Know when and why debt funds can give negative returns

Summary: Debt funds are known for their low risk and predictable returns. So it seems surprising that they can, and have delivered, negative returns in the past. Learn why this happened and if you should still invest in them.

Many investors think debt mutual funds are completely safe - almost like fixed deposits (FDs). After all, the word debt sounds like low risk and stable returns.

But that's not how debt mutual funds work.

They can - and occasionally do - deliver negative returns. Yes, even these so-called 'safe' funds can lose value.

It doesn't happen all the time, but it's important to understand when and why this can happen, so you're not caught off guard.

Why debt mutual funds aren't like FDs

Debt mutual funds invest in things like treasury bills, government bonds and corporate debt. These sound secure, and in many ways, they are. But there's one big difference: these bonds are traded on the market, so their prices change every day.

And since a debt fund's value depends on the current prices of the bonds it holds, the fund's NAV (net asset value) can go up or down.

This is very different from fixed deposits (FDs), where your returns are fixed and known in advance.

When can debt funds deliver negative returns?

#1 When interest rates go up

There's a simple rule in bond investing: when interest rates rise, existing bond prices fall.

Why? Because new bonds now offer higher returns, making older ones less attractive.

In 2022, when the RBI sharply raised interest rates, many long-duration debt funds, especially gilt funds, saw short-term losses. This wasn't due to poor quality or mismanagement; it was just a natural response to rising rates. Our recent analysis on how interest rates affect debt funds explains this inverse relationship in detail, showing why longer-duration bonds are most sensitive to rate changes.

#2 When a company defaults

Some debt funds aim for higher returns by investing in bonds issued by lower-rated companies. But if one of those companies defaults or gets downgraded, the value of those bonds drops - sometimes sharply.

A well-known example is the Franklin Templeton crisis in 2020. Six of its debt funds held lower-rated securities that became illiquid and risky. The funds had to be shut down, and investors suffered major losses.

#3 When there's a market panic

Even safe, high-quality bonds can fall in value if panic strikes the market and no one is willing to buy them.

This happened in March 2020 during the Covid-19 crash. Liquidity dried up, and some debt funds couldn't sell their holdings. Even liquid funds - considered the safest debt funds - showed small but real losses.

How bad can it get?

Debt funds are generally known for their stability, but even they have seen occasional one-day losses - triggered by interest rate spikes, credit events or sudden market stress. The table below shows the worst single-day returns and how frequently daily returns have been negative, based on category averages rolled daily over the last 20 years.

These events aren't common, but they show that debt funds are not risk-proof. Our latest analysis explains the factors that drive why debt mutual funds can give negative returns, providing deeper insight into the mechanics of negative returns and their recovery patterns. Choosing the right fund and understanding what it holds can help you avoid unpleasant surprises.

So, what should you do?

Despite the risks, debt mutual funds can still be a smarter choice than bank fixed deposits - especially if you choose the right fund. They offer better post-tax returns, more liquidity and no penalty for early exit. But to make the most of them, you need to understand the risks and choose wisely.

Investors must acknowledge that risk in debt funds is real. These are not one-size-fits-all products. Even in debt funds, some funds take on higher risk to chase extra returns, while others stay conservative and prioritise capital protection. Knowing where your fund falls on this spectrum is critical.

At Value Research, we've always maintained: don't get adventurous with your debt fund investments. In fixed income, your goal should be safety first, returns second. If you want to take higher risks for better returns, consider equity funds instead.

Here's how to evaluate a debt fund before investing:

• Check credit quality: On Value Research, search for the fund, click on the 'Portfolio' tab and scroll down to the 'Rating-wise Holdings'. The more it holds in low-rated papers, the riskier it is.
• Look at YTM: A high Yield to Maturity vis-a-vis category average may mean the fund is stretching for returns. Our recently updated guide on how to evaluate debt funds with YTM and average maturity provides the framework to assess these metrics properly. Check this against the credit quality and portfolio.
• Review holdings: Significant exposure to a single issuer is a potential red flag.
• Look at worst returns: Use the Best & Worst Performance feature available under the 'Returns' tab. A fund with a history of steep drawdowns is worth a closer look - especially in categories like short or liquid funds, where stability is expected.

If this sounds too much work for you, head over to Value Research Fund Advisor. Our analysts have done the homework for you.

Explore Fund Advisor today

Also read: 3 reasons debt funds aren't just for retired & boring people

This article was originally published on April 21, 2025, and last updated on January 05, 2026.