In a rare fit of generosity, the Monetary Policy Committee (MPC) decided in its June meeting to cut the repo rate by 50 basis points and slash the Cash Reserve Ratio (CRR) for banks by 100 basis points. The CRR cut will be phased out over four tranches from September to November.
Both repo rate and CRR cuts, as everybody knows, will reduce interest rates on loans and deposits, as banks and NBFCs pass on their cost savings to their customers.
This is why many investors found it puzzling that market yields on bonds actually spiked up after the MPC announcement. For instance, between June 5 (the day ahead of the MPC meeting) and June 12, the market yield on the five-year Indian government bond has edged up from 5.78 per cent to 5.98 per cent and that on the 10-year bond has risen from 6.18 per cent to 6.35 per cent.
Why market rates rose
There’s a good explanation for why market interest rates went up and not down after the policy review on June 6. Bond markets, like stock markets, are forward-looking and try to factor in events before they unfold. With the MPC signalling its intention to cut rates right from the beginning of 2025, bond markets have been running ahead of the MPC. Consequently, bond yields across tenures have been falling for the last 18 months or more.
The accompanying table shows us that yields on government securities (G-Secs) have been declining from early October 2023. From January 1 2025, yields on G-Secs have fallen by between 43 and 123 basis points, depending on the tenor.
After running on the expectation that the MPC would go on with its rate-cutting cycle for many more months, the market was caught unawares by the signal on June 6 that the MPC may now pause and take stock before trimming rates any further. The Governor’s statement on June 6 said that having reduced the repo rate by 100 basis points quickly, monetary policy was left with ”very little space” to support growth further. Therefore, the MPC would “carefully assess” incoming data for future rate actions. The MPC changing its policy stance from “accommodative” to “neutral” also underlined this message.
These are strong hints that further rate actions by the MPC will now be on pause, unless there are surprises from incoming GDP or inflation data. It is this signal that has prompted the bond markets to back-track after the policy. Before marking down rates any further, they will now be looking for cues from monthly inflation numbers, quarterly GDP prints and future MPC meetings to get a fix on the direction of interest rates from here.
These mixed signals from the latest MPC meeting call for a pivot in your debt investment strategy. Here are the changes you need to make in your debt portfolio.
Closing FD window
While the MPC has cut policy rates by 100 basis points so far in 2025, banks and NBFCs have not reduced their fixed deposit rates by as much. This is because intense competition for deposits forced them to hang on to their FD rates to woo depositors. But this situation has been changing in the last couple of months. With the RBI making ample liquidity available to banks through Open Market Operations (OMOs) and other avenues, the scramble for deposits has lessened for the large banks. Systemically important banks have, thus, sharply slashed their FD rates. As the CRR cut puts more easy money in the hands of banks from September, further cuts in bank FD rates are in the offing.
Systematically important banks, which are the go-to banks for large depositors, are usually the first to transmit rate cuts, as they find it the easiest to garner deposits. Therefore, post-policy, HDFC Bank’s interest rates on one-year, three-year and five-year FDs have fallen to 6.25 per cent, 6.40 per cent and 6.15 per cent respectively. Even before the policy HDFC Bank had trimmed its savings bank rate to 2.75 per cet. SBI’s rates are now at 6.5 per cent, 6.55 per cent and 6.30 per cent. Other public sector banks are likely to see equally prompt FD rate cuts.
What to do
While systemically important banks are usually the first to slash rates, private banks with weaker financials such as IndusInd Bank (6.85-7.35 per cent on one-three year FDs), RBL Bank (7.1-7.5 per cent) and small finance banks such as Equitas (7.6-7.8 per cent) and AU SFB (7.1-7.35 per cent) are likely to continue to offer higher FD rates. This is because these banks usually have a harder time garnering deposits. (The rates mentioned are at the time of writing this article and could change).
