Bond and debt mutual funds offer steady returns and portfolio diversification, but they come with inherent risks. Although less volatile than equities, they remain sensitive to market dynamics. Understanding three major risks, duration, credit, and liquidity, is essential for informed decision-making and prudent portfolio management. Let’s break them down.
Duration risk
Also known as interest rate risk, duration risk impacts bond pricing and debt fund performance due to the inverse link between bond prices and interest rates. Typically, bond prices fall when rates rise and vice versa. So, when the RBI lowers rates, existing higher-yield bonds become attractive, increasing their prices and benefitting the funds that hold them. Conversely, when the RBI hikes rates, newer bonds offer better yields, making older ones less appealing and driving their prices down, which hurts fund returns.
Debt funds are typically categorised by duration: liquid (very low), short (1–3 years), medium (3–5 years), and long-duration or gilt funds (above 7 years). Longer-duration funds are more sensitive to interest rate changes and tend to experience greater volatility compared to short-term funds.
Interest rate movements are influenced by factors such as inflation expectations, RBI policy, and liquidity. For instance, in 2022–2023, the RBI hiked the repo rate by 250 bps to curb inflation, pushing 10-year government bond yields up 130 bps to 7.6 per cent. Long-duration funds saw 4–6 per cent losses for the one-year period that ended on June 2022. On the other hand, a 100 bps cut in 2025 amid low inflation and weak growth helped these funds deliver better return, with long-duration and 10-year gilt funds gaining 8 per cent and 11 per cent respectively in the last one year period ending June 17, 2025.
To manage duration risk, fund selection must align with asset allocation strategy and cash flow needs. For short-term goals, liquid, low-duration, and money market funds offer safety and stability. Several debt fund categories, including short-duration, corporate bond, and banking & PSU funds, use a blend of accrual and duration strategies and adjust durations dynamically between 1 to 4 years. Consistent investing across interest rate cycles in such funds helps manage volatility. Long-term portfolios can benefit from SIPs in long-duration, dynamic bond, or gilt funds to average costs and smoothen returns. Individual bond investors can mitigate interest rate risk by holding bonds to maturity.
Credit risk
Credit risk or default risk, refers to the possibility that issuers may fail to repay interest or principal. In India, several episodes have highlighted the dangers of this risk. It typically rises when funds invest in lower-rated papers (below AAA) to boost yields, a strategy that can be profitable in stable markets but risky during turmoil. Defaults and credit downgrades involving DHFL, ADAG, Essel Group, and Yes Bank have hurt many investors. The most notable event was Franklin Templeton’s 2020 closure of six schemes heavily exposed to lower-rated and structured credit, triggered by Covid-induced market panic. Though all investors were eventually repaid, the episode exposed the perils of chasing yield through credit risk.
But credit risk isn’t limited to low-rated papers. The 2018 IL&FS crisis was a turning point. Despite holding a AAA rating, IL&FS defaulted, resulting in sharp mark-to-market losses for debt funds exposed to it. The event showed if risks are misjudged, investors can be caught off guard even by the highest-rated issuers. .
In response to such events, SEBI strengthened regulations, introducing stricter valuation norms, curbs on unlisted debt exposure, and mandatory side-pocketing to isolate troubled assets and protect other investors.
To mitigate credit risk, investors must review the fund’s credit profile. Funds with high allocations to AAA and sovereign securities, such as gilt and Banking & PSU funds, carry lower credit risk. Credit risk funds must invest at least 65 per cent in AA and below instruments, making them inherently riskier. Aligning investments with one’s risk tolerance, opting for high-quality accrual strategies, and limiting exposure to low-rated issuers are prudent ways to navigate this space.
Liquidity risk
Liquidity risk in bonds and debt mutual funds arises when it becomes difficult to sell securities quickly without causing a significant drop in their prices. Under normal conditions, fund managers can buy or sell bonds with minimal impact on pricing. But in times of stress like downgrades, economic disruptions, or regulatory shifts, liquidity may vanish, causing sharp price drops, especially in long-duration or low-rated instruments.
Most debt funds are open-ended, allowing investors to redeem units at any time. When there are large-scale redemptions, fund managers may be forced to liquidate their most liquid holdings first to meet cash demands. This can leave the portfolio concentrated in riskier assets, leading to further erosion in Net Asset Value (NAV) and adversely affecting remaining investors. This risk was evident between 2018–2020, when IL&FS-related defaults led to massive repricing in NBFC and infrastructure bonds. The most notable case was Franklin Templeton’s closure of six schemes due to severe liquidity stress during Covid-19. Liquidity risk is often interconnected with credit risk, as downgrades can trigger sell-offs and dry up liquidity further.
To mitigate this risk, SEBI mandates that debt funds maintain 15–20 per cent of their assets in highly liquid instruments such as government securities. Investors should opt for debt funds that are mandated to invest exclusively in high-quality AAA-rated papers. Adopting a diversified strategy across different maturity profiles also helps withstand market stress while avoiding excessive exposure to liquidity shocks.
Published on June 21, 2025
