As fixed deposit (FD) interest rates decline, fixed-income investors are left wondering, “Where should I invest now?” For these investors, the primary goal is to ensure the safety of their investments. A clear alternative is debt mutual funds, especially now, given the Reserve Bank of India’s (RBI) decision to cut the repo rate by 100 basis points in 2025. Typically, when a rate-cut regime begins, it is widely believed that debt mutual fund interest rates will rise, prompting more investors to shift their focus to these funds. The trend is evident in the data as well.
In 2025 alone, debt mutual funds saw a significant inflow of ₹1.38 lakh crore, totaling approximately ₹18,75,665.88 crore in Assets Under Management (AUM), making them second only to equities, according to the Association of Mutual Funds in India (AMFI).
Often regarded as the “safest bet” within the mutual fund landscape, debt mutual funds aim to strike a balance between safety and reasonable growth over time. However, are debt mutual funds truly as secure as they seem? Is there a possibility for investors to encounter negative returns with these funds? In this blog, we will explain the associated risks of debt mutual funds that investors often tend to overlook.
Understanding how debt mutual funds work
To understand the risks associated with debt mutual funds, we first need to grasp how they operate.
Debt mutual funds typically invest in fixed-income instruments such as bonds, treasury bills, and corporate debt. These funds lend money to governments, banks, or companies for a specified period in exchange for interest payments. For investors like you, this means receiving the principal amount back at the end of the investment period, which is why it’s referred to as “fixed income.” Additionally, you earn extra money on your investment.
Let’s consider a hypothetical debt mutual fund scheme called “ABC Debt Fund,” which collects ₹100 crore from investors.
The fund manager decides to allocate this money in the following manner:
- ₹40 crore in government bonds (safe and government-backed)
- ₹30 crore in AAA-rated corporate bonds (from financially strong companies)
- ₹20 crore in bank certificates of deposit (short-term lending to banks)
- ₹10 crore in AA-rated corporate bonds (slightly riskier but offering higher interest)
Every year, these borrowers pay interest, typically ranging from 5% to 6%, depending on the specific investments. The fund collects this interest and returns it to investors, either by reinvesting it (in the growth option) or distributing it (in the IDCW option).
Why are debt mutual funds considered safe?
Take Rahul, for example. He has always invested his savings in fixed deposits. When his friend suggested investing in a debt mutual fund, specifically the ABC Debt Fund, he decided to make a comparison.
The fund appeared to offer higher returns and more flexible redemption options compared to fixed deposits. To him, it felt like a smarter yet equally safe choice. This is where psychology can play tricks on investors. Because the structure of debt mutual funds differs from that of equities, many equate low volatility with no risk.
Additionally, the net asset value (NAV) of these funds does not fluctuate as sharply as that of equities, which contributes to the perception of debt mutual funds as a safer investment. However, this belief that “low volatility = no risk” can be misleading.
But the question is: Are debt mutual funds really safe?
Now imagine if one of the AA-rated companies that ABC Debt Fund invests in runs into financial trouble and fails to repay. As a result, the value of that company’s bond falls in the market. Since 10% of the fund’s money is invested in the AA-rated bonds, the NAV of this scheme also drops. Rahul will suddenly see his “safe” fund giving very low or negative returns.
This happens because these bonds are traded in the market, which most investors don’t realise. The value of a debt mutual fund depends on the current market prices of the bonds it invests in, directly impacting your returns.
Hence, understanding the portfolio of a debt mutual fund matters. While short term government securities are usually safe, bonds like AA-rated ones carry risks, depending on the company’s financial strength.
The problem with Rahul was, in all this comfort, he forgot to ask a simple question: Where exactly is his money being invested, and what risks do those investments carry?
What are the risks of debt mutual funds?
Given below are the common types of instruments that debt mutual funds invest in.
Source: SEBI & AMFI
From the table, you can see that risks are still present, only they are not prominently visible. Now, let’s understand the risks of debt mutual funds in detail by revisiting real-life examples.
1. Credit risk (Default risk)
Credit risk is the risk when the borrower (say, a company) may fail to repay. It is highest in funds chasing high yields, since higher returns usually mean the borrower carries a lower credit rating. It is also known as default risk, as the company defaults on the payments to its investors.
A well-known example would be the collapse of Lehman Brothers during the global financial crisis in 2018. This US company was considered very safe at the time, due to which many debt mutual funds around the world had invested in the bonds of the company.
Suddenly, when it went bankrupt during the crisis, it failed to repay its investors, i.e., defaulted on its payments. The bonds, once trusted, became worthless (lost credit ranking) overnight, leading to a sharp drop in their NAV values. As a result, investors lost money.
2. Interest rate risk
Interest rate risk happens because bond prices move in the opposite direction of interest rates. When interest rates rise, the value of existing bonds falls, and vice versa. If you hold a bond offering 6% and new bonds in the market start offering 8%, the 6%-bond will naturally lose its value. Longer-duration funds are more affected because their cash flows are locked for longer periods.
For example, in India during 2022, when the RBI raised interest rates to control inflation, the value of long-term government bonds fell. Debt mutual funds holding these bonds saw their values dropping because the older bonds now paying lower interest became as compared to the new bonds issued at higher rates.
3. Liquidity risk
Liquidity means how quickly and easily you can sell an investment and get cash without losing much value. Sometimes, funds invest in securities that are not easy to sell. Also, if too many investors redeem their money at the same time, the fund may struggle to generate cash to fulfill every investor’s demand and may not be able to sell, causing liquidity risk.
