Why Debt Funds Are Regaining Relevance In FY26?

As we near an end to another year and prepare to welcome the last quarter of this fiscal, debt mutual funds have quietly found their way back into investor portfolios in fiscal 2026.

Surge in domestic liquidity, stable short-term interest rates and supportive policy signals from the Reserve Bank of India are making fixed-income investments look attractive again, particularly for investors seeking stability amid global uncertainty.

According to Swapnil Jagnam, Co-Fund Manager and Dealer, Fixed Income at HDFC AMC, the current environment is being driven more by domestic liquidity factors than by global uncertainty, making fixed-income investments more attractive once again.

One of the biggest reasons behind renewed interest in debt funds is the sharp improvement in liquidity since the start of the financial year. The Reserve Bank of India has taken several steps to ensure sufficient money remains available in the banking system. These include open market bond purchases, forex swap operations, and a cumulative 100 basis point cut in the cash reserve ratio (CRR).

While some of this liquidity was absorbed due to RBI’s intervention in the foreign exchange market, the system continues to remain in ample surplus. Interbank liquidity has averaged around Rs 2 lakh crore, while durable liquidity has stayed above Rs 4 lakh crore so far in fiscal 2026.

This surplus liquidity has helped keep overnight interest rates close to the policy repo rate, reducing volatility at the very short end of the yield curve. The RBI has also been actively using variable rate repo and reverse repo operations to ensure that short-term borrowing rates remain aligned with policy rates.

According to Jagnam, global factors such as currency volatility or overseas rate movements have had limited influence on overnight to six-month maturities. Short-term yields in India continue to be driven largely by domestic liquidity conditions.

In this environment, overnight funds remain conservative and stable. These funds invest mainly in overnight instruments such as tri-party repos and reverse repos, which means their returns are closely linked to system liquidity rather than market movements or currency swings.

Liquid funds, however, require more active management. After an initial fall in short-term yields following RBI’s rate cuts, yields firmed up as the supply of money market instruments like certificates of deposit and commercial paper increased. Looking ahead, short-term yields may rise slightly in the fourth quarter of financial year 2026 due to seasonal issuance, before easing again as supply normalises.

Fund managers are therefore adjusting portfolio duration carefully, while maintaining high credit quality and diversification, making liquid funds suitable for managing short-term liquidity needs says Jagnam.

From a broader perspective, Jagnam expects inflation to remain benign into 2026, keeping monetary conditions supportive. Economic growth, however, is likely to moderate gradually after peaking in the second quarter of fiscal 2026, partly due to global trade uncertainties and questions around the sustainability of the GST-led consumption boost.

Globally, major central banks, including the US Federal Reserve, are expected to remain largely accommodative. This helps ease pressure on the rupee and supports Indian bond markets.

Domestically, the government securities yield curve has steepened sharply since March 2025. The yield gap between long-term bonds such as 15-year, 30-year and longer maturities and the 10-year benchmark has widened significantly, making longer-duration bonds relatively more attractive.

Additional support for duration-oriented debt funds comes from structural factors such as the possibility of India’s inclusion in global bond indices, expectations of one more rate cut in the current cycle, ample liquidity, and manageable government bond supply.

Jagnam advises investors to align debt fund choices with their liquidity needs and investment horizons:

• Short-term surplus: Overnight or liquid funds can be used instead of savings accounts.

• Medium-term goals: Ultra-short-term, money market, low-duration or floating-rate funds, depending on risk appetite.

• Longer-term surplus (24 months or more): Longer-duration debt funds may be considered.

Recent liquidity management norms introduced by the Securities and Exchange Board of India now require debt funds to hold a minimum level of highly liquid assets and conduct regular stress tests. While this may slightly weigh on returns, it improves portfolio resilience and investor protection.

Despite the supportive backdrop, risks persist. If US inflation stays elevated or trade-related pressures continue, the US Fed may cut rates less than markets expect, which could affect the rupee and RBI policy. Domestically, unexpected inflation spikes, strong consumption, or commodity price shocks could push yields higher. Currency pressures could also emerge if global trade negotiations fail, leading to capital outflows.