As 2025 draws to a close, the fixed-income market is ending on a relatively sombre note. The Reserve Bank of India has cut policy rates by 125 basis points and bought government bonds worth Rs. 6.5 trillion in 2025. This drove short to medium duration bond yields lower and boosted the performance of debt schemes investing in such bonds. For much of the year, investors enjoyed steady returns as falling yields created tailwind for bond portfolios. But as we step into 2026, the environment looks markedly different.
The Emerging Macro Landscape
Inflation has bottomed out, normalisation ahead. The historic drop in inflation this year is aided by favourable base effect from last year’s higher food prices and one-off tax cut on a wide range of good and services. As these impacts fade out, CPI inflation would inch higher toward the 4.0%–4.5% range next year.
Rate easing cycle mostly over. With inflation trending near 4% next year and GDP growth holding above 6.5%, further rate cuts from here looks unlikely. The RBI will most likely keep rates ‘lower for longer’ and maintain sufficiently large liquidity surplus to facilitate transmission of earlier rate cuts into the real economy.
Fiscal risks are resurfacing. With income tax cuts and GST rate reduction, government’s revenue collection has taken a hit. Decline in nominal GDP growth has further dampened the tax collections. The pace of fiscal consolidation and debt reduction might slowdown in coming years – indicating increased supply of government bonds.
From market’s perspective, a ‘lower for longer’ monetary policy setup and easy liquidity environment should be supportive for the short to medium duration bonds up to 5 years. While the longer duration bonds might face pressure from the weakening fiscal position of the government and rising supply of sovereign bonds.
What Does This Mean for Investors?
For investors, this means the gains from falling interest rates are now behind us, and it would be prudent to recalibrate return expectations. Rather than chasing returns through aggressive bets of high duration funds, the focus should shift to risk-adjusted returns, diversification, and aligning strategies with liquidity needs and investment horizons.
For investors, this is also a good time to revisit asset allocation holistically. Fixed income remains a critical component of a balanced portfolio, but the approach must evolve with the changing macro backdrop. By prioritizing accrual strategies and matching investments to time horizons, investors can efficiently navigate the macro challenges.
Investors should now focus onaccrual-based strategies—earning returns primarily from interest income rather than betting on falling yields. In practical terms, this means favouring portfolios with low to moderate portfolio duration to keep sensitivity to interest rate volatility under check.
Here’s how different investors can approach asset allocation for their fixed income portfolio:
- Short-Term Investors (seeking liquidity)
If your priority is safety and quick access to cash, you can consider short term strategies like Money Market fund, Ultra Short Duration or Low duration Funds. These strategies provide stability and rely primarily on interest accruals from short term debt securities without exposing you to significant interest rate risk. - Investing for medium term goal (1–2 years investment horizon)
For those looking to accumulate funds for goals that are one to two years ahead can consider strategies such as short duration fund or corporate bond fund. Even Floater funds with good credit quality and low duration would be a great option for these kinds of goals as these funds can better adapt to the changes in interest rate cycles. - Long-Term Investors looking for portfolio diversification (beyond 2 years)
Investors having longer investment horizon or looking to diversification in their overall portfolio, can consider Dynamic Bond funds which has flexibility to adjust the portfolio positioning as interest rate cycles evolve. Investor looking for better tax efficiency and have investment horizon beyond 2 years can consider Income plus arbitrage funds.
Pankaj Pathak is a Fund Manager at UTI AMC
Disclaimer:
The views expressed are author’s own views and not necessarily those of UTI Asset Management Company Limited. The views are not an investment advice, and investors should obtain their own independent advice before taking a decision to invest in any asset class or instruments.
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.