How RBI's Repo Rate Cut Will Affect Debt Mutual Fund Returns

The Reserve Bank of India announced on June 6, 2025, a cut in the repo rate by 50 basis points from 6.0% to 5.5% and reduced the Cash Reserve Ratio (CRR) by 100 basis points. This shift in policy rates is especially relevant for debt mutual fund investors navigating interest rate cycles.

Let us understand in detail how this repo rate cut by the RBI will affect your returns on debt mutual funds.

Why Repo Rate Matters For Debt Mutual Funds 

Repo Rate refers to the interest rate at which the Reserve Bank of India lends money, collateralized by government securities, to commercial banks. The repo rate is considered the benchmark for all short-term rates in the economy. The borrowing cost for banks goes down because of a reduction in repo rates by the RBI, which encourages banks to offer lower lending rates.¹

The change in interest rate environments directly impacts the investment in debt mutual funds since they invest in fixed-income instruments. When interest rates drop, the newly issued bonds begin to have lower yields than those of the existing ones in the portfolio, which carry higher coupon rates. Thus, those older bonds will be more appealing and lead to an increase in the Net Asset Value (NAV) of the fund.

For instance, suppose a fund holds a 5-year bond with a return of 7% per annum. After the cut of 50 bps in the repo rate, new bonds in the market are available only at 6.5%. With a higher coupon, this older bond becomes more attractive to investors. The increased demand causes the price of the bond to go up. The price appreciation thus increases the NAV of the debt mutual fund holding such a bond.

The result? The current value of the fund's assets goes up due to revaluation in the market, even without fresh inflows.

Impact On Different Debt Fund Categories 

Here is how the repo rate cut can affect different types of debt mutual funds:

1. Long Duration Funds: Best Placed For Rate Cuts

Long-duration funds are invested in bonds with maturities of 7–10 years or more. These funds are highly sensitive to interest rate changes. A small shift in rates can lead to noticeable changes in their Net Asset Values (NAVs). The 50 basis point (bps) repo rate cut by the RBI, combined with the market expectation of another 25 bps cut by the end of FY26, creates a favourable setup for capital gains².

With declining yields, long-duration bonds have a greater rise in price than short-term ones. This is because they have a higher modified duration, which results in larger price movements when rates shift.²

Example: A 10-year government bond with a 7% coupon can jump 4–5% in price if yields fall by 0.5%. That appreciation flows into the NAV of long-duration debt funds. For investors, this could translate into 1–2% extra returns annually in addition to the regular accrual income.

Long duration funds are best suited for Investors with 3–5-year horizons who can stay invested through short-term NAV fluctuations.

2. Understanding Short-Term And Liquid Funds

Short-term debt funds invest in securities with maturities of 1–3 years, while liquid funds hold papers maturing in up to 91 days. These funds are less affected by interest rate swings due to their lower duration. That makes them stable, low-volatility options.

While their capital appreciation due to a rate cut is limited, they also gain from modestly higher prices and rolling down of yields over the term. Investors may also look forward to a modest increase in NAVs in the next few months, particularly in high-quality short-term funds.

Example: If short-term yields go down by 0.2–0.3%, NAVs could rise by 0.3–0.6% in a year. It's modest but more certain.

Short-term funds are good for conservative investors with a 1–2 year horizon, interested in parking emergency or surplus funds with low risk tolerance.

3. Gilt vs Credit Risk Funds: Which One Should You Choose?

Gilt funds invest only in government securities, which means they carry no credit risk. However, they are highly sensitive to interest rate changes. When interest rates fall, gilt funds can deliver higher returns due to longer duration. But they can also be hit hard if rate expectations suddenly change.

Example: In past rate cut cycles (like in 2020), long-term gilt funds delivered double-digit returns due to sharp drops in yields.

But these gains come with volatility. If the RBI delays further cuts or inflation flares up, gilt prices can correct sharply.

Credit Risk Funds allocate at least 65% of their portfolio to lower-rated bonds (below AA). While they carry higher credit risk, they benefit from:

• Falling rates, which reduce refinancing costs
• Increased liquidity as a result of CRR reductions
• Credit spreads narrowing

For example, an AA-rated credit risk fund might benefit as its yields decrease and spreads compress. This can boost NAVs but at the cost of heightened exposure to default risk and downgrade risk.

These are suitable for investors with a medium-risk appetite, those who want higher yields compared to vanilla debt funds, and individuals who are willing to monitor fund performance and quality closely.

Should You Change Your Debt Fund Strategy? 

A repo rate cut might tempt investors to chase quick gains, but that is rarely a sustainable strategy. Instead, your debt mutual fund investment strategy should be guided by three key factors: 

• Investment horizon
• Risk profile
• Return expectations

To build a more balanced and resilient portfolio, consider a mix of long-duration funds, short-duration funds, and gilt funds. This combination can help you optimise potential returns while managing interest rate risk. 

However, it is important to avoid overexposure to highly volatile categories, especially if your goal is capital preservation or steady income.

When Should You Rebalance Your Mutual Fund Portfolio? 

Over time, market movements could lead your mutual fund portfolio to deviate from your initial asset allocation³. Left uncorrected, this discrepancy can subject you to increased risk or water down your potential for returns. 

