Debt Fund Duration Risk vs Credit Risk: How Debt Funds Lose
Debt fund duration risk vs credit risk: how rate moves and defaults hit NAV, SEBI's risk matrix, 2026 category names and tax, with exact illustrative maths.
In this article
- Why bond prices move with interest rates
- Duration: the number that measures rate sensitivity
- Credit risk: when the borrower does not pay
- Side-by-side comparison
- Debt fund categories and their main risks
- The Potential Risk Class (PRC) matrix
- How to choose by time horizon
- Tax: same for both risks
- Key takeaways
A debt fund can lose money in two different ways. Duration risk (interest rate risk) is the fall in bond prices when interest rates rise; it is usually temporary for an investor who holds long enough. Credit risk is the loss when a borrower defaults or is downgraded; it can be permanent. Knowing which risk you are taking, and how much, is the single most useful thing to check before buying a debt fund.
Why bond prices move with interest rates
A bond pays fixed interest. If market rates rise after you buy it, new bonds pay more, so your older bond is worth less to a buyer and its price falls. If rates fall, your bond's higher coupon becomes more valuable and its price rises. A debt fund's NAV is the market value of all its bonds, so it moves the same way. For the mechanics of coupon, price and yield, read bond coupon vs yield to maturity.
Duration: the number that measures rate sensitivity
Fund factsheets show two duration numbers:
- Macaulay duration is the weighted average time, in years, until you receive the bond's cash flows. SEBI uses it to define debt fund categories.
- Modified duration turns that into price sensitivity: modified duration = Macaulay duration ÷ (1 + yield). It tells you the approximate percentage change in NAV for a 1 percentage point change in yields.
Worked example: a rate rise (illustrative)
A fund has a Macaulay duration of 6.42 years and a portfolio yield to maturity (YTM) of 7%. These are illustrative figures.
- Modified duration = 6.42 ÷ 1.07 = 6.0
- If yields rise by 0.50 percentage points, the approximate NAV change = −6.0 × 0.50% = −3.0%
- On ₹5,00,000 invested, that is an immediate mark-to-market fall of about ₹15,000
The same fund gains about 3.0% (₹15,000) if yields fall by 0.50 points. The estimate is an approximation that works best for small rate moves.
Now compare a liquid fund with an illustrative modified duration of 0.10. The same 0.50-point rise moves its NAV by about −0.10 × 0.50% = −0.05%, or ₹250 on ₹5,00,000.
Why duration losses are often temporary
The bonds keep paying interest, and the fund reinvests maturing money at the new, higher yields. Very roughly, a fund recovers a rate-driven fall over a period similar to its duration if rates then stay steady. In the example, a 7% yield earns about ₹35,000 a year on ₹5,00,000 (7% × ₹5,00,000), more than the ₹15,000 price hit, so a one-year holder could still end positive. This is illustrative and assumes no further rate rise and no defaults.
Credit risk: when the borrower does not pay
Credit risk has nothing to do with rate moves. It is the chance that a company whose bonds the fund owns:
- Is downgraded by a rating agency, which pushes the bond's price down, or
- Defaults, so interest and principal are delayed or never paid.
Worked example: a default (illustrative)
A fund has 5% of its portfolio in one company's bonds. That company defaults and the fund writes the bonds down to zero.
- NAV impact: roughly −5%
- On ₹5,00,000: a loss of about ₹25,000
Unlike the duration example, there is no automatic recovery from higher yields. Money comes back only if the company later repays something.
SEBI allows funds to create a segregated portfolio (side pocket) when a holding is downgraded below investment grade or defaults. The troubled bond is split into a separate portfolio, and every investor at that date gets units in it. Your main NAV drops by the bond's value, but if the company later pays, the money flows to those segregated units. This prevents new investors from gaining, or quick redeemers from escaping, at others' expense. It does not erase the loss.
Indian investors saw both risks play out: the IL&FS default in 2018 and Franklin Templeton's 2020 decision to wind up six debt schemes showed that "debt" does not mean "safe".
Side-by-side comparison
| Duration (interest rate) risk | Credit risk | |
|---|---|---|
| Trigger | Market yields rise | Borrower downgraded or defaults |
| Effect on NAV | Gradual or sudden fall, rise if rates fall | Sudden fall, can be large |
| Usually temporary? | Often, if you hold for about the duration | May be permanent |
| Measured by | Macaulay and modified duration | Rating mix, Credit Risk Value |
| Highest in | Long duration, gilt, dynamic funds | Credit risk funds, lower-rated corporate paper |
| Lowest in | Overnight, liquid, money market funds | Government securities, T-bills, AAA paper |
Debt fund categories and their main risks
SEBI defines most debt categories by Macaulay duration. Under the Master Circular of 20 March 2026, several categories were renamed; many fund houses applied the new names from August 2026. For example, "Short Duration Fund" became "Short Term Fund" and "Low Duration Fund" became "Ultra Short to Short Term Fund". The duration bands for the categories below were unchanged as of October 2026.
