As whispers of a new interest rate cycle grow louder, investors are beginning to eye an old favourite with renewed interest, debt and conservative hybrid mutual funds. With the Reserve Bank

of India (RBI) having already trimmed rates by 50 basis points and more cuts possibly on the horizon, could these quiet achievers become portfolio front-runners? The answer lies in the

subtle yet powerful dynamics between bond prices and interest rates, and how savvy investors might ride this wave.

Normally, both debt funds and conservative hybrid funds are poised to benefit mainly due to the inverse relationship between interest rates and bond prices.

better returns to investors.

Debt mutual funds and conservative hybrid funds typically become more attractive in a falling interest rate environment due to the inverse relationship between interest rates and bond

prices. Nikhil Aggarwal, Founder & Group CEO, Grip Invest, says, "When rates fall, the market value of existing bonds rises, leading to capital gains, especially for funds holding medium to

long-duration securities. For example, a fund with a 4-year duration gains ~2% NAV for every 0.5% rate cut."

Conservative hybrid funds, which usually allocate 75-90% to debt and 10-25% to equity, can benefit from low interest rates in two ways. The debt portion of the portfolio sees capital gains

as bond prices rise, similar to debt funds. The equity allocation has the potential to generate higher returns if lower interest rates stimulate economic growth and improve corporate

profitability, which can lead to higher stock prices. This combination of stable debt returns and potential equity upside makes conservative hybrid funds appealing.

Himanshu Srivastava, Associate Director - Manager Research, Morningstar Investment, says, "The onset of a rate cut cycle in India could indeed enhance the appeal of debt funds and

conservative hybrid strategies, particularly for investors seeking risk-adjusted returns with lower volatility. As interest rates decline, bond prices rise, benefiting duration-oriented debt

funds, especially categories such as dynamic bond, gilt, and medium-to-long duration funds. The potential for comparatively better return in this scenario, in addition to accrual income,

makes these funds an attractive proposition in a falling rate environment."

"For conservative hybrid funds (which typically allocate 10–25% to equities and the rest to debt), the falling interest rate backdrop could also be supportive. The debt portion stands to

benefit from a potential rate cut if positioned appropriately, while the equity component provides a kicker from improved sentiments and market upturn. These funds may appeal to cautious

investors who are looking for relatively stable returns with limited equity exposure," said Srivastava.

However, investors must be mindful of a few risks. "First, while the direction of rates may be downward, the timing and pace of cuts can be uncertain. Premature positioning in

longer-duration funds could result in interim volatility. Second, in conservative hybrids, the equity allocation, though limited, introduces market risk, which may be amplified during an

uncertain or down-trending market environment," said Srivastava.

Besides, investors should remember that the real benefits of investing in these funds during low interest rates go beyond just interest rate movements. The quality of the underlying debt

securities, the strategy used by the fund manager and the broader macroeconomic environment all play a role in delivering returns.

Shweta Rajani, Head - Mutual Funds, Anand Rathi Wealth Limited, said, "An important point to consider is that while the initial phase of a rate-cutting cycle tends to be very favourable for

these funds, there are important drawbacks to consider. As interest rates continue to fall and reach very low levels, the scope for further capital appreciation in debt funds diminishes. The

initial gains from rising bond prices, hence, are just a one-time result. The fund will also reinvest in newer bonds offering lower yields, as the existing bonds in the portfolio mature.

This reduces the income from interest payments. This means that after the initial rise, future returns from debt funds and the debt portion of conservative hybrids will depend more on the

lower interest income rather than capital appreciation."

"Hence, debt funds and conservative hybrid funds do appear more attractive in a low-interest rate cycle due to the capital appreciation from rising bond prices. However, as interest rates

settle at lower levels, the future returns from these funds will mostly come from interest income, which may be lower," Rajani.

Overall, in a lower interest rate regime, debt and conservative hybrid funds can serve as effective vehicles for income generation and portfolio stability. However, a well-calibrated

approach aligned with investment horizons, risk appetite, and interest rate outlook remains essential.

"Investors should be cautious not to rush into these funds purely based on short-term gains. Instead, they should maintain an 80:20 allocation of equity to debt over the long term. Investors

in the highest tax bracket can opt for arbitrage funds, which provide debt-like returns with equity-like taxation," said Rajani.

"By maintaining a diversified debt allocation, investors can effectively balance the potential for capital appreciation with the need for flexibility in a dynamic interest rate environment,"

said Aggarwal.