Time to get into debt funds: Which ones should you pick?

The interest rate cuts by the RBI and falling inflation have boosted returns of debt mutual funds. Find out which category of debt fund should you buy now
Debt funds are on a roll, thanks to the rate cuts by the RBI and the decline in inflation over the past few months. A cut in interest rates is beneficial for debt funds holding bonds of higher coupon rates. Funds that line their portfolios with very long term bonds are the biggest gainers when bond yields start moving southwards. The average long duration fund has shot up 2.65% in the past one month. The best performing scheme, Aditya Birla Sun Life Long Duration Fund has risen 3.11%. The average maturity profile of the bonds in its portfolio is more than 26 years.

Experts feel the good times will continue. Bond yields have declined from In February, the RBI had cut the repo rate by 25 basis points to 6.25%. Last week, it further cut the rate by another 25 basis points and shifted its stance from "neutral" to “accommodative”, which leaves the door open to further rate reductions if necessary.

The change in stance also reflects the central bank’s assessment of the economic growth and inflation in the coming months. However, experts are divided on whether this will translate into more rate cuts. Some expect the RBI to reduce the repo rate by another 25-50 basis points during this financial year while others believe there will be an extended pause.

Given this situation, short duration funds seem like a good bet right now. These schemes invest in bonds with a residual maturity of 18-24 months. The short maturity profile makes the interest rate negligible. Go for short duration funds if you want stable returns.

Investors who believe that the RBI will indeed cut rates can go for medium term or long duration bonds. As explained earlier, these funds will be the biggest beneficiaries when rates decline. Long-term bond funds delivered double-digit returns in the past one year. However, if rates don’t fall as expected, these funds could give muted returns.

Can’t decide whether to go for short-term funds or long duration schemes? Why not opt for dynamic bond funds? Debt funds are required to invest in bonds of certain tenures as per their mandate. But dynamic bond funds have the flexibility to alter the average maturity profile of their portfolio as per the reading of the fund manager. Dynamic bond funds have done better than short and medium term debt funds in the past one year.

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