In India, debt mutual funds are often marketed as “safer than equity” investments. Many retail investors equate debt with security, assuming their money is risk-free. After all, isn’t debt supposed to be about lending and earning stable returns?
But here’s the hard truth: debt funds carry risks that are often invisible to investors. They may not be as volatile as equity funds, but they’re far from risk-free.
This blog will break down the hidden risks of debt funds, explain why investors misunderstand them, and share real-life Indian case studies to highlight how overlooking these risks can cost you dearly.
What Are Debt Mutual Funds?
Debt mutual funds invest in fixed-income securities like:
- Government bonds
- Corporate bonds
- Treasury bills
- Commercial papers
- Certificates of deposit
The idea is simple: the fund manager lends money to governments or companies in exchange for interest. Investors expect stable, predictable returns.
But the story isn’t so straightforward. Debt funds are influenced by interest rate movements, credit ratings, market liquidity, and fund manager decisions—all of which introduce risks.
🏦 Types of Debt Funds in India
SEBI has clearly categorized debt funds into 16 types based on duration, credit quality, and investment strategy. Here are the most common categories investors should know:
1. Liquid Funds
- Invest in short-term securities with a maturity of up to 91 days.
- Ideal for parking emergency funds or short-term surplus.
- Example: Nippon India Liquid Fund.
2. Ultra Short Duration Funds
- Invest in instruments with a maturity of 3–6 months.
- Slightly higher return potential than liquid funds.
- Useful for goals such as paying fees or taking a vacation in 6 months.
3. Low Duration Funds
- Securities with 6–12 months maturity.
- Balance between liquidity and yield.
4. Short Duration Funds
- Maturity of 1–3 years.
- Popular among investors seeking better-than-FD returns with moderate risk.
5. Medium Duration Funds
- Average maturity of 3–4 years.
- Returns are influenced more by changes in interest rates.
6. Medium to Long Duration Funds
- Maturity of 4–7 years.
- More volatile, suitable only for long-term investors.
7. Long Duration Funds
- Average maturity >7 years.
- Highly sensitive to interest rate cycles.
- Example: Gilt funds with constant maturity (10 years).
8. Dynamic Bond Funds
- Fund managers actively adjust the maturity of their portfolios based on their views on interest rates.
- Returns vary depending on the manager’s skill.
9. Corporate Bond Funds
- Must invest at least 80% in AA+ and above-rated corporate bonds.
- Lower credit risk, but still not risk-free.
10. Credit Risk Funds
- Must invest 65% in AA and below-rated bonds.
- High yield, but very risky.
- Example: Franklin Templeton schemes that suffered in 2020.
11. Banking & PSU Debt Funds
- Invest at least 80% in bonds issued by banks, PSUs, or public financial institutions.
- Considered relatively safer.
12. Gilt Funds
- Invest in government securities only.
- No default risk, but high interest rate risk.
13. Gilt Funds with 10-Year Constant Maturity
- Always maintain 10-year maturity papers.
- High volatility, but suitable for long-term investors seeking a pure interest rate play.
14. Money Market Funds
- Invest in money market instruments with a maturity of up to 1 year.
- Slightly higher risk-return than liquid funds.
15. Overnight Funds
- Invest in securities with 1-day maturity.
- Safest in the debt fund category.
- Suitable for very short parking of money.
16. Floater Funds
- Invest in bonds with floating interest rates.
- Useful when interest rates are rising.
📌 Key Lesson: Each debt fund type serves a different purpose. Mis-matching your goal horizon with the wrong fund category is one of the biggest mistakes investors make.
Why Do Investors Prefer Debt Funds?
- Perceived safety – Unlike equities, NAV fluctuations look smaller.
- Better taxation vs. FDs (before 2023 changes) – Long-term indexation made them tax-efficient.
- Liquidity – Unlike fixed deposits, many debt funds allow redemption at any time.
- Diversification – Used to balance equity-heavy portfolios.
This perception of stability often blinds investors to the hidden dangers.
🚨 Risks Investors Overlook in Debt Mutual Funds
Let’s break down the significant risks with examples and case studies from Indian markets.
1. Interest Rate Risk
Debt fund NAVs move inversely to interest rates. When the RBI hikes repo rates, bond prices fall, pulling down fund NAVs.
👉 Example: In 2022, when RBI increased interest rates aggressively to control inflation, long-duration debt funds saw negative returns—even though they were supposed to be “safe.”
- If you invested ₹10 lakh in a gilt fund in Jan 2022, you might have seen your value drop to ₹9.5 lakh by December.
- Investors who expected FD-like stability were shocked.
Lesson: Longer-duration debt funds are susceptible to interest rate changes.
2. Credit Risk (Default Risk)
Debt funds lend to companies. If a company delays or defaults on repayment, the NAV takes a hit.
