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Interest rates are softening. The Reserve Bank of India Governor Raghuram Rajan in his credit policy in early April reduced repo rates by 25 basis points to 6.5 per cent. Rajan hinted at further rate cuts should monsoon be good this year.

Bankers too are seeing interest rates softening going forward. “Interest rates should soften during the year. It is towards the softening side,” ICICI CEO and MD, Chanda Kochchar said on Friday while releasing the bank’s Q4 2016 results.

Falling interest rate would have a definite impact your debt portfolio. Fixed deposits and other small savings will earn lower interest rates. In fact, recently the government cut small saving rates significantly. In such a scenario, debt mutual funds might emerge as a good investment option.

Vidya Bala, Head Mutual Fund Research, FundsIndia.com, told FeMoney that debt funds would emerge as a preferred fixed-income investment.

“There is little choice but to diversify your fixed income portfolio into debt funds. The current rate cut provides opportunity for a medium-term rally in the bond market with yields easing up at the long end of the curve (long tenure bonds to rally),” Bala said.

She pointed out that moving to a lower interest rate regime over the next few years, your fixed income portfolio would get impacted on a few counts. Firstly, you will face reinvestment risk (significantly lower rates) on all your fixed deposits maturing and coming up for reinvestment, and also for any fresh investment you may plan.

Secondly, slashing of rates of small savings schemes across board, including public provident fund (PPF) and the quarterly reset of these rates, your returns from small savings schemes would head southward. That means progressively you might get lower interest on your PPF and any fresh investment in any of the small savings would also lock you into lower rates.

Among bond funds, Bala recommends Birla Sun Life Dynamic Bond fund to play the easing interest rate scenario, if the investment time-frame is not less than 2-3 years. “Its track record of consistently beating fixed deposit rates means you will have superior returns across rate cycles. The fund currently has close to 85 per cent of its portfolio in long-term gilts that will see a rally with easing rates,” she points out.

For investors looking for sustained opportunities over the long term (rather than interest rate cut opportunity), Bala suggests considering adding an income accrual fund such as HDFC Medium Term Opportunities. “This will ensure more sustained returns over different rate cycles as the fund does not take active duration call and instead invests in quality corporate bonds,” she says.

Manoj Nagpal, CEO, Outlook Asia Capital, says “Falling interest rates provide an impetus to duration-oriented debt funds and on the other hand lower the coupon yield in accrual oriented funds and floating rate funds. Within a falling interest rate regime one can use a twin strategy of shifting the portfolio allocation to duration funds like long-term debt fund and gilt funds and simultaneously locking in part of investments in FMPs (Fixed Maturity Plans) and Tax-Free Bonds. This twin strategy can be helpful to tactically benefit and optimizing returns from debt funds,” nagpal said.

Nagpal says for a conservative investor who does not want to play this cycle himself Dynamic Bond funds can provide the right path. Among funds, he suggests ICICI Prudential Gilt Fund, Kotak Bond Fund and Birla Dynamic Bond Fund in each of the categories that can be considered.

Anil Rego, Founder and CEO, Right Horizons also suggest investing in debt funds. “Investors may opt for debt mutual funds, at least for the next few months, instead of bank or small savings term deposits. If RBI cuts interest rates further, the returns of debt funds will improve till the lower rates are factored into bond prices (there is an inverse relationship between interest rates and bond prices. As interest rates drop, bond prices appreciate).