FDs with smaller private banks and small finance banks clearly carry higher risks than systemically important banks or PSU Banks. Depositors can take selective advantage of their higher rates, by capping their FDs in them at ₹5 lakh per bank. This is because account balances (deposits plus savings account balances) of up to ₹5 lakh with scheduled banks are protected by deposit insurance. However, these banks offer their best rates for upto three-year tenures. It would be best for depositors to stick to these shorter maturities with these FDs. Among these choices, small finance banks currently seem to offer better reward for risks.
Because NBFCs depend on banks and markets for their funds, FD rate cuts in NBFCs usually kick in after banks have slashed FD rates, in a falling rate cycle. However, this time around, NBFCs have already begun to cut rates.
However, AAA-rated NBFCs such as Sundaram Finance (7.5 per cent for three years), Sundaram Home Finance (7.65 per cent for three-five years) still offer a good deal. Though NBFC deposits don’t carry deposit insurance, the pedigree and long track of these NBFCs in underwriting and deposit servicing, makes them good bets. With NBFCs, investors should use the current window of opportunity to lock into current rates for four-five years.
Post office or small savings schemes, where the Central government resets rates at the end of every quarter, are usually the last to adjust to a falling rate cycle. Despite the 50-basis point cut in repo rates, schemes such as the Senior Citizens Savings Scheme (8.2 per cent), Post Office Monthly Income Scheme (7.4 per cent) and National Savings Certificates (7.7 per cent) still offer healthy rates. Investors and seniors need to grab the opportunity to lock into such instruments before rates get reset on from July 1. The combination of the sovereign guarantee and high rates currently make these instruments better than bank or NBFC deposits on risk-reward.
Fixed vs floating
Theoretically, in a falling rate cycle, investors should prefer fixed rate instruments over floating rate ones. Therefore, the time would appear to be ripe for bond investors to now prefer fixed rate instruments over floating rate ones. However, the actual decision today is not so straight-forward.
With gilt yields in the market pre-empting rate cuts (as the table shows), floating rate bonds (which are pegged to G-Sec yields) have already factored in a good bit of the decline in interest rates. There may, therefore, be limited logic to exiting floating rate bonds now, after the June 6 announcement. Many top performing debt funds are invested in the Government of India’s Floating Rate Bonds. Their returns would have already moderated to some extent. As fund managers will, in any case, be taking active calls on the fixed versus floating question, it is unnecessary for investors in debt funds to take any action.
However, the rate cuts do have implications for existing and prospective investors in the GOI Floating Rate Savings Bonds sold by the RBI (and leading banks). This bond, with a seven-year lock-in period, resets its interest rate every half year. However, it is necessary to note that the reset happens with a lag. Moreover, the interest rate on the bond is set at a 35-basis point spread over the prevailing rate on the NSC. Therefore, the interest on this bond, currently at 8.05 per cent, is likely to be reset only after NSC rates are changed. The NSC already offers a 25-30 basis point spread over bank deposit rates. Therefore, the GOI Floating Rate Savings Bond is likely to remain an attractive instrument for debt investors who can lock in their money and forego liquidity for seven years.
Duration vs accrual
Debt mutual funds invest in market instruments. As we saw, market instruments have run ahead of MPC actions. Therefore, the critical piece of information for debt mutual fund investors from this MPC meeting, was the signal that rates may not fall much more from here.
This may call for a shift in their debt strategy. With market yields falling sharply, debt funds which focus on long-duration instruments (gilt funds with 10-year constant maturity, long duration funds) have rocketed to the top of the table with one-year returns of over 11 per cent. However, entering these funds now hoping for a repeat performance is highly risky, as much of the bond rally is done and dusted. Long duration bonds may now see more two-way moves, as the rate direction has turned unclear.
Investors who had a minimum five-year horizon in mind while betting on gilt funds, constant maturity funds and long duration funds, can hold on as the rate cycle will eventually turn. But those who cannot hang on to their funds for five years should now switch to corporate bond funds or PSU and banking funds. These funds offer higher yields than gilts and thus offer potential for slightly better returns today. The liquidity unleashed by CRR cuts is also likely to temper short-term interest rates in the market in the coming months. In short, debt fund investors across the board need to brace for lower returns with the possibility of higher volatility, as the easy money seems to be over.