Investors opt for liquid funds to stash away their savings for the short term. By nature, liquid funds invest in short maturity debt securities that offer high liquidity and safety. However, as with all market-linked investments, there is always an inherent risk.Investors were in for a huge shock on September 10, 2018, when the NAVs of a few liquid funds and ultra short-term funds fell by over 1 per cent. However, the nightmare did not stop there. Over the next few weeks, NAVs of these funds fell further, dropping by nearly 5 per cent in a day.On September 8, 2018, ICRA revised the short-term rating for the commercial papers of IL&FS and IFIN to ICRA A4 from ICRA A1+. On September 17 evening, ICRA further downgraded the CPs of IL&FS Financial Services (ILFS-FS) to 'D' from 'A4'. Corporate bonds and long-term loans of IL&FS were downgraded to BB from AA+, a drop of 9 notches.On consolidating the holdings of open-ended debt funds, we find 18 debt funds had a total exposure of around Rs 2,500 crore (as on August 31, 2018) to the affected instruments.As per the principle of fair valuation defined by Sebi Regulations, the value of the securities in the portfolio of mutual funds had to be written down by 25 per cent to reflect the fair value, as the credit rating was below investment grade.This adversely affected the NAV of funds that had a high exposure to IL&FS debt.On analysing the portfolio holdings (as of August 31, 2018) of 292 open-ended debt funds, as many as 18 schemes had an exposure to IL&FS group debt papers.Of these 18 open-ended debt schemes, which included a few liquid funds and ultra short-term (UST) funds, 10 schemes lost over 1 per cent in a day. This is quite uncommon for such category of funds as the volatility is expected to be extremely low.Schemes such as Principal Cash Management Fund, Motilal Oswal Ultra Short Term Fund and Principal Ultra Short Term Fund were the worst affected. NAVs of these funds fell by 3-5 per cent in a single day. Over the three weeks since the trouble started, these funds lost over 5 per cent each. Principal Cash Management Fund and Motilal Oswal Ultra Short Term Fund declined by 8 per cent and 6 per cent each, effectively wiping out the entire gains made over the year.The events of the past few weeks brought back memories of how credit downgrades and/or defaults in companies like Amtek Auto, Jindal Steel & Power, and Ballarpur Industries that adversely impacted debt mutual funds.The adverse effects of taking on high credit risk came to the forefront in August 2015. JPMorgan India Short Term Income Fund and JPMorgan India Treasury Fund bore the brunt of their holdings in Amtek Auto Ltd . Brickwork Ratings had downgraded its rating to 'C', from 'A+', while CARE suspended the coverage of Amtek Auto. NAVs of the funds fell by 1-3 per cent each.Less than a year later in February 2016, Jindal Steel and Power (JSPL) underwent a ratings downgrade. Crisil had downgraded JSPL's long-term rating from BBB+ to BB+. A month later, the rating deteriorated to default status. Schemes of Franklin Templeton Mutual Fund and ICICI Prudential Mutual Fund suffered, with the NAV of the schemes falling by nearly 3 per cent in a day.Another shocker came in February 2017, when India Ratings and Research downgraded Ballarpur Industries' long-term issuer rating to 'IND D' from 'IND BBB-'. Non-convertible debentures (NCDs) and commercial paper of the company were downgraded to 'IND C' from 'IND BBB-' and 'IND A3'. Investors in Taurus Dynamic Income Fund, Taurus Ultra Short Term Bond Fund, and Taurus Short Term Income suffered a loss of over 11% in a day.When a 5-star rated liquid fund like Principal Cash Management Fund loses as much as 5 per cent in a day and over 8 per cent in three weeks, it comes as a wake-up call for investors. Debt schemes of even large AMCs have borne the brunt of sudden credit downgrades in the past.As a reassurance for debt investors, such sharp credit downgrades are rare. There have been just four notable incidents in the past three years or so, which have affected only a small percentage of schemes that were overexposed to the de-rated assets.There are a number of quality schemes that have generated respectable returns for investors. On taking a consolidated view, most debt funds are well-diversified and have a high allocation to top-rated debt securities.About 110 open-ended debt schemes (out of 292) are well-diversified with an allocation to over 40 securities in their portfolio. Over 130 such schemes have an exposure of over 85 per cent to high-rated debt (AA+ & above), including government securities.Avoiding such rare incidents of a sharp downgrade is difficult. As an investor, you need to diversify your mutual fund holdings. If you have a short-term investment horizon of less than a year or so, it is best to avoid funds with a high exposure to low-rated debt.(Jason Monteiro is AVP of Research & Content at Prabhudas Lilladher. Views are his own)