Debt mutual funds and negative returns? Why ‘safe’ investments can still lose money

The very name of debt mutual funds creates a sense of comfort, especially when compared to the volatility of equities. By pooling investments into relatively safer instruments, debt mutual funds are often expected to provide steady returns while protecting capital. But this could be a surprise to you. These funds can, and sometimes do, deliver negative returns; they are not immune to risks.

That tiny red mark you see on returns can cause quite a stir in your minds. Getting negative returns from debt mutual funds is usually rare and short-lived, but this probability is something you shouldn’t ignore. Being aware of why they occur can help you avoid panic and make informed decisions.

In this blog, we will learn why you can get negative returns from debt mutual funds, the stories behind the numbers, and what investors can learn from them. But pause, how well do you know about these funds themselves?

What are debt mutual funds?

Debt mutual funds are the type of mutual funds that invest in fixed-income instruments that are relatively safer, like government bonds, corporate bonds, commercial papers, and treasury bills. The returns come mainly from two sources: interest income from the bonds held and capital gains or losses when bond prices fluctuate.

What makes debt mutual funds attractive to investors?

• They are less volatile than equities.
• They serve as an option for regular income, which adds predictability.
• They have a range of categories, from liquid funds to long-duration funds.
• They are easier to buy or sell compared to individual bonds.
• They provide easy diversification as they invest across multiple bonds.

In short, these benefits make investors believe they are relatively safer than equities, but is it truly the case? And from where do investors get this perception?

Why debt feels safer than it actually is

Investor psychology plays a powerful role here. The belief in safety comes from the idea that debt equals fixed returns. That “mental anchor” carries over when we look at debt mutual funds, even though the two are structurally different. After all, bonds pay interest regularly, so shouldn’t funds built on them be stable too?

The mismatch between your perception (safe, steady, and guaranteed) and reality (risks, liquidity issues, sensitive to interest rates) is what leads to disappointment when you get negative returns from them.

Let’s look at real-world data that challenged this perception of safety, usually during periods of rate volatility or credit defaults.

Historical cases of debt mutual funds volatility

These examples show that these funds don’t fail often, but when they do, they surely make headlines.

Even “safer” liquid funds weren’t spared. In March 2020, some liquid funds reported 1-day negative returns, something unimaginable for investors who parked money for short-term safety.

Debt mutual funds: Single-day negative returns in March 2020

Source: 1 Finance Research

When people see negative returns in debt mutual funds, even if it’s small and temporary, the fear factor sets in.

• Some panic and withdraw immediately, locking in losses.
• Others lose trust and vow never to touch them again.
• A few stay patient, realizing the dip is short-lived and part of the journey.

Our brains are wired to feel losses more strongly than gains. A -0.5% dip feels way worse than a +0.5% gain feels good. That’s why investors often overreact to what is, in most cases, a temporary blip, even though the same investors might tolerate big swings in equity funds.

Why debt mutual funds show losses and what you can about it

Along with the risks associated with debt mutual funds, another reason why some show losses is tied to the different strategies they follow. Essentially, debt mutual funds use two main approaches: the accrual (income) strategy and the duration strategy and understanding these is key to knowing why losses can happen.

What should be your debt mutual fund strategy?

1. Accrual (income) strategy: The fund manager holds bonds till maturity and primarily earns from interest income. These funds are relatively stable and less sensitive to interest rate changes.

2. Duration strategy: The fund manager invests in long-duration bonds and looks for opportunities to benefit from falling interest rates. But in a rising interest rate cycle, these funds are most likely to show negative returns in the short term.

This is why simply asking “Did this fund give negative returns last year?” won’t give you a full answer. Instead, investors should ask:

What is your investment horizon?

Your investment horizon, how long you can keep your money invested. It is one of the most important factors in deciding which type of debt mutual fund makes sense.

1. For short-term goals (like 1 year)

If you need the money soon (e.g., child’s school fees, a vacation next summer, an emergency fund), safety matters more than chasing returns.

• You can stick to liquid funds, ultra-short-term, or low-duration funds.
• Avoid long-duration funds. Even a small interest rate hike can cause temporary losses, which you don’t have time to recover from.

2. For long-term goals (like 3-5 years)

You can consider long-duration funds for your long-term goals. These funds benefit from falling interest rates, but can see a dip when interest rate rises. That’s why they are best entered with a favorable interest rates outlook, ideally after consulting a Qualified Financial Advisor (QFA).

Negative returns are usually temporary, and happens when the wrong strategy is matched with the wrong horizon.

A debt mutual fund investment: A quick checklist for you

1. Have clarity about your goals.
2. Match your time horizon with the fund’s strategy.
3. Check the credit quality of a debt scheme, not just its returns.
4. Don’t react to daily NAV movements.
5. Diversify across different debt categories.

Summarizing,

Getting negative returns from debt mutual funds is possible. And being aware about it helps you stay prepared rather than surprised. However, negative returns don’t make these funds any less good investment options. It usually means the fund wasn’t the right fit for your time horizon and investment goals. If you match your goal and investment horizon with the right strategy, i.e., accrual for short-term and duration for long-term goals (with proper guidance), debt mutual funds can be a good investment decision.