What it holds
A debt fund lends. Its portfolio is made of instruments where somebody has borrowed money and promises to pay it back with interest — government securities, corporate bonds, commercial paper, certificates of deposit, treasury bills.
You are not buying a share of a business. You are buying a share of a loan book, and the two questions that decide everything are: will the borrowers pay? and what happens to the value of these loans if interest rates move?
Those are the two risks. They are independent of each other, and a fund can carry a lot of one and almost none of the other.
Two ways it makes money — and one of them can be negative
Accrual. The instruments pay interest, and that interest accrues into the fund every day. This part is steady and positive.
Price change. The bonds themselves are marked to market daily, and their prices move. This part can be negative.
Why bond prices move is worth one sentence of arithmetic, because it explains the behaviour that surprises people most. A bond paying 7% is worth less once new bonds are being issued at 8% — nobody will pay full price for the lower coupon, so its market price falls until its effective yield matches. Rates up, bond prices down. And because a debt fund marks its holdings to market, that shows up immediately as a fall in NAV.
So a debt fund's NAV can and does fall, without anybody having defaulted on anything. That is not a malfunction. It is the mechanism working correctly.
Risk one: duration
Duration measures how sensitive the portfolio is to a change in interest rates. Longer-dated bonds are more sensitive, because a change in the going rate applies to more remaining years of payments.
The usable form is modified duration, which behaves as a multiplier: a portfolio with modified duration of 4 will lose roughly 4% of its value if yields rise by one percentage point, and gain roughly 4% if they fall by one. It is an approximation, and it is close enough to size a position with.
That single number tells you more about a debt fund's likely behaviour than its name does. A gilt fund holding long-dated government paper has no credit risk worth discussing and can still fall meaningfully when rates rise. Worked through in duration and interest-rate risk.
Risk two: credit
Credit risk is the possibility that a borrower does not pay.
Higher-rated borrowers pay lower interest; lower-rated ones pay more, because lenders demand compensation for the chance of not being repaid. A debt fund reaching for extra yield is, almost always, reaching down the credit ladder — and the extra yield looks like skill right up until the moment it does not.
Credit risk does not behave like duration risk. Duration losses are gradual, visible daily and reverse when rates fall. A default is sudden, large and does not reverse: the holding is written down, and in a stressed market the fund may also struggle to sell anything else at a fair price. Indian debt funds have experienced exactly this, and the resulting write-downs have run to substantial single-day falls in what investors regarded as conservative products.
The portfolio disclosure lists holdings and their ratings. It is the only place this risk is visible before it materialises.
Why the category name is not a risk label
Here is the specific mistake this article exists to prevent.
SEBI's debt categories are defined largely by maturity or duration bands. “Short Duration” requires the portfolio to sit inside a stated duration range. It says nothing whatsoever about credit quality.
So two short duration funds — one holding sovereign and top-rated paper, another holding lower-rated corporate paper — occupy the same category, appear in the same comparison table, are sorted next to each other by return, and carry entirely different risks. The one with the better trailing number is frequently the one taking more credit risk, and the ranking makes that look like outperformance.
| Duration risk | Credit risk | |
|---|---|---|
| Constrained by the category name? | Usually yes | No |
| How losses arrive | Gradually, marked daily | Suddenly, on a downgrade or default |
| Do they reverse? | Yes, if rates fall back | Largely no |
| Where to see it | Modified duration in the factsheet | Rating breakdown in the portfolio disclosure |
The questions that decide
- When do I need this money? The single most useful input. Matching the fund's duration roughly to your horizon means rate moves matter far less, because you hold long enough for accrual to dominate.
- What is the modified duration? Multiply it by a plausible rate move to see the swing you are accepting.
- What is the credit breakdown? Not the average rating — the distribution, and the size of the largest non-sovereign holdings.
- What is the yield to maturity, net of the expense ratio? YTM is the return the current portfolio would produce if everything paid as promised and nothing was traded. It is an indication, not a promise, and a YTM notably above peers is a signal about credit risk rather than about skill.
- Is there an exit load, and does its window fit my horizon?
None of that is a recommendation, and this article does not make one. It is what is knowable in advance.
Looking inside one
Every scheme publishes its holdings, ratings and duration in a monthly portfolio disclosure and factsheet. That document answers most of the questions above and is the one part of fund marketing that is not marketing.
FNOTrader's Mutual Funds app carries the full AMFI NAV history — around 34 million NAV rows — so a debt fund's actual behaviour through past rate cycles is inspectable rather than described, alongside rolling-return distributions and drawdowns. A debt fund's worst drawdown is a more honest description of its risk than its category name.
Common questions
What is a debt fund?
A mutual fund that lends rather than buys equity — its portfolio holds government securities, corporate bonds, commercial paper and similar instruments. Returns come from interest accruing daily plus changes in the market price of those instruments.
Can a debt fund lose money?
Yes, in two distinct ways. Bond prices fall when interest rates rise, which shows up immediately as a fall in NAV without anyone having defaulted; and a borrower can default or be downgraded, which writes down the holding suddenly and largely permanently.
Why does a debt fund's NAV fall when interest rates rise?
Because a bond paying 7% is worth less once new bonds are issued at 8% — its price falls until its effective yield matches the new going rate. Debt funds mark holdings to market daily, so that repricing appears immediately in NAV.
What is the difference between credit risk and duration risk?
Duration risk is sensitivity to interest rates: losses are gradual, visible daily and reverse if rates fall back. Credit risk is the borrower not paying: losses are sudden, large and do not reverse. They are independent, and a fund can carry a great deal of one and little of the other.
Does a debt fund's category tell me how risky it is?
Only partly. SEBI's debt categories are defined largely by maturity or duration bands, so the name constrains interest-rate sensitivity and says nothing about credit quality. Two funds in the same category can hold sovereign paper and lower-rated corporate paper respectively.
What is modified duration and how do I use it?
A multiplier for interest-rate sensitivity. A portfolio with modified duration of 4 loses roughly 4% if yields rise one percentage point and gains roughly 4% if they fall one. It is an approximation, and close enough to size a position with.
Is a higher yield to maturity better in a debt fund?
Not on its own. YTM is what the current portfolio would return if everything paid as promised, and a YTM notably above category peers is usually a signal that the fund is holding lower-rated paper — information about credit risk rather than about manager skill.
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