Debt Funds
Funds that lend: returns come from interest plus rate moves, carrying credit risk and duration risk most buyers underestimate.
Why you care
Debt funds lend money — to governments and companies — and earn interest. That makes them steadier than equity, but "steadier" is not "safe." They carry two risks most buyers miss: the borrower not paying back (credit risk), and interest rates moving against the bonds they hold (duration risk). A debt fund can and does have red days.
Run the numbers
A fund holds a 5-year bond and interest rates rise 1%. The bond's market price falls roughly 5%, and because it's marked to market, the fund's NAV drops with it (illustrative). Nobody defaulted; rates simply moved. The longer the bonds a fund holds, the harder this hits.
Where this goes
SEBI sorts debt funds by maturity and credit quality, from long-duration and credit-risk funds at the risky end down to the shortest, safest liquid funds. Both risks show up as volatility in the fund's returns — which is why a debt fund's "how bumpy" number matters as much as its yield.
Why you care
Debt funds invest in bonds and other lending instruments, earning returns from the interest those instruments pay plus any change in their market price. They're the lower-risk box relative to equity, and they're where people park money they can't afford to see swing wildly. The dangerous misconception is that "debt" means "guaranteed." It doesn't. A debt fund is a portfolio of loans marked to market every day, and its NAV moves.
Two risks drive that movement. Credit risk is the chance a borrower doesn't pay, either downgrading or defaulting, which knocks the value of its bonds; this is what blew up several credit-risk funds during past defaults. Duration risk is subtler and catches more people. When market interest rates rise, existing bonds paying the old, lower rate become worth less, so their price falls. A fund holding them takes a mark-to-market hit even though nobody defaulted. The longer the average maturity (the "duration") of a fund's holdings, the more its NAV whips around when rates move. A short-maturity fund barely notices a rate change; a long-duration or gilt fund can have a genuinely bad quarter.
Run the numbers
A debt fund holds a bond with about 5 years of duration, and market interest rates rise by 1% (illustrative):
- As a rough rule, a bond's price falls by (duration × rate change): 5 × 1% ≈ 5%.
- The bond is marked to market, so that ~5% fall flows straight into the fund's NAV.
- No default happened. The loss is pure duration risk, from rates moving against bonds the fund already held.
Flip it and falling rates lift debt-fund NAVs, which is why long-duration funds rally when the RBI is expected to cut. The lesson for a buyer is to match the fund's duration to your horizon. Use short/liquid funds for money you need soon, and only take duration risk if you can hold through the rate cycle.
Where this goes
SEBI's debt categories are really a risk ladder sorted by maturity and credit quality, and its safest, shortest rung is the liquid fund — barely any duration risk, built for parking cash. Both credit and duration risk express themselves as standard deviation, the volatility of the fund's returns. That's why judging a debt fund on yield alone is a mistake: the steadier fund with a slightly lower yield is often the better holding for money you can't afford to watch fall.