The Two Risks in Every Debt Fund

Debt funds are lower risk than equity, not risk-free. Almost every surprise in the category traces back to one of two sources.

1. Interest-rate risk

Bond prices move inversely to yields. When rates rise, the bonds a fund already holds lose market value and NAV dips. Sensitivity is measured by duration: roughly, a fund with 5-year duration loses about 5% of value for a 1% rise in yields, and gains similarly when yields fall.

2. Credit risk

The chance that a borrower fails to pay, or is downgraded. Higher-yielding portfolios earn that extra yield precisely by lending to weaker credits. A single default in a concentrated portfolio can produce a sudden, permanent NAV drop — this is what has caused the category's worst episodes in India.

Matching category to horizon

• Weeks to months: overnight and liquid funds — minimal duration and credit risk.
• One to three years: low duration, short duration, money market and corporate bond funds.
• Longer, with tolerance for swings: gilt and long-duration funds — no credit risk, high rate risk.
• Credit risk funds: extra yield for genuine default risk; check issuer concentration.