I have seen investors shocked when debt funds lost money

“Sir, this is like a fixed deposit, only better.” That is how debt mutual funds are often sold.

Safer than equity. Higher returns than a bank FD. Money available whenever you want. The words feel familiar. I know many people who hear this pitch from a bank relationship manager or a distributor and say yes within minutes. They believe a debt fund is a smarter version of an FD.

That belief is where my problem starts. 

A bank FD gives guaranteed principal and fixed interest. A debt mutual fund does not. It is market-linked. Its value moves every day. It can go down. This difference is not a small technical point. It is the core risk that so many investors miss at the start.

When the myth breaks in real life

I remember the first time this hit close to home. A retired uncle called me in a worried voice.

He had put a part of his savings in a debt fund that was labelled “short duration” and “low risk.” For months, the NAV moved in tiny steps and he barely noticed it. Then one week the value fell by more than one percent. He asked me, “How can a safe fund lose money?” He had planned his monthly cash flow on the belief that a debt fund behaves like an FD. That week broke that belief.

A few months later, a younger colleague had a similar shock. He parked his emergency fund in a corporate bond fund because the past returns looked better than a savings account. He thought it was a cautious move before he tried equity. A negative month and a scary headline about a credit downgrade were enough to push him into panic. He wanted to redeem at once. Both these cases were different people at different life stages, yet the surprise was the same. They thought “debt equals safety.” They found out it is not that simple.

Why debt funds can lose money

Let me explain the main reasons in plain words. This is actually not rocket science. These are the basic things that drive bond prices and in turn your debt fund’s NAV.

1) Interest rate risk

Bond prices and interest rates move in opposite directions. When market interest rates rise (Assume repo rate for understanding), the price of existing bonds falls because new bonds offer higher coupons. A debt fund owns many bonds. When those bond prices fall, the fund’s NAV falls.

The size of that fall depends on the fund’s “duration,” which is a measure of how sensitive it is to rate changes. Longer duration funds feel a bigger impact. A one percent rise in interest rates can push a long duration fund down by several percent on paper. Even a short duration fund can see a temporary dip. This is normal mark to market movement, but it is still a loss if you sell on that day. Many investors discover this only after they see the first red minus on their statement.

2) Credit risk

Not every bond is a Government of India security. Many funds hold corporate bonds. If a company runs into trouble, the value of its bond can drop sharply. A downgrade hurts the price. A default can cause a write down. This shows up as an NAV fall. You may not track every issuer inside your fund. You may only see a tidy category label like “corporate bond fund.” Inside that label there can be a mix of very safe names and some that carry more risk. The extra yield you see on a factsheet often comes from taking some credit risk. That is fine when nothing goes wrong. It is painful when a single issuer stumbles.

3) Liquidity risk

Bonds do not always trade as easily as large company stocks. In a stress period, buyers can disappear and prices can gap down. If many investors try to redeem at the same time, the fund may have to sell bonds at poor prices. That hits the NAV. In rare cases you can even see restrictions on redemptions for a period while the fund collects cash from maturing papers. This is not common, but it has happened. Liquidity looks invisible until the day you need the exit.

4) Horizon mismatch

Debt funds come in many types. Liquid. Ultra short. Short duration. Corporate bond. Gilt. Dynamic bond. Each behaves differently. If you put a three month emergency fund into a long duration gilt fund, you have a mismatch. You have taken interest rate risk for a goal that needed stability. If you put a five year goal into a credit risk fund because the past return looked high, you have accepted a risk that can appear suddenly. The problem is not the category itself. The problem is using the wrong category for the wrong time frame.

5) Behaviour risk

Numbers do not cause the final loss. Our reactions do. A small negative month triggers anxiety. We redeem and lock in the mark to market loss. We chase the debt fund that has the best one year return on a chart, and we ignore the extra risk that produced that return. We listen to a confident pitch and skip the factsheet. Behaviour turns a temporary dip into a permanent dent.

How this hurts different investors

A retiree wants stability and predictable income. A dip of two or three percent in a debt fund feels large when the whole plan is built around small monthly withdrawals. The retiree also has less time to wait for recovery. The emotional cost is high.

A first time investor uses a debt fund as the safe entry point before trying equity. A negative month at the start can shake confidence in the entire idea of investing. That person now treats all mutual funds as risky. A poor first experience can push a saver back to fixed deposits for years.

Even a middle aged professional with some experience can fall into the trap of labels. I did this too. I saw “short duration” and assumed very low risk. I did not check the average maturity, the top holdings, or the credit mix. I only saw a calm return line and thought it would continue. That lazy shortcut can hurt anyone.

How to use debt funds sensibly

I still invest in debt funds. I just use them with clear rules.

1. Match time frame to category: For money you may need within a few months, stick to liquid or ultra short duration funds. For one to three years, look at short duration or high quality corporate bond funds. For longer horizons, you can consider a mix that includes some gilt exposure if you understand rate risk. Do not take long duration for short needs.
2. Prefer quality over yield: If a fund is offering meaningfully higher yield than peers in the same category, ask why. Extra yield often means extra credit risk. For core money, I prefer funds that hold Government securities, treasury bills, public sector bonds, and top rated corporate papers. I skip funds that dip too far down the rating ladder.
3. Read two numbers before you invest: Check the modified duration to understand interest rate sensitivity. Check the credit quality breakdown. Even a quick look at the top ten holdings can reveal if the portfolio is plain vanilla or stretched.
4. Diversify your “safe” bucket: Do not keep all your stable money in one fund or one category. Split between a couple of high quality funds and some fixed deposits or small savings schemes. Diversification reduces the impact of a single event.
5. Set expectations upfront: Accept that a debt fund’s NAV can go down in some months. Accept that there is no guarantee. If you do not want any visible fluctuation in principal, an FD is the right tool. If you want market linked flexibility and tax efficiency, a debt fund is useful, but only with full awareness.
6. Do not react to noise: A red day or a red week is not a reason to hit redeem. If the portfolio quality is fine and your time frame matches the fund, allow the bonds to pay interest and mature. Recovery comes from time and cash flows, not from impulsive exits.

I now share these suggestions with everyone

Debt mutual funds are useful tools. They can help you earn better post tax returns than a savings account. They can help with liquidity. They can smooth a portfolio. 

But they are not fixed deposits. They carry interest rate risk, credit risk, liquidity risk, and behaviour risk. If you treat them like FDs, you will feel shocked the first time the NAV falls. If you treat them like market-linked fixed income, you will use them better and sleep better.

The next time someone calls and says, “Sir, this is like a fixed deposit, only better,” pause. Ask what the fund holds. Ask about duration. Ask about credit quality. Ask yourself when you will need the money. Choose the right tool for the job. Safety is not a label. Safety is a fit between the product and your purpose.

I have seen what happens when that fit is missing. It is not only about money. It is also about trust and peace of mind. Learn the difference now, before a small red number forces you to learn it the hard way.

Disclaimer

Note: This article relies on data from fund reports, index history, and public disclosures. We have used our own assumptions for analysis and illustrations.

The purpose of this article is to share insights, data points, and thought-provoking perspectives on investing. It is not investment advice. If you wish to act on any investment idea, you are strongly advised to consult a qualified advisor. This article is strictly for educational purposes. The views expressed are personal and do not reflect those of my current or past employers.

Parth Parikh has over a decade of experience in finance and research. He currently heads growth and content strategy at Finsire, where he works on investor education initiatives and products like Loan Against Mutual Funds (LAMF) and financial data solutions for banks and fintechs.