Despite the Reserve Bank of India’s rate cut in early December, bond yields in India have risen, catching investors in fixed-income mutual funds by surprise.
WHAT ARE THE MANDATORY RETURNS?
A bond’s yield is the annual return an investor earns on a bond, expressed as a percentage. Although a bond’s coupon or interest rate is fixed, the yield fluctuates because it depends on the price you pay for the bond in the market. Bond yields and prices move in opposite directions: when prices fall, yields rise, and vice versa.
WHAT ARE TRIGGERS MOVEMENTS IN MANDATORY YIELDSAND HOW DO THEY REACT?
Bond yields react to a combination of macroeconomic and market factors. The most direct trigger is the central bank changing interest rates. When policy rates rise, yields rise, and when rates are cut, yields tend to fall. Inflation expectations also play an important role. This is because expected inflation drives up yields as investors demand more yield to compensate for the erosion of purchasing power. Fiscal policy is also important: Heavy government borrowing increases the supply of bonds, which can lower prices and increase yields.
WHY DID MANDATORY YIELDS INCREASE DESPITE THE RBI’S RATE CUT IN DECEMBER?
The yield on benchmark 10-year government securities rose from 6.5% on December 2 to 6.7% on December 23, before falling slightly to 6.63% on January 13. This was unexpected after the RBI cut the repo rate by 25 basis points in early December. Analysts attribute the rise to an increase in the supply of bonds. Indian states have announced a record borrowing plan of 5 lakh crore for the January-March quarter. The oversupply caused bond prices to fall, thereby increasing yields. Foreign portfolio investors also sold Indian bonds amid pressure on the rupee. Additionally, markets are forward-looking. Yields have fallen through 2025 on expectations of rate cuts. With the RBI offering a cumulative cut of 125 basis points, this optimism is taken into account.
WHAT HAPPENS TO DEBT MUTUAL FUNDS WHEN RETURNS INCREASE?
Debt funds that invest in long-term bonds feel the impact of rising yields more because their portfolios contain longer-dated securities. Long-term bond funds don’t simply hold bonds until maturity to earn coupon income. They actively manage portfolios to benefit from price movements. When yields fall, the price of long-term bonds rises sharply because these bonds have a longer duration and are more sensitive to changes in interest rates. Fund managers often sell these bonds before maturity to lock in capital gains. This is why long-term funds typically generate significant gains in a falling rate environment. Short-term debt funds are less affected as their bonds generally mature within a year. Short-term funds tend to remain relatively stable and may even benefit from rising yields sooner.
HOW CAN DEBT MUTUAL FUND INVESTORS OPTIMIZE RETURNS NOW?
In 2025, investors in long-term bond funds made money because bond prices rose and investors realized capital gains. In addition to interest income, investors earned high single- and double-digit returns, which is not often the case. Now, wealth managers recommend a barbell strategy: about half in short-term funds (1 day to 24 months) to capture current high returns and maintain liquidity, 30-40% in medium-term funds (2-5 years), and 10-20% in long-term gilded funds (above 5 years) to capture capital appreciation if returns decline after the recent rise.
