Debt Fund ratings - Different Methodology compared to Equity

When we set out to do debt mutual fund ratings, it was clear we would have to take a different approach than what we used for equity. As an investor and a student of finance, when the subject of mutual funds came up, the default category that came to mind was always equity. That is probably a function of how mutual funds have been marketed in India for years: as a relatively safe way to get equity exposure, given the historical inclination towards fixed income instruments with capital protection. As a result, debt mutual funds may have been shortchanged in terms of how much exposure they have been given to retail investors.

The function of debt mutual funds in a retail investor's portfolio is to act as a relatively stable anchor, less buffeted by the head and tailwinds that rock equity markets day-to-day. They may not offer the potential of outsized returns that equity funds offer, but they are essential to make sure overall asset allocation aligns with the investor's risk profile.

Types of Debt Mutual Funds

It would be a mistake to treat debt mutual funds as a single category. There are 14 SEBI-defined sub-categories, each with a different risk profile and time horizon. Here is how they group together in terms of what an investor would actually use them for.

The common thread is that none of these categories are trying to beat the stock market. They sit at different ends of the safety-to-yield spectrum. The right choice depends on your investment horizon and how much day-to-day NAV movement you can live with.

How Have Debt Mutual Funds Performed?

Debt fund returns in India broadly follow the prevailing interest rate cycle. The RBI's policy rate is the single largest driver of returns across categories. In a falling rate environment, longer-duration funds deliver strong capital gains. In a rising or uncertain rate environment, short-duration and floating-rate funds hold up better.

Across all categories, returns over the past three years have generally been in the 7 to 9% range. That sounds narrow, but the real differences show up in how smooth or bumpy the ride is. A Liquid fund and a Long Duration fund might deliver similar headline returns in a given year, yet one barely moves while the other swings considerably more. The differentiation in our ratings comes primarily from stability and drawdown behaviour, not just returns.

The chart below shows where each category sits on the risk spectrum, measured by how much the fund's NAV typically fluctuates day-to-day (annualised volatility). The approximate annual return for each category is shown alongside each bar.

One category that deserves a specific mention is Credit Risk. On the surface it can look calm, but the average masks significant fund-level dispersion. Some funds were affected by past credit events involving companies like Yes Bank, Vodafone Idea, and IL&FS. Credit risk funds can deliver strong returns when the underlying bonds hold up, but when they do not, the damage tends to be sudden and sharp. This is the one debt category that genuinely requires more due diligence before investing.

Top-Rated Debt Funds: Some Examples

Categories Where Most Funds Are Equivalent: Liquid and Overnight

Liquid and Overnight funds invest in the shortest-dated, highest-quality instruments under strict SEBI guidelines. In practice, the difference in performance between the best and worst fund in these categories is often just a few basis points a year. Imposing a ranking on a category where the top and bottom funds differ by less than 3 composite score points would create distinctions that are not real.

So for these categories, rather than Premier to Watch, we classify funds as Equivalent or Watch. Equivalent means the fund is doing its job properly and is indistinguishable from most of its peers. A Watch label in these categories is a genuine outlier flag, not an average performer.

The two examples below are Equivalent-rated funds. They are good funds. So are most of the other Liquid and Overnight funds in our universe. If you are parking money for a short period, the choice between these and most other funds in the same category matters far less than making sure you are in the right category for your time horizon.

Categories With Meaningful Differentiation: Banking & PSU and Corporate Bond

Move further along the risk spectrum to Banking & PSU and Corporate Bond funds, and the story changes. These categories have enough spread in performance across funds that a Premier-rated fund is genuinely doing something better than a Watch-rated one. The differences in stability, drawdown behaviour, and return delivery are real and sustained over time.

Here are the top 3 funds in each category from our current ratings, along with what sets them apart.

These three funds sit at the top of the Banking & PSU category because they combine tight NAV stability with consistent above-median returns. Banking & PSU funds invest only in bonds issued by banks and government-owned entities, which means credit risk is low by design. The differentiation between funds here comes from how well the portfolio is managed within those constraints: how smoothly the NAV moves, how rarely it dips, and how consistently it delivers returns above the category median. ITI, UTI, and Bandhan have all done this well over the measurement period.

Corporate Bond funds invest mostly in AA+ rated corporate bonds, which carry slightly more credit risk than Banking & PSU but also offer higher yields. The top three here are Premier-rated because they have delivered above-median returns without taking on disproportionate volatility. DSP Corporate Bond Fund has had minimal NAV dips even in volatile bond market periods, with returns consistently above the category average. The contrast with lower-rated funds in this category is meaningful: Watch-rated Corporate Bond funds have experienced larger drawdowns and more erratic month-to-month returns, making them harder to hold through difficult periods.

How We Evaluate Debt Mutual Funds

Our debt rating system starts from the premise that stability is the primary job of a debt fund, not return maximisation. Every fund is evaluated on six stability metrics: volatility, downside deviation, maximum drawdown, Ulcer Index, return consistency, and drawdown frequency. All six are calculated as percentile scores relative to category peers, then averaged into a Stability Score. A separate Excess Return Score captures how the fund's returns compare to the category median. The two are combined into a Composite Score, with stability weighted more heavily for conservative categories (70 to 80%) and less so for higher-duration or credit categories where return generation is part of the mandate (50 to 60%).

For categories where all funds perform within a genuinely narrow band (Liquid, Overnight, Ultra Short), we skip the four-tier ranking and classify funds as Equivalent or Watch instead. In all other categories, funds are ranked into four tiers: Premier (top 15%), Select (next 35%), Standard (next 35%), and Watch (bottom 15%). Ratings cover all 14 SEBI debt sub-categories and are updated monthly.

Debt fund ratings at Qonfido are updated monthly. The goal is to give you a clear, honest picture of which funds in each sub-category are doing their primary job well and which ones are not. Like our equity ratings, these are a starting point for your decision, not a substitute for understanding your own investment horizon and risk tolerance.