Debt mutual fund dangers are actual. Learn how and when debt funds can provide damaging returns, and what buyers ought to watch earlier than investing.
When most buyers hear the time period “debt mutual fund,” they image stability, security, and predictable returns. In spite of everything, not like fairness funds, debt funds don’t spend money on shares — so that they have to be risk-free, proper?
Sadly, that’s a harmful fantasy. Debt funds can generate damaging returns, and historical past has proven a number of examples the place buyers misplaced cash.
Debt Mutual Fund Dangers: Can They Give Adverse Returns?
On this submit, we’ll break down why debt funds can go damaging, the situations the place this occurs, examples from the previous, and what you are able to do to scale back the danger.
1. Why Do Traders Suppose Debt Funds Are At all times Protected?
- Debt funds spend money on fixed-income devices — like authorities securities, company bonds, treasury payments, and business papers.
- These devices typically pay mounted curiosity and are thought of much less unstable than equities.
- As a result of financial institution FDs, PPF, and different “debt” merchandise give predictable returns, many assume debt mutual funds work the identical means.
However debt mutual funds are market-linked. The NAV modifications each day primarily based on market circumstances, rate of interest actions, and credit score high quality — which implies you possibly can lose cash, at the very least within the quick time period.
2. How Debt Funds Can Give Adverse Returns
Let’s undergo the principle threat components that may result in damaging returns, together with examples.
a) Curiosity Fee Threat
Debt devices have an inverse relationship with rates of interest.
- When rates of interest rise, bond costs fall.
- When rates of interest fall, bond costs rise.
Impression on Debt Funds:
- Lengthy-duration funds are most delicate to rate of interest modifications as a result of they maintain long-maturity bonds.
- A sudden rate of interest hike by the RBI may cause a right away drop in NAV.
Instance:
- In 2013, when the RBI unexpectedly tightened liquidity to manage the falling rupee, 10-year authorities bond yields jumped from round 7.2% to 9% inside months.
- Many gilt and long-duration funds noticed 1–3% damaging returns in just some weeks.
b) Credit score Threat
That is the danger that the bond issuer fails to repay curiosity or principal. If a bond is downgraded or defaults, the fund holding it may take a big hit.
Impression on Debt Funds:
- Credit score threat funds, company bond funds, and a few short-duration funds are extra uncovered.
- Downgrades may cause sudden NAV drops even when the precise default hasn’t occurred but.
Historic Instance:
- IL&FS Disaster (2018) — Debt papers of IL&FS group firms had been downgraded to “junk” standing. A number of debt funds with IL&FS publicity noticed NAVs drop in a single day.
- DHFL Default (2019) — Funds holding DHFL debt devices needed to mark them down, resulting in sudden losses.
- Some Franklin Templeton schemes confronted extreme markdowns throughout this era.
c) Liquidity Threat
If the fund can not promote its bonds available in the market when wanted (attributable to low demand or market stress), it might must promote at a lower cost, resulting in losses.
Instance:
- Franklin Templeton Debt Fund Closure (April 2020) — Six schemes had been shut down as a result of they couldn’t liquidate papers in a burdened market throughout COVID-19. Traders confronted losses and delayed redemptions.
d) Focus Threat
When a fund holds a big portion of belongings in a single issuer or sector, any hassle there can hit the NAV laborious.
Instance:
- Some debt funds in 2019–20 had over 8–10% publicity to a single NBFC. When downgrades occurred, the NAV influence was disproportionately massive.
e) Length Mismatch & Yield Motion
If a fund’s portfolio maturity doesn’t match the investor’s holding interval, short-term fluctuations can result in short-term losses.
Instance:
- A protracted-duration gilt fund can submit -1% returns in a single month if yields spike — despite the fact that over the long run, it might carry out effectively.
f) Segregated Portfolios (Facet-Pocketing)
When a bond within the portfolio defaults or will get downgraded to under funding grade, SEBI permits the AMC to create a “aspect pocket.”
- The worth of this bond is faraway from the principle NAV — inflicting a right away drop.
- If restoration occurs later, buyers might get some a refund, however in the meantime, the NAV displays a loss.
3. Which Classes Are Extra Weak?
Completely different debt fund classes have totally different threat profiles. Right here’s a simplified view:
| Debt Fund Class | Threat Stage | Essential Dangers | Extra Prone to Go Adverse? |
| In a single day / Liquid Funds | Low | Minimal rate of interest threat, very low credit score threat | Uncommon (normally solely in excessive default circumstances) |
| Extremely Quick / Low Length | Low–Medium | Credit score threat in some circumstances | Attainable in credit score occasions |
| Quick Length Funds | Medium | Credit score + some rate of interest threat | Attainable |
| Company Bond Funds | Medium | Credit score threat | Sure, if huge downgrade |
| Credit score Threat Funds | Excessive | Excessive credit score/default threat | Sure, extra seemingly |
| Gilt Funds / Lengthy Length | Excessive | Rate of interest threat | Sure, throughout charge hikes |
| Dynamic Bond Funds | Medium–Excessive | Depends upon technique | Attainable |
4. Previous Adverse Return Situations in India
Let’s have a look at some actual circumstances the place debt funds delivered damaging returns:
- 2013 Taper Tantrum:
RBI’s liquidity tightening + world bond sell-off ? Gilt funds fell 2–3% in a month. - IL&FS Default (2018):
NAVs of some debt funds fell in a single day attributable to score downgrades. - DHFL Disaster (2019):
Write-downs hit short-duration and credit score threat funds. - Sure Financial institution AT1 Bond Write-off (2020):
Funds holding AT1 bonds misplaced worth after RBI-directed write-off throughout Sure Financial institution’s rescue. - Franklin Templeton Closure (2020):
Six schemes froze redemptions; buyers confronted losses and delays.
5. How you can Cut back the Threat of Adverse Returns in Debt Funds
When you can’t take away threat fully, you possibly can handle it:
- Match funding horizon with fund class: By no means attempt to match your requirement with the common maturity of the fund. At all times select the fund whose common maturity is way lower than your requirement. Many buyers, and in reality the monetary business, wrongly preach that your requirement ought to be equal to the common maturity of the fund.
- For few months: Follow in a single day funds.
- For few months to a yr – liquid funds.
- For 3–12 months: Extremely quick / low length funds.
- For 1–5 years: Extremely quick, low length funds and cash market funds
- Lengthy-duration or gilt funds provided that you possibly can maintain for 10+ years.
- Verify portfolio high quality:
- Search for excessive AAA-rated devices. Do keep in mind that credit standing isn’t CONSTANT. Rankings might change at any time if there are any adversarial incidents with the bond issuing firm.
- Keep away from funds chasing larger yields by taking lower-rated papers.
- Watch focus ranges:
- Keep away from funds with >5% publicity to a single issuer.
- Keep up to date on rate of interest cycles:
- If charges are more likely to rise, keep away from long-duration funds.
- Favor transparency:
- It’s laborious to seek out however attempt to spend money on a fund which clearly talked about the place they make investments (not what the class definition is).
6. Closing Ideas
Debt mutual funds are not financial institution FDs. They carry market dangers — typically resulting in damaging returns. The influence depends upon the class, portfolio high quality, rate of interest atmosphere, and market occasions.
The important thing takeaway? Don’t spend money on debt funds blindly, assuming security simply because there’s no fairness. Perceive the class, match it together with your funding horizon, and monitor the underlying dangers.
Debt funds are highly effective instruments for diversification and tax effectivity — however provided that you respect the dangers that include them.
Consult with our earlier posts on Debt Mutual Funds Fundamentals – HERE.
