Debt Funds Part 4

14.1 Liquidity Risk

When people hear the term “mutual fund risk,” they usually think of equity markets swinging up and down. Debt funds, on the other hand, are often assumed to be “safe.” That assumption is misleading. Debt funds carry their own set of risks—default risk, credit risk, interest rate risk—and one more subtle but powerful risk: liquidity risk.

Liquidity risk in debt funds can be understood in two layers. First, the bond market itself may not be liquid. Imagine a bank holding a corporate bond that nobody wants to buy in the secondary market. The bank is stuck holding it until maturity, even if it urgently needs cash. Second, the fund house (AMC) must always be ready to meet redemption requests from investors. If too many investors want their money back at once, the AMC needs cash immediately. If the bonds it holds cannot be sold quickly, the AMC faces a crunch.

Think of it like a shopkeeper who has stocked up on expensive furniture. Customers suddenly demand refunds, but the shopkeeper cannot sell the furniture overnight to raise cash. The mismatch between assets  and liabilities  creates liquidity stress.

SEBI allows a scheme to borrow up to 20% of its net assets, for no more than six months, to meet redemptions or payouts. But borrowing is a red flag, it signals that the AMC’s cash buffer is running thin. Investors can spot this by checking monthly portfolio disclosures. If the “cash” line turns negative, it means borrowing has begun. This doesn’t automatically mean collapse, but it’s a warning sign. Since 2021, most open-ended debt schemes must also hold at least 10% of their assets in liquid instruments as a buffer. In 2020, Franklin Templeton’s debt funds showed negative cash balances before shutting down several schemes. The lesson: liquidity risk is invisible until stress builds, but attentive investors can connect the dots early.

14.2 – Banking & PSU Debt Funds

At first glance, a “Banking & PSU Debt Fund” sounds straightforward: a fund that invests in bonds issued by banks and public sector undertakings. These institutions are considered safer because banks are closely regulated by the RBI and PSUs often carry implicit government backing. But the reality is more nuanced.

By regulation, at least 80% of the portfolio must be in debt of banks, PSUs, public financial institutions and municipal bodies. The remaining 20% can go into other debt and money-market instruments. This 80-20 mix creates a hidden layer of risk. For example, a fund might hold 1–2% exposure to a private company bond. If that company defaults, the fund’s NAV takes a hit, even though the name “Banking & PSU” gave investors a sense of complete safety.

Duration risk also matters. Many Banking & PSU funds hold medium-term papers, with average maturities of 3–4 years. This means they are sensitive to interest rate changes. If rates rise, bond prices fall, and recovery can take time. Investors should therefore treat these funds as medium-term vehicles, suitable for a 3–5 year horizon, not for short-term parking.

In short, Banking & PSU Debt Funds are relatively safer than credit heavy funds, but they are not risk-free. The “cocktail” of 80% safe and 20% flexible investments requires investors to read the portfolio carefully rather than relying only on the fund’s name.

SEBI’s circular of 26 February 2026 also created a related category, Sectoral Debt Funds. These must invest at least 80% in AA+ and above rated debt of a single sector, such as financial services, energy, infrastructure, housing or real estate. As with Banking & PSU funds, the name tells you where the money goes, but not how much interest rate or concentration risk the fund carries, so read the portfolio.

Banking & PSU Debt Funds

14.3. Credit Risk Funds

Credit Risk Funds are the adrenaline junkies of the debt world. Their mandate is to invest at least 65% in lower-rated corporate bonds (AA and below, excluding AA+). These bonds pay higher interest because the issuers are riskier. The fund manager’s bet is that the company will not default and may even improve its credit rating over time. If that happens, the bond price rises, boosting the fund’s NAV along with the coupon income.

Picture a landlord renting out property to a tenant with a shaky financial history. The tenant agrees to pay double the rent to compensate for the risk. If the tenant stabilizes his income, the landlord benefits both from the high rent and from the improved reputation of the property. But if the tenant defaults, the landlord suffers a heavy loss. That’s exactly how credit risk funds operate.

The danger lies in concentration. Even within SEBI’s single-issuer limits (lower for lower-rated papers), some funds allocate large chunks to a single company. If that company defaults, the NAV can collapse overnight. For retail investors, this risk is unnecessary. Most personal financial goals—retirement, education, home purchase—can be achieved with safer debt categories. Credit Risk Funds are better left to institutional players who can absorb shocks. For individuals, avoiding them is the wiser choice.

High ratings are no guarantee either. DHFL was rated AAA until early 2019, was downgraded as its troubles grew and defaulted in June 2019. The losses hit many debt schemes, not only credit risk funds, which is why every debt investor should check the quality of the papers in a portfolio.

Credit Risk Funds

14.4.GILT Funds

A Gilt Fund is a mutual fund that invests mainly in government bonds. Because the government backs these bonds, there’s almost no risk of losing your money due to default.

1. Standard GILT Funds– At least 80% in government securities, with flexibility for the rest.
2. 10-year Constant Maturity GILT Funds (formerly Constant Duration GILT Funds)– At least 80% in government securities, with the portfolio’s Macaulay duration kept at 10 years.

While credit risk is absent, interest rate risk is significant. Longduration bonds are highly sensitive to rate changes. If interest rates rise, the value of these bonds falls sharply. Recovery can take years. For example, a 10year constant maturity gilt fund can lose substantial value in a rising rate cycle, even though the government backing remains intact.

Therefore, GILT Funds are suitable only for investors with long horizons—ideally 5–10 years or more—who can ride out interest rate cycles. For most retail portfolios, they are not essential. Safer debt categories already provide stability without exposing investors to extreme duration risk.

GILT Funds

Key Lessons

• Liquidity risk is real in debt funds; watch cash balances and borrowing levels.
• Banking & PSU Debt Funds are safer but not pure; the 20% flexibility can add hidden risk.
• Credit Risk Funds chase yield through risky bonds—retail investors should avoid them.
• GILT Funds eliminate credit risk but magnify interest rate risk; they demand long horizons.