| Category (older name in brackets) | Macaulay duration | Main risk to watch |
|---|---|---|
| Overnight | 1 day | Very low on both |
| Liquid | Up to 91 days maturity | Low; check credit quality |
| Ultra Short Term (Ultra Short Duration) | 3 to 6 months | Low duration risk |
| Ultra Short to Short Term (Low Duration) | 6 to 12 months | Low duration, some credit |
| Short Term (Short Duration) | 1 to 3 years | Moderate duration |
| Medium Term (Medium Duration) | 3 to 4 years | Higher duration, often credit |
| Medium to Long Term (Medium to Long Duration) | 4 to 7 years | High duration |
| Long duration | Over 7 years | Very high duration |
| Gilt | Varies; at least 80% in government securities | Duration, almost no credit risk |
| Credit risk | No band; at least 65% in bonds rated below the highest rating | High credit risk |
Category names and some rules differ slightly across fund houses during the transition, so read the scheme's own notice or factsheet.
The Potential Risk Class (PRC) matrix
Every debt scheme shows a 3 × 3 grid in its documents that caps the maximum risk the fund can take:
| Interest rate risk ↓ / Credit risk → | Relatively low (A) | Moderate (B) | Relatively high (C) |
|---|---|---|---|
| Relatively low (Class I) | A-I | B-I | C-I |
| Moderate (Class II) | A-II | B-II | C-II |
| Relatively high (Class III) | A-III | B-III | C-III |
Class I to III depends on the maximum Macaulay duration the fund may run (up to 1 year, up to 3 years, or any). A to C depends on a minimum Credit Risk Value, a weighted score of the portfolio's ratings. A fund in A-I is the most conservative; one in C-III can take the most of both risks. The PRC is a ceiling, not the current position, so pair it with the latest factsheet.
How to choose by time horizon
| When you need the money | Categories investors commonly consider |
|---|---|
| Days to 3 months | Overnight, liquid |
| 3 to 12 months | Money market, ultra short term |
| 1 to 3 years | Short term, corporate bond, banking & PSU debt |
| 3+ years, can tolerate swings | Gilt, dynamic, longer duration funds |
As a rule of thumb, keep the fund's Macaulay duration at or below your holding period, and prefer top-rated portfolios unless you deliberately want credit risk. Compare against a bank FD, which carries DICGC insurance up to ₹5 lakh per depositor per bank as of October 2026, using the FD calculator. This is general guidance, not personalised advice.
Tax: same for both risks
As of October 2026, debt fund units bought on or after 1 April 2023 are taxed at your slab rate on redemption, whatever the holding period. Units bought before that date and held over 24 months are taxed at 12.5% without indexation. See capital gains tax on mutual funds for details, and stocks vs bonds vs gold for where debt fits in a portfolio.
Key takeaways
- Duration risk comes from rising rates and is often temporary; credit risk comes from defaults and downgrades and can be permanent.
- Modified duration ≈ % NAV change for a 1-point yield move: in the illustration, 6.0 × 0.50% = 3.0%, or ₹15,000 on ₹5 lakh.
- A 5% holding written down to zero cuts NAV by about 5%; side-pocketing isolates it but does not erase it.
- Check Macaulay duration, rating mix and the PRC cell before investing; match duration to your holding period.
- As of October 2026, post-April 2023 debt fund units are taxed at slab rates.
Frequently asked questions
Can debt mutual funds give negative returns?
Yes. A sharp rise in interest rates can push down the NAV of long-duration funds for a while, and a default or downgrade of a bond in the portfolio can cut the NAV of any debt fund holding it. Debt funds are not guaranteed like bank deposits.
What is the difference between duration risk and credit risk?
Duration risk is the loss from interest rates rising, which lowers the price of existing bonds; it is usually temporary if you hold long enough. Credit risk is the loss from a borrower failing to pay or being downgraded, which can be permanent.
How do I find a debt fund's duration and credit quality?
The monthly factsheet shows Macaulay duration, modified duration, yield to maturity and a rating-wise breakdown of holdings. The Potential Risk Class matrix in the scheme documents summarises both risks in one grid.
Which debt fund has the lowest risk?
Overnight and liquid funds carry the lowest interest rate risk because their holdings mature within a day or up to 91 days. Credit risk depends on what they hold, so also check that holdings are mainly government securities, treasury bills or top-rated paper.
How are debt fund gains taxed in 2026?
As of October 2026, gains on debt fund units bought on or after 1 April 2023 are added to your income and taxed at your slab rate, whatever the holding period. Older units held over 24 months are taxed at 12.5% without indexation.
This article is for general education and is not personalised financial, tax or legal advice. Rates and rules are as of 19 Oct 2026; confirm current terms with your lender, AMC or a qualified adviser.
