Recyclable biocomposites based on degradable polymer systems and cellulosic plant fibers are attractive in a sustainable society, because of enhanced polymer properties and also from an end-of-life perspective. Improved understanding is required for how the degradable polymer matrix is affected during compounding in addition to effects from the cellulosic fiber structure and its chemical nature. This work reveals that a poly(ε-caprolactone) matrix undergoes localized, heterogeneous polymer degradation in the fiber-matrix interphase region during melt-compounding. The extent of localized degradation correlates with the initial moisture content in the wood cellulose fiber, where moisture content is controlled by different fiber modification methods by PCL-grafting. As an effect, high moisture content results in a destabilized and degraded fiber-matrix interphase. This was found through careful analysis of how the polymer population changed after compounding, using two different methods: molar mass distribution from SEC and end-group concentration from NMR. The results are important not only with regard to fiber/matrix interface compatibility but also to understand fiber modification for improved biocomposites recycling.