That is where rebalancing comes in handy. It ensures your desired equity, debt, and other asset mix by bringing your investments back in line with your goals, time horizon, and risk tolerance.

There are two tested ways of managing rebalancing well:

1. Time-Based Rebalancing

Here, you check and rebalance your portfolio at a fixed, periodic interval, usually every 6 or 12 months, without worrying about market performance. This technique provides discipline and avoids emotional decision-making.

This works because:

• Promotes uniform asset allocation
• Eliminates market-timing temptation
• Very useful for salaried investors with SIPs or stable cash flows

Example: If your original allocation was 60% equity and 40% debt, but after 12 months, equity grows to 70%, you book profits and shift 10% back to debt, restoring the 60:40 balance.

This method is best for investors who prefer automation and discipline in financial planning.

2. Threshold-Based Rebalancing

Also referred to as tolerance-band rebalancing, this method entails acting only when an asset class moves outside a predetermined range, such as ±5% from the initial target. It is more adaptable than the time-based approach and can more effectively handle volatile markets.

Here is how it works:

• Establish target ranges for all asset classes.
• For instance: Equity 60% (threshold ±5%), Debt 40% (threshold ±5%)
• Review periodically (monthly or quarterly).
• Rebalance only if allocation exceeds the band—you reduce transactions that way.

Example: Your debt allocation was 40%. A rally in the bond market pushes it to 46%. That's a +6% drift. You then trim your debt exposure by 6%, bringing it back to 40%.

This is best for investors who:

• Like flexibility over fixed schedules
• Have enough time to check the portfolio
• Want to cut unnecessary churning

Both work. Select the one best for your investment habit, time availability, and desire for control. The most important thing is to rebalance regularly and not respond impulsively.

Smart Tips For Debt Fund Investors 

If you prefer investing in debt funds, keep these points in mind:

1. Match Fund Duration with Investment Horizon: Use ultra-short or low-duration funds for 1–2 years and dynamic or long-duration funds for 3+ years.

2. Monitor Fund Duration and Modified Duration: Funds with higher average maturity gain more while rates are cut, but drop more if rates increase again.

3. Use Platforms Such as Grip: Grip Invest gives access to curated corporate bonds and fixed-income products. You can diversify your portfolio beyond mutual funds with pre-vetted, rated opportunities.

4. Do not Chase Past Performance: Look beyond 1-year returns. Study fund strategy, risk level, and consistency over market cycles.

5. Maintain Liquidity: Hold a portion in overnight or liquid funds for unplanned expenses, regardless of interest rate direction.

Conclusion 

A repo rate cut lowers borrowing costs but also reshapes return dynamics across debt mutual funds. While long-duration funds offer higher return potential, they come with more volatility. Conservative investors may prefer the stability of short-term and liquid funds, while gilt and credit risk funds offer a balanced mix of risk and reward.

The key is to align your debt fund choices with your investment goals, risk tolerance, and time horizon. Whether you rebalance periodically or based on thresholds, staying disciplined can help you optimise returns while managing risk in a falling rate cycle.

Login to Grip Invest to explore curated fixed-income opportunities and build a smarter, more resilient portfolio.

FAQs On RBI Repo Rate Cut Impact On Debt Mutual Funds

1. How does a repo rate cut boost debt mutual fund returns?

A rate cut lowers bond yields, which lifts prices. This boosts the NAV of debt funds holding such bonds.

2. Which debt mutual funds benefit most from falling interest rates? 

Long-duration and gilt funds gain the most, as they are more sensitive to rate cuts.

3. Is it a good time to invest in long-duration debt funds after the RBI rate cut?

Yes, if you can hold on for 3–5 years and ride out interim NAV fluctuations. 

References:

1. Nippon India, mutual Fund, accessed from: https://mf.nipponindiaim.com/investoreducation/repo-rate

2. Economic Times, accessed from: https://economictimes.indiatimes.com/news/economy/policy/rbis-50-bps-rate-cut-surprise-reserve-bank-of-india-two-economists-from-sbi-state-bank-of-india-and-piramal-who-beat-the-crowd-are-back-with-another-monetary-policy-call/articleshow/121691517.cms?from=mdr

3. HDFC Bank, accessed from: https://shorturl.at/12mUX

Want to stay at the top of your finances? 

Join the community of 4 lakh+ investors and learn more about Grip Invest, the latest financial knick-knacks, and shenanigans in the world of investing.

Happy Investing!

Disclaimer - Investments in debt securities/municipal debt securities/securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully. The investor is requested to take into consideration all the risk factors before the commencement of trading.
This communication is prepared by Grip Broking Private Limited (bearing SEBI Registration No. INZ000312836 and NSE ID 90319) and/or its affiliate/ group company(ies) (together referred to as “Grip”) and the contents of this disclaimer are applicable to this document and any and all written or oral communication(s) made by Grip or its directors, employees, associates, representatives and agents. This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip does not guarantee or assure any return on investments and accepts no liability for consequences of any actions taken based on the information provided. For more details, please visit www.gripinvest.in

Registered Address - 106, II F, New Asiatic Building, H Block, Connaught Place, New Delhi 110001