Debt funds are superior to bank deposits in terms of returns and taxation. But are debt funds as safe as bank deposits? Majority of investors believe that debt funds are 100% safe and carry 0% risk.

Unfortunately this is not true.

While debt funds carry lower risk than equity funds, they are still not risk-free. In fact, some debt funds like Credit Risk funds are riskier than equity funds. So before investing in debt funds, let us learn about the 5 major risks in debt funds

5 Major Risks in Debt Funds

Risks in debt funds

Risks in Debt Funds #1: Interest Rate Risk

- Interest Rate risk is inbuilt in debt funds. This is because bond prices and interest rates have an inverse relationship.

  • When interest rate rises – Bond Yield falls
  • When interest rate falls – Bond Yield rises

You cannot avoid interest rate risk in debt funds. So, the best way to manage interest rate risk is by building an all-weather portfolio.

For example: In falling interest rates, long term debt funds perform well. Whereas in rising interest rates, short term debt funds provide better returns.

If you do not track interest rate cycles, then you can invest in Dynamic Bond Funds. In dynamic bond fund, the fund manager dynamically invests in both short term and long term papers to benefit from both falling & rising interest rates.

Risks in Debt Funds #2: Credit Risk

Debt mutual funds invest in debt securities such as bonds, debentures, treasury bills etc. These securities can be issued by public or private companies and the government.

When you invest in a debt fund, you are basically giving a loan to these private companies and government. You become the lender and the company or government is the borrower. The borrower promises to repay the loan on maturity and pay timely interest.

But what happens when the borrower is unable to repay the loan or make timely interest payment?

Credit Risk.

Yes, Credit risk is when the borrower is unable to repay the borrowed money. Credit risk is also known as Default Risk. The riskiness of a debt fund can be understood using Credit Ratings.

Every debt fund carries a credit rating. In India, credit ratings are assigned by CRISIL, ICRA, CARE etc. The below grid will help you in evaluating the paper quality of debt funds.

Credit Ratings for Short Term Bonds

Ratings Credit Risk
AAA Highest Safety
AA High Safety
A Adequate Safety
BBB Moderate Safety
BB Moderate Risk
B High Risk
C Very High Risk
D Expected to Default (Junk)

Credit Rating for Long Term Bonds

Ratings Credit Risk
A1 Lowest Risk – Highest Safety
A2 Low Risk – Adequate Safety
A3 Moderate Risk – Moderate Safety
A4 High Risk
D Expected to Default (Junk)

Debt funds investing majorly in AAA or A1 rated bonds are safer and carry very little credit risk. Conservative investors should invest in such debt funds.

Debt funds investing in B, C, D rated papers carry high credit risk. Ideally investors should avoid such debt funds.

But if aggressive investors want to invest in such low credit rated funds, then they should invest in Credit risk debt funds. This fund invests in low credit rating papers and are very risky. They are only suitable for aggressive investors with a medium – long time horizon.

How to Avoid Credit Risk?

There are 2 ways to avoid or manage credit risk in debt funds:

  • Invest in only those debt funds that invest in high credit rated papers like corporate bond funds. These funds invest 80% of the corpus in AAA rated funds and are highly stable.

  • You can also invest in Gilt mutual funds which invest in only government securities and carry Zero Credit Risk.

Risks in Debt Funds #3 – Liquidity Risk

: Liquidity risk arises when you cannot easily sell your debt funds. Liquidity risk is high in close-ended debt funds such as Fixed Maturity Plans (FMPs). These funds can be redeemed only on a fixed maturity date. While they are listed on the market, they have very little liquidity and hence selling them is not easy.

The best way to avoid liquidity risk is by investing in open-ended debt funds which can be redeemed any time. There are 16 types of open-ended debt funds in India for investing, hence investors should avoid close-ended debt funds.

Risks in Debt Funds #4 – Reinvestment Risk

Reinvestment Risk arises when the underlying debt papers mature. Let us understand reinvestment risk in detail using an example.

Suppose your debt fund invested in ABC Ltd Bond offering an interest rate of 7%. This bond matures in 2 years. After 2 years, there is a fall in interest rate and other bonds in the market are offering 6% instead of 7%. When ABC Ltd bond matures, your fund manager will have no option but to reinvest in lower interest rate bonds. This is known as reinvestment risk. Reinvestment risk increases in a falling interest rate scenario.

The best way to avoid reinvestment risk is by investing in long term debt funds. They invest in long term papers which do not mature frequently and hence have lower reinvestment risk.

Risks in Debt Funds #5 – Concentration Risk

: Concentration risk arises when your debt fund manager fails to diversify the portfolio.

For example: suppose your fund manager believes that ABC Ltd is a great company. So he invests 20% of the corpus in ABC Ltd Bond.

Due to loss of contracts or other issues, ABC Ltd goes bankrupt and defaults on the bonds. The entire 20% corpus will be written-off. All because your fund manager failed to diversify the portfolio.

You can avoid concentration risk by checking if the number of securities held by the debt fund is in line with its peers.

So, these were the 5 major risks in debt funds. To eliminate overall risks in debt funds, investors should consider the following:

  • Investment Horizon: You can avoid risks in debt funds by investing as per your investment horizon. So, if your investment horizon is less than 3 years, you should stick to short term debt funds only. You shouldn’t invest in long term bonds just because they have generated higher returns in the last 6 months.

  • Risk Tolerance: You should always analyse your risk profile before investing in debt funds. Remember, not all debt funds are low-risk. Credit risk, floater funds, long term debt funds all carry high risk and are suitable for aggressive investors only.

  • Financial Goals: The best way to eliminate risks in debt funds is by investing as per your financial goals. When you invest as per set financial goals, you will not take poor investment decision and end up investing in wrong type of debt fund.

    Now that you understand the 5 major risks in debt funds, the next step is to select the best debt fund and start investing. But with 16 different types of debt funds in the market, which fund should you invest in? Are corporate bond funds better for short term goals or dynamic bond funds?

    We agree that selecting the best debt fund is not easy. Hence we have done the hard work so you don’t have to. The experts at RankMF have shortlisted the best debt funds in each category – short term, medium term and long term. Our recommendations will help you generate superior returns. So, say goodbye to mediocre debt funds and invest in the best debt funds in India by opening a FREE RankMF account today!

risks in debt funds

Frequently Asked Questions by investors:
Which are safest debt funds?
Liquid funds , Overnight funds and gilt funds are considered to be the safest types of debt funds in India.
Are Debt funds safe?
Debt funds carry lower risk than equity funds. So debt funds are safer than equity funds. But debt funds carry different types of risk like credit risk, interest rate risk etc.
Are gilt funds safe?
Gilt fund is a type of debt fund which only invests in securities issued by central or state governments. Hence they carry zero default risk. Hence gilt funds are safe from a default perspective. But they carry high interest rate risks.
Are short term debt funds safe when interest rates are falling?
Short term debt funds are preferred during rising interest rate scenarios. During falling interest rates, long term debt funds are ideal.
Which is the least safe debt fund in India?
The riskiest debt fund categories are credit risk debt funds, dynamic bond funds and long term debt funds.