👉 Case Study: IL&FS Crisis (2018)
When IL&FS defaulted on its debt obligations, many debt funds holding IL&FS papers saw sudden NAV crashes. Investors who thought they were in “safe funds” woke up to 3–6% losses overnight.
👉 Case Study: Franklin Templeton Debt Fund Freeze (2020)
Six Franklin Templeton debt schemes shut down due to exposure to low-rated securities. ₹26,000 crore of investor money was stuck for months. This was a wake-up call: even “big brand” funds are not immune to credit risk.
Lesson: Higher yield in debt funds usually means higher risk. If a fund is earning a higher return than its peers, it may be lending to riskier borrowers.
3. Liquidity Risk
Liquidity risk arises when the fund is unable to sell its underlying securities easily in the market. This becomes a problem during crises.
👉 Example: In March 2020, when COVID panic hit, corporates and banks stopped buying low-rated bonds. Debt funds were unable to liquidate their holdings, forcing Franklin Templeton to shut down six schemes.
Lesson: Debt funds aren’t always liquid, especially when markets panic.
4. Concentration Risk
If a debt fund invests too heavily in a single issuer or sector, any problems with that issuer or sector can drag down the entire fund.
👉 Example: In 2017–18, several funds had concentrated exposure to companies like DHFL. When DHFL faced a credit downgrade, these funds saw NAV erosion.
Lesson: Check the portfolio. If a fund holds 8–10% of its assets in one corporate bond, the risk is high.
5. Reinvestment Risk
When bonds mature, fund managers must reinvest proceeds. If interest rates are lower than before, future returns will fall.
👉 Example: In 2016, many funds enjoyed high yields from older bonds. As those matured in 2018–19, reinvestments occurred at lower yields, which pulled returns down.
Lesson: Falling interest rate environments reduce reinvestment income.
6. Inflation Risk
Debt funds may yield returns of 5–6% when inflation is 6–7%. In real terms, your wealth doesn’t grow.
👉 Example: Between 2010 and 2014, many investors in short-term debt funds earned ~6% while inflation hovered at 8–9%. Purchasing power eroded.
Lesson: Debt funds preserve capital, but may not beat inflation.
7. Regulatory Risk
SEBI’s rules on debt fund categorization (2017) and the removal of indexation benefits for long-term capital gains (2023) changed the landscape for investors.
Lesson: Debt funds are also subject to policy changes that impact taxation and strategy.
📊 Real-Life Investor Case Studies
Case 1: The Retired Bank Officer
Mr. Sharma, 62, invested ₹20 lakh from his retirement corpus in Franklin Ultra Short Bond Fund (2020). He wanted “safe, regular income.” When the fund was shut, his money was locked for months. While he eventually recovered most, the psychological stress was immense.
Takeaway: Don’t park all retirement money in debt funds. Diversify across safer instruments, such as PPF, SCSS, or bank FDs.
Case 2: The Aggressive Young Investor
Rohit, 30, invested in a credit risk fund because it was showing 9% returns while peers showed 6%. After the IL&FS default, his NAV fell by 10% in a month.
Takeaway: High returns in debt funds almost always mean higher risk.
Case 3: The SIP Investor
Ananya started a SIP in a gilt fund in 2021. By mid-2022, as the RBI hiked rates, her NAV was negative. She thought “debt = safe,” and exited in panic, booking losses. Had she stayed longer, her returns would have normalized.
Takeaway: Match the duration of your debt fund with your goal horizon. Don’t panic at interim NAV changes.
✅ How to Invest Wisely in Debt Funds
- Match horizon with fund type:
- Liquid/Ultra-short for <1 year goals.
- Short-duration for 1–3 years.
- Gilt/long-duration only if horizon is >5 years.
- Liquid/Ultra-short for <1 year goals.
- Check credit quality: Avoid chasing high-yield funds. Stick to AAA/government securities.
- Diversify across products: Mix debt funds with FDs, PPF, EPF, and RBI bonds.
- Review regularly: Debt funds aren’t “set and forget.”
- Understand taxation: Post-2023, debt funds are taxed like FDs (as per the slab).
Final Words
Debt mutual funds are not villains—but they’re also not risk-free. The problem lies in perception. Many Indians enter debt funds expecting “FD safety + higher returns.” The reality is nuanced: debt funds involve credit, interest rate, liquidity, and reinvestment risks that can catch the unprepared off guard.
If used wisely—aligned with goals, risk tolerance, and horizon—debt funds can be a valuable component of a portfolio. But blind faith can be dangerous.
💡 Remember: Debt funds are tools, not magic wands. Understand their risks before investing, and you’ll be able to use them effectively without nasty surprises.
Disclaimer
The information provided in this blog is for educational purposes only and should not be considered as financial, investment, or tax advice. Please consult a qualified financial advisor before making any investment decisions.
VSJ FinMart is an AMFI-registered mutual fund distributor (MFD) and does not provide investment advisory services. Mutual fund investments are subject to market risks; please read all scheme-related documents carefully before investing.