. In addition, reasonable accrual levels also supported the performance of debt funds,” says Joydeep Sen, corporate trainer and author. 

The global environment was also conducive. “The decline in global inflation, receding from post-Covid highs, created an environment where long-term interest rates dropped in anticipation of central banks’ cuts,” says Mahendra Kumar Jajoo, chief investment officer-fixed income, Mirae Asset Investment Managers. 

Tight liquidity, due to banks realigning their asset-liability management (ALM), led to higher short-term rates. “Overnight rates have been around 6.5–6.75 per cent, as system liquidity has been mostly in deficit. Short-term instruments like the 3-month commercial paper (CP) and certificates of deposit (CD) yielded close to 7 per cent, leading to high average returns in liquid and money market funds,” says Sandeep Bagla, chief executive officer, TRUST Mutual Fund (MF). 

“The inclusion of Indian bonds in JP Morgan indices (which brought around Rs 1 trillion in inflows) drove strong performance in India’s bond markets,” says Devang Shah, head-fixed income, Axis Mutual Fund.

 

Maintain allocation to debt funds in 2025

 

Fixed-income investments can serve as a defensive asset class amid high equity valuations. “Debt funds provide flexibility for rebalancing portfolios during equity market corrections. For short-term goals, debt continues to be the most appropriate asset class,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. 

Allocation to debt funds should be driven by a variety of factors, regardless of market levels. “Investment decisions should depend on risk appetite, objectives, and horizon,” says Sen.

 

Positive drivers of return

 

RBI recently shifted to a neutral stance and cut the cash reserve ratio (CRR). Experts are of the view agree that a rate-cutting cycle by the central bank in 2025 can significantly influence fixed-income performance. 

“In this environment, we expect the RBI to cut rates to stimulate growth, which will be positive for fixed income,” says Jajoo. 

Shah concurs. “We expect a 50-basis point rate cut in the next six months. Further fiscal consolidation by the government, with an anticipated fiscal deficit below 4.5 per cent for FY26, will lead to strong bond demand-supply dynamics,” he says.

 

Negative factors that could inhibit growth

 

Geopolitical factors could impact returns of debt funds. “Geopolitical instability, higher inflation and fiscal deficit due to tariff increases, and debt scare in the US is a possibility, especially after President Donald Trump assumes office in January 2025,” says Jajoo. Bagla too believes that imposition of tariffs by the Trump Administration could increase global inefficiencies, lead to inflationary impulses, and drive yields higher. 

Global central bankers, while reducing the cost of money, are simultaneously shrinking the size of their balance sheets. “Diminished global liquidity can adversely affect sentiment,” says Bagla.

 

Tilt towards longer-duration funds?

 

Many investors had tilted their debt fund portfolios towards longer-duration funds in 2024. But experts do not think that is advisable in 2025. 

“We expect RBI to cut rates in February 2025, but it is likely to be a shallow rate-cut cycle, with a 50–75 basis point cut in 2025. Longer-term bonds do not appear to have much room for appreciation as inflation expectations are still not firmly anchored,” warns Bagla. A part of the rally in bond prices has already taken place in anticipation. One basis point is one-hundredth of a percentage point. 

Dhawan warns that investors looking to buy longer-duration funds need to be mindful of potential volatility. “They may also not see significant capital appreciation unless growth slows down rapidly,” he adds.

 

Diversify across duration  

 

Instead of chasing past year’s performers, experts suggest paying heed to one’s investment horizon. “Match the investment horizon with the portfolio maturity of the fund you would like to invest in. For instance, if the maturity is three years, the horizon should be at least two years or more. It cannot be one month. Avoid investing in longer-duration funds for a shorter horizon,” says Sen. 

Build a portfolio diversified across duration to manage risk better. “Allocate 30 per cent to long-duration funds and 70 per cent to low and short-duration funds. Avoid over-allocating to one type of funds,” says Mahendra Jajoo. He also suggests that investors need to be agile and move out of long-duration funds after the initial rate cuts. 

In 2025, inflation is likely to be under control but growth is likely to weaken. “Allocation to dynamic bond funds, and short to medium term funds, including corporate funds, can help capture the interest rate cycle,” says Shah. According to him, investing in dynamic bond funds allows investors to play all parts of the rat cycle.

 

Dos and don’ts

 

Be prepared for some volatility in your fixed-income portfolio. Keep an eye on the US Federal Reserve’s interest-rate and other monetary policy actions, the rupee’s behaviour against the dollar and other currencies, and incoming US President Donald Trump's policies.

In case you try to earn higher returns by taking more credit risk, you need to be mindful of the challenges. “Lower-rated bonds may not be as liquid. These bonds also carry higher default risk,” says Dhawan. 

Factors that will impact debt fund returns in 2025

 

Positive drivers

 

A rate-cutting cycle by the central bank in 2025 of 50-75 basis points is expected to positively influence fixed-income performance 

Fiscal consolidation by the government is projected, with an expected fiscal deficit below 4.5 per cent for FY26, which could improve G-Sec demand-supply dynamics

 

Inhibiting factors

 

Geopolitical instability, higher inflation, fiscal deficits, and tariff increases in the US could negatively impact debt fund returns

The imposition of tariffs by the US administration could create inflationary pressures, driving yields higher 

Global central banks are simultaneously reducing the cost of money and shrinking balance sheets, which could lead to diminished global liquidity and adversely affect market sentiment

 

(The writer is a Mumbai-based independent financial writer)