Debt mutual funds made a strong comeback in July, erasing the losses recorded in the previous month. The liquid fund category experienced net inflows of ₹1.07 lakh crore, as against June, which saw outflows worth ₹1,711 crore. The renewed interest has been spurred by the attractiveness of liquid funds that currently offer returns above 6%.

Explaining the sharp reversal, Anurag Mittal, head of fixed income at UTI AMC, stated that the sizable inflows seen in July primarily reflected the reversal of quarter-end redemptions by certain institutional investors, who had temporarily withdrawn in June for short-term requirements. "As their cash balances got rebuilt, they redeployed the same in July.  Category AUM closed July at ₹5.7 lakh crore, which was largely unchanged from April’s ₹5.6 lakh crore," he added.

"When fixed income yields are on the decline, investors typically move towards higher maturity options like money market, short duration, corporate bond, banking & PSU fund, debt fund, and other asset classes,” said Umesh Sharma, CIO–debt, The Wealth Company Mutual Fund.

Recently, he added, the AUM in the liquid fund category has been growing again as portfolio yields have reached a sweet spot (where traditional alternative avenues have lower yields) and are now starting to move lower. “Also, fixed income yields at the longer end (1-year and above) have been volatile with an upward bias in the recent past, and that could be leading to more risk-averse behaviour from the investors."

This means that since long-term debt returns may remain unstable, investors are playing it safe by putting more money into liquid funds that currently offer steady and decent short-term returns.

Funds’ safety 

However, the credit quality of these schemes is often overlooked. To increase returns, some funds invest in lower-rated instruments—a strategy that can quickly become risky if market conditions worsen. Given that the core objective of fixed income allocation is to provide stability, a debt investor’s foremost priority must be the safety of the portfolio.

It involves evaluating whether the scheme has sufficient exposure to highly liquid assets, such as government bonds and treasury bills, and whether it also includes allocations to bank CDs, which offer a combination of safety and liquidity. "Equally important is an evaluation of the portfolio’s long-term equivalent credit ratings, as these offer a more comprehensive view of underlying credit quality," said Mittal.

Many investors today get carried away by headlines, social media buzz, or the ease of trading on commission-free platforms. “This often leads them to churn their portfolios or switch funds based on short-term market fluctuations rather than focussing on fundamentals such as credit quality and long-term stability. In debt funds especially, such short-termism undermines the purpose of fixed income allocation, which is to provide steady compounding and safety,” said Prashasta Seth, CEO of Prudent Investment Managers LLP.

He emphasised that the true advantage of debt funds lies in consistency and disciplined holding, rather than pursuing quick gains. “In the liquid fund category (or any short-term category), one needs to look at the long-term, ratings-based exposure to gauge the differential credit risk between portfolios that are otherwise 100% A1+ or equivalent,” said Sharma.

Securing gains in volatile times

Beyond assessing long-term equivalent ratings, investors must also evaluate whether the portfolio is sufficiently diversified and insulated from concentration or sensitivity risks. "Since allocations to liquid funds are typically intended for short-term parking, even modest volatility can erode returns. A prudent rule of thumb is to compare the fund’s yield-to-maturity with that of its benchmark or category, and any material deviation should prompt closer scrutiny," said Mittal.

"Investors should refer to the underlying investment strategy/ restrictions/ guardrails (such as minimum long-term rating exposure that a fund can take, issuer exposure caps, sectoral caps, group exposure caps, etc)," said Sharma.

Investors can also take the services of a professional advisor who can guide them through the intricacies mentioned above.