Can debt funds be an alternative to fixed deposits in a falling interest rate regime?

If you have always relied on fixed deposits (FDs), you probably like the certainty they offer. There are no surprises, and you are aware of what you will receive in return.

However, what happens if interest rates begin to decline? Your returns gradually decrease.

In a period of falling interest rates, debt funds may be a compelling substitute for fixed deposits. Experts believe that many debt funds might actually profit when interest rates decline because the bonds they currently own may appreciate.

Naturally, there are some risks associated with debt funds, such as their susceptibility to fluctuations in interest rates and the credit standing of the bonds they invest in.

Both Abhishek Bisen, Head, Fixed Income at Kotak Mahindra AMC, and Prashant Pimple, CIO, Fixed Income at Baroda BNP Paribas Mutual Fund, say debt funds can serve as an effective alternative to FDs, particularly in a falling interest rate environment, provided investors understand how they function and the risks involved.

Before reading further, please note that this is just for informational purposes only and not intended to recommend any of the schemes mentioned below. You should make an investment decision based on your personal financial goals and risk appetite.

How do falling interest rates impact debt funds?

“When interest rates are falling, debt funds, especially those with higher duration, tend to outperform FDs because Mark-to-Market (MTM) gains boost returns. FDs do not benefit from falling rates; they simply offer the locked-in coupon.

Thus, in a rate cut cycle, debt funds often deliver returns higher than their stated Yield to Maturity (YTM),” Bisen said.

“Declining interest rates provide an opportunity for capital appreciation in the bonds and other fixed income instruments that constitute a portfolio of a debt fund,” Pimple said.

What are the key risks investors should be aware of?

Debt funds carry three primary risks: interest rate risk, credit risk and reinvestment risk.

• Interest rate risk: Debt funds benefit when rates fall, but an unexpected rise in interest rates, particularly for longer-duration funds, can lead to mark-to-market losses and a temporary decline in portfolio value.

“As rates rise, especially for longer duration instruments, portfolio values can decline,” says Prashant Pimple, CIO – Fixed Income at Baroda BNP Paribas Mutual Fund.

However, over an appropriate holding period, volatility tends to even out. “If you stay invested for a period close to the average maturity of the portfolio, interest rate fluctuations tend to even out,” adds Abhishek Bisen, Head–Fixed Income at Kotak Mahindra Asset Management Company.

• Credit risk: There is also the possibility that a bond issuer may be downgraded or default, leading to erosion of capital. “The bonds and debentures that the debt fund invests in can be downgraded, or the company issuing them can default,” says Pimple.

Bisen notes that this risk can be mitigated by choosing high-quality or AAA-oriented portfolios.

• Reinvestment risk: Debt funds, like fixed deposits, are also exposed to reinvestment risk. If securities mature during a low-interest-rate environment, the proceeds may need to be reinvested at lower prevailing yields, reducing accrual income, explains Pimple.

Matching fixed income allocation to goals

According to Pimple, fixed income allocations should be bucketed based on time horizon:

• Near-term needs: Liquid funds and money market funds
• Medium-to long-term goals: Short-duration, corporate bond, medium- and long-duration funds

The key is aligning fund duration with your investment horizon.

Disclaimer: This article is written purely for informational purposes and should not be considered investment advice from Upstox. Investors should do their own research or consult a registered financial advisor before making investment decisions.