Debt fund investors are becoming more selective. With bond yields high and the rate outlook uncertain, they are choosing carefully where to park their money.
The latest mutual fund data shows the shift. Debt funds attracted Rs 1.88 lakh crore in July. In August, they saw an outflow of Rs 8,127 crore. But the headline numbers do not tell the full story. Investors kept putting money into liquid, money-market and ultra-short-duration funds in August, even as several longer-duration categories saw outflows.
That points to a more selective approach to fixed income. Investors are staying with funds that hold shorter-maturity papers, where they can earn prevailing yields without taking much interest-rate risk.
The backdrop has also become harder for bond investors. The 10-year government bond yield rose from 6.83% at the end of July to 6.95% at the end of August, a rise of 12 basis points (0.12 percentage points). By September 21, it climbed to 7.06%, according to Anil Bamboli, Head of Fixed Income at HDFC AMC.
Global bond yields have also moved higher, with US Treasury yields close to 5%. Fund houses point to higher crude prices, geopolitical tensions, inflation worries, US fiscal concerns and expectations of rate hikes by the US Federal Reserve and possibly the RBI.
Debt fund flows in August
| Category | August net flow |
| Liquid funds | 19,934 |
| Money-market funds | 11,734 |
| Ultra-short-duration funds | 4,257 |
| Gilt funds | -1,824 |
| Corporate bond funds | -3,190 |
| Short-duration funds | -4,259 |
| Overnight funds | -30,654 |
| All other debt categories | -4,126 |
| Total, open-ended debt funds | -8,127 |
Source: AMFI
Liquid and money-market funds continue to attract money
Liquid funds received Rs 19,934 crore in August. Money-market funds attracted Rs 11,735 crore, while ultra-short-duration funds received Rs 4,257 crore. These categories kept drawing money even as overall debt fund flows turned negative.
The preference for liquidity was even stronger in July. Liquid funds attracted Rs 1.19 lakh crore that month. Together with overnight funds, they accounted for 85% of total inflows into open-ended debt funds.
Ovas Bakshi, Head of Retail Sales at Kotak Mahindra AMC, says continued inflows into liquid, money-market and ultra-short-duration funds indicate a preference for “liquidity, lower interest-rate sensitivity and relatively predictable accrual”.
Investors, he says, are comfortable earning prevailing short-term yields while retaining flexibility instead of committing significantly to longer-duration strategies in an uncertain rate environment.
The Rs 71,000 crore overnight-fund reversal
Overnight funds attracted Rs 40,413 crore in July. In August, they saw an outflow of Rs 30,654 crore. That is a swing of more than Rs 71,000 crore in one month.
This can look like a sudden shift in investor sentiment. But experts caution against reading too much into one month’s movement in overnight funds.
Bakshi says these funds are heavily influenced by institutional cash-management needs. Corporates and institutions may park surplus cash in overnight funds for a while and withdraw it when they need the money for operations. The reversal between July and August should not necessarily be seen as a structural change in retail investor sentiment, he says.
Sandeep Yadav, Executive Director and Head of Fixed Income at DSP Mutual Fund, offers another explanation. He says surplus liquidity in the financial system kept overnight rates soft.
“Seeking better returns, investors rotated out of lower-yielding overnight funds and switched into liquid and money market funds,” Yadav says.
Bamboli also points to the sharp rise in system liquidity. He says overnight rates in August were well below the 5.25% repo rate, while liquid fund yields were largely in the range of 6% to 6.25% as of August 31, with limited duration risk.
That helps explain why some money moved to liquid and money-market funds instead of leaving fixed income altogether.
Why investors are cautious about longer-duration funds
The pressure is more visible in categories with greater interest-rate sensitivity. In August, gilt funds saw an outflow of Rs 1,824 crore. Corporate bond funds lost Rs 3,190 crore and short-duration funds saw an outflow of Rs 4,259 crore. All three generally hold longer-maturity bonds than liquid, money-market and ultra-short-duration funds.
Duration is a measure of how sensitive a bond fund is to changes in interest rates. Bond prices fall when yields rise, and longer-duration bonds are more sensitive to these moves. The net asset values (NAVs) of longer-duration debt funds can therefore swing more.
Bamboli says longer-duration funds are more sensitive to rising yields and that this has pushed investors towards shorter-duration and liquidity-oriented categories.
Fund houses differ on whether higher yields are an opportunity
Not all fund houses want investors to stay away from longer-duration bonds.
Yadav takes a cautious view. He says investors should continue with shorter-duration funds for now until there is greater clarity on geopolitical issues and tariffs.
Bakshi also prefers short-duration funds for a one-year horizon. However, he says that if yields rise another 20 to 25 basis points, investors could consider longer-duration funds.
Bamboli takes a more constructive view. He says that with many negative factors already priced into fixed-income valuations, a phased approach to adding duration may be appropriate at current levels. He identifies a sustained rise in oil prices, aggressive rate hikes by major global central banks and a significant overshoot in domestic inflation as key risks to that view.
ICICI Prudential Mutual Fund is the most bullish on duration. Its latest note says Indian bond markets look attractive and that rate hikes are already priced in. It prefers adding long duration to fixed-income portfolios and sees the possibility of Indian yields softening if global risk assets come under pressure.
Where fund houses stand on adding duration
| Fund house | Stance | Key condition or risk |
| DSP Mutual Fund | Cautious | Stay in shorter-duration funds until geopolitical issues and tariffs are clearer |
| Kotak Mahindra AMC | Cautious for now | Consider longer duration if yields rise another 20 to 25 basis points |
| HDFC AMC | Constructive | Add duration in phases; risks are higher oil, aggressive global rate hikes and a domestic inflation overshoot |
| ICICI Prudential Mutual Fund | Bullish | Rate hikes already priced in; prefers adding long duration |
Source: Fund house comments and ICICI Prudential Mutual Fund note.
The market is not a simple case of short duration being good and long duration being bad. The bigger issue is where yields go from here.
What to watch
The direction of the 10-year government bond yield will matter most. So will the RBI’s liquidity management, inflation, crude oil prices and global bond yields.
If inflation stays under control and rate hikes do not happen, yields could stabilise or fall, which would help longer-duration funds. If oil prices stay high, inflation pressure builds and global yields keep rising, duration could remain volatile.
For now, investors are choosing the safety and flexibility of shorter-term funds, while some fund houses are starting to see value in longer-duration bonds. Where yields go from here, more than where they stand today, could decide which side wins.
Disclaimer: This article is for informational and educational purposes only. It is not investment advice or a recommendation to invest in any particular debt fund, bond or other financial product. Debt funds are subject to market risks, including interest-rate, credit and liquidity risks. Investors should consider their investment goals, risk appetite and time horizon and consult a qualified financial adviser before making investment decisions.
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