One example of liquidity risk is Franklin Templeton. In April 2020, Franklin Templeton suddenly shut down six of its debt schemes in India as it failed to sell the underlying bonds to meet investor redemption requests during the COVID-19 market volatility. The schemes had invested in lower-rated corporate bonds, which became very hard to trade in the market during these redemption requests.
The lack of buyers in the market meant the fund couldn’t be sold easily and generate enough cash quickly. When investors wanted to exit at the same time, the illiquidity issue led to the closing of all six of its funds as they couldn’t meet its redemption target.
4. Reinvestment risk
Reinvestment risk occurs when the bond reinvests the money it gets back after its maturity at a lower interest rate. If interest rates have fallen, such reinvestments happen at lower yields, forcing them to reinvest in bonds with higher interest rates.
For example, in India, after the taper tantrum of 2013, interest rates were high, and many debt mutual funds invested in bonds at those higher rates. However, the RBI responded to this event by steadily cutting interest rates in the following years. The funds that were earlier locked into higher-yielding bonds now offered much lower returns and faced reinvestment once these matured. This reduced the overall income for investors.
5. Concentration risk
Concentration risk happens when a fund invests too much in a single company, sector, or the same type of security. If that company defaults or the sector isn’t trending anymore, investors may face big losses.
In 2015, two debt schemes from JP Morgan, JP Morgan India Short Term Income Fund (JSTI) and JP Morgan India Treasury Fund (JTF), had a combined exposure of around ₹200 crore to the bonds issued by the Amtek Auto Group at that time. When Amtek Auto defaulted on its payments, the funds suffered a sudden drop in their values.
This showed how concentration risk can hurt debt mutual fund investors when too much money is tied to one borrower or group, and that borrower fails to repay the money.
6. Prepayment risk
Prepayment risk arises when borrowers repay loans or bonds earlier before the intended maturity date, usually when the interest rates fall. These funds are forced to reinvest this early-received money in other bonds at lower interest rates, impacting your overall returns. Mortgage-backed securities are especially vulnerable to this type of risk.
For example, taking advantage of falling interest rates, many homeowners would close their expensive mortgage loans to invest in cheaper ones. Debt mutual funds holding these expensive loans will have to reinvest as they received the money earlier, putting it in the bonds with lower interest rates. As a result, investors who invested in these funds will receive less returns.
An important note: It’s essential not to view debt mutual funds entirely in a negative light because of the risks discussed. The primary risks actually lie with the underlying bonds and debt instruments themselves. These funds pool investments and are managed by professionals, offering a safer way to access the fixed-income market compared to investing directly in individual bonds.
Try our Mutual Fund Overlap Calculator to know how diversified your portfolio is.
Why many investors overlook the risks in debt mutual funds
Even when these risks exist, many investors continue to see debt mutual funds as completely safe. This happens largely due to behavioural biases.
- Investors usually fall prey to “crowd mentality”.
- Investors assume funds are safe because defaults have not happened recently.
- They believe that AMCs (usually the notable ones) will always protect their money.
- Some investors redeem immediately when they see a small drop in NAVs, locking in losses that might have recovered with time.
In many cases, this is how investors respond when “the perception of safety” breaks.
How to choose the right debt mutual fund for your portfolio
A few simple steps can help investors manage risks in debt mutual funds better:
- Match the fund type with your investment horizon. Short-term needs are better served with liquid or ultra-short funds, while longer horizons can look at high-quality short or medium-duration funds. Don’t invest in a fund with longer average maturity than your own investment horizon.
- Understand the type of risk you are willing to take for your goals. Longer-duration funds (like gilt funds) are highly sensitive to RBI rate moves. Also, funds chasing higher yields by investing in lower-rated papers carry the risk of defaults/downgrades. If you want safety, go for AAA-rated corporate bond funds.
- Consider the fund’s top 10 holdings exposure (avoid funds heavily concentrated in a few issuers).
- Higher modified duration means greater sensitivity to the interest rate changes.
- Choose a fund with a lesser expense ratio.
- You must check the credit quality of the securities that the fund invest in. Do not chase higher returns blindly. Stick to funds that mostly hold AAA or sovereign securities if stability is your priority.
- Prefer higher AUM fund with well diversified in good quality of securities, lesser AUM fund might have less no. of investor which could impact investor concentration, if they exit it clearly impacts NAV price.
- Seek qualified advice during such crucial decisions. You can consult our Qualified Financial Advisor for the same.
Conclusion
Do these risks in debt mutual funds make them somewhat irrelevant? Absolutely not! They are equally important as equities to build your mutual fund portfolio.
Despite the above risks, debt is a critical pillar of asset allocation for it brings:
- Stability: Debt cushions your portfolio against equity volatility.
- Predictability: The income stream from coupons/interest can provide regular cash flow.
- Capital Protection: High-quality debt (like sovereign bonds) can protect capital during equity downturns.
The right mix of equity and debt ensures your portfolio doesn’t swing wildly and can sustain through different market cycles.
Understanding these risks and aligning the choices with your own goals and horizon can help you use them effectively.
If you are confused, you can always consult with a qualified financial advisor, to ensure your goals and risk profile match. The key is not to avoid debt mutual funds, but to approach them with awareness rather than assumptions.
