India’s debt mutual fund industry is showing signs of reviving its appetite for credit risk. A bl.portfolio analysis of actively-managed debt funds over the past eight years shows that exposure to lower-rated debt instruments (AA and below) declined sharply in the aftermath of a series of credit events, but has begun to recover over the past year.

The share of AA-and-below instruments in active debt fund assets fell from 12.4 per cent in April 2018 to 2.6 per cent by April 2023. It briefly recovered in 2024, slipped further to 2.3 per cent in April 2025, and then rose to 3.1 per cent in April 2026. In absolute terms, exposure dropped from more than ₹1.2 lakh crore in 2018 to about ₹30,000 crore at its trough in April 2023, before rebounding to ₹55,059 crore by April 2026.

For this study, debt index funds, debt ETFs, overnight funds and gilt funds were excluded. The analysis is restricted to 13 actively-managed debt fund categories that have the flexibility to invest in lower-rated debt securities. These are credit risk, medium duration, low duration, dynamic bond, short duration, ultra short duration, banking & PSU, medium to long duration, floating rate, corporate bond, money market, long duration and liquid funds.

Credit events hit

The retreat from lower-rated bonds is rooted in a series of credit events that exposed the fragility of high-yield investing. During 2017-20, many fund houses followed a yield-chasing model that relied on lower-rated issuers rather than prioritising liquidity. Many debt fund schemes, including those in the short-duration and ultra-short-duration categories, held sizeable exposure to bonds rated AA and below.

A series of bond downgrades and defaults hit debt funds hard. The collapse of IL&FS in 2018 triggered widespread markdowns across debt schemes. This was followed by defaults and downgrades involving DHFL, Reliance Group entities, Essel Group companies and several NBFCs. The final blow came in 2020 when Franklin Templeton wound up six debt schemes with assets exceeding ₹25,000 crore due to severe liquidity pressures.

De-risking

These events shattered the perception that debt funds were low-risk alternatives to fixed deposits. Investors began avoiding debt funds with sizeable allocations to lower-rated papers and shifted towards categories with higher-quality portfolios, forcing fund managers to reduce exposure to lower-rated credits.

Credit risk funds, which are mandated to maintain significant exposure to lower-rated securities, were among the hardest hit. The category’s AUM plunged from ₹73,417 crore in 2018 to ₹21,098 crore in 2026, a decline of nearly 71 per cent. Although these funds continue to maintain the highest allocation to AA-and-below papers, their influence on the overall debt fund market has diminished sharply.

Credit risk funds and medium-duration funds saw the sharpest erosion in AUM among credit-heavy categories. Other categories such as low duration and dynamic bond did not see similar AUM erosion, but they still cut exposure to AA-and-below papers sharply over the period

Preference for high-quality debt

Investors increasingly favoured safety, liquidity and predictability over incremental yield. Categories associated with higher-quality portfolios, such as corporate bond funds, banking & PSU funds and money market funds, emerged as the biggest beneficiaries. Their AUM grew 207 per cent, 155 per cent and 359 per cent, respectively, over the past eight years.

Fund managers also changed their approach. For schemes that had relied on lower-rated bonds to generate incremental returns, liquidity and portfolio quality became the primary focus. Even categories such as medium-duration, dynamic bond and short-duration funds sharply reduced exposure to lower-rated issuers. The average allocation to AA-and-below papers in medium-duration funds fell from 35 per cent in April 2018 to 27 per cent in April 2026. Low-duration funds reduced such exposure from 12 per cent to 5 per cent, while dynamic bond and short-duration funds cut it from 8 per cent to 4 per cent.

Credit risk funds also saw their reported allocation to AA-and-below papers fall to about 55 per cent over the past eight years. This should be read with some caution. Portfolio-disclosure numbers are calculated on total scheme assets, while regulatory allocation requirements and liquidity buffers may use different bases. Post-2020 liquidity-risk rules also pushed debt schemes to maintain a minimum liquidity cushion, making reported AA-and-below exposure lower than earlier periods.

Increase in AA-and-below allocation

Yet the latest data hint at a notable shift. After reaching a low of 2.3 per cent of assets in 2025, lower-rated exposure increased to 3.1 per cent in 2026. In value terms, exposure rose from ₹37,610 crore to ₹55,059 crore.

Several medium-duration, dynamic bond and credit risk schemes raised allocations to AA-and-below securities. At the fund level, the shift is even more pronounced. Schemes that significantly increased exposure include Aditya Birla Sun Life Dynamic Bond Fund, SBI Medium to Long Duration Fund and SBI Medium Duration Fund (see tables).

This revival looks more like a calibrated shift than a return to aggressive risk-taking. The rise is visible in select schemes rather than across the entire debt fund universe. Fund managers appear to be adding credit exposure selectively for incremental yield, even as overall exposure to AA-and-below papers remains far below the levels seen before the credit events of 2018-20.

What it means for investors

The era of aggressive yield-chasing through lower-rated bonds is unlikely to return anytime soon, with fund managers now prioritising capital protection. While credit risk is making a comeback as a source of alpha, it comes with higher volatility, making it crucial for investors to assess portfolio quality rather than focusing solely on returns.

Category selection remains critical. Corporate bond funds and banking & PSU funds offer relative safety, while credit-oriented funds demand a higher risk appetite and greater patience. The lessons from past credit events remain fresh, and both fund managers and investors appear determined not to repeat earlier mistakes.

Published on June 6, 2026