Debt Funds vs Fixed deposits: Is it wise to go for mutual funds after RBI's rate cut?

During the recent monetary policy review meeting held between February 5 and 7, 2025, the Reserve Bank of India (RBI) made the decision to reduce the policy repo rate from 6.50% to 6.25%. This marks a change after maintaining the rate unchanged for eleven consecutive meetings, which is about five years. The new Governor, Sanjay Malhotra, led this decision to decrease the rate by 25 basis points.

The repo rate, which is the interest rate at which the central bank lends to commercial banks, plays a crucial role in determining borrowing costs for businesses and individuals. The reduction of 25 basis points may prompt banks to lower their lending rates, ultimately making loans more affordable for borrowers. However, this could also result in a decrease in fixed deposit interest rates, impacting investors who depend on these returns.

Falling interest rates and debt funds

When interest rates decrease, the bonds within debt funds, especially those with higher coupon rates, become more valuable as they continue to provide higher interest rates compared to newly issued bonds. This increase in value pushes up bond prices, ultimately boosting the Net Asset Value (NAV) of the debt fund.

On the other hand, the rate cut can be positive for debt mutual funds. Experts believe that debt mutual funds have turned more attractive post the rate cut and investors should gradually increase their allocation to debt, especially in categories that benefit from falling rates, while maintaining a diversified approach to mitigate risks and optimize returns.

The impact of declining rates is particularly significant in long-duration funds. Long-term debt funds benefit greatly from rate decreases due to the higher interest rates offered by the bonds they hold for a longer period. Consequently, the NAV of long-duration debt funds experiences an increase, Value Research stated.

"Some would say that this rate cut by MPC/RBI is premature, that Inflation is not under control yet. Monetary easing is the need of the hour, from a trying to revive the economy perspective. For monetary easing to be effective, more rate cuts are needed for a long period of time. Liquidity needs to be easy as well. I feel that the inflation projection of 4.2% for FY26 is a tad optimistic. I expect further rate cuts of 50 bps during the year. It is a bold move by the RBI. The short-term funds are likely to perform better. The long end of the curve will move lower once the inflation battle is won, which is some time away. There is pressure on currency as well, which will make interest rates volatile, though within a range," said Sandeep Bagla, CEO, TRUST Mutual Fund.

“Yes, debt funds have turned more attractive post this rate cut. Bond prices move inversely to interest rates, meaning that as yields fall, existing bonds with higher coupon rates appreciate in value... Investors should gradually increase their allocation to debt, especially in categories that benefit from falling rates, while maintaining a diversified approach to mitigate risks and optimize returns," said Sagar Shinde, VP of Research, Fisdom.

""As RBI carries out open market liquidity operations and the repo rate is cut, we can assume that FD rates have peaked in this cycle and will start falling now. Those locked into their FDs will continue to enjoy high rates. Those creating new FDs will have to settle for a little less. This is going to be a good year in fixed income mutual funds. Long-term debt funds do very well in rate cut years. Short-term debt funds will also benefit from NAV appreciation," said Adhil Shetty, CEO, BankBazaar.com.

He added: "As borrowing costs decrease, corporate earnings are likely to improve, boosting investor confidence in equities and equity-linked mutual funds."

"We expect interest rates to decline further. In this environment, investors should consider dynamic bond funds for medium to long term debt allocation," said Pankaj Pathak, Fund Manager -Fixed Income, Quantum AMC.

When interest rates decrease, the high coupon rate bonds within debt funds gain in value. Bond prices and yields demonstrate an inverse correlation. Conversely, an increase in interest rates is deemed unfavorable for mutual fund investors, particularly those invested in debt funds, as it can negatively affect the debt market.

The relationship between bond yields and prices is such that a rise in interest rates or bond yields results in a decrease in the Net Asset Value (NAV) of debt funds. Essentially, this means that debt mutual funds will deliver lower returns.

In regards to the rate cut, Shinde suggested that investors consider long-duration, dynamic bond funds, and gilt funds as they could potentially see the most gains in a declining interest rate environment. "These funds, which primarily invest in government securities, are ideal for those with a 3–5-year horizon, allowing them to fully capture the rate cut’s impact over time."