Debt funds and what has happened

Debt fund taxation

On April 23, 2020, Debt investors and advisors were shocked to learn that Franklin Templeton, one of the more renowned fund houses, was closing down six of its fixed income schemes. Most of these funds had good ratings, and the sudden announcement was a bolt out of the blue. So are debt funds a bad investment option? Let’s learn more about Debt Funds / Bond Funds.

Most of us are under the impression that Debt funds or fixed income funds are fail safe or risk free or guaranteed. It is none of these. Debt funds are a comparatively lower risk investment option, compared to Equity, and is in no way a zero risk investing option. Debt funds invest in bonds / debentures issued by various institutions / companies and earn interest on the money they have invested. It is this interest that forms the basis of the returns that is generated from a debt fund and given to the unitholders. The returns are as safe as the repayment capacity of the company issuing the debt instrument.

A company or the government when in need of capital can either approach the Equity or debt market. When investors purchase a government/corporate bond, they are effectively lending the government or that particular company money. Company A issues 100 bonds with a face value of Rs.1000. The company raises Rs.100000 with the issuance of this tranche of bonds. As an investor, if you have bought a bond, you have basically lent the company Rs.1000, in return for which the company owes you an Interest. This is exactly like individuals taking loan from a bank and paying interest on it, except that in this case the company is the borrower and the bond that you have bought is the loan that they have taken from you. Just like banks conduct a check on your repayment capacity, companies also have credit ratings assigned to them, a credit score to understand the risk of your investment. Usually a AAA rated (highest credit rating) bond indicates bonds issued by companies with high level of credit worthiness and strongest capacity to repay investors who have invested in their bonds. Now just like loans have different payment periods, bonds also have different maturity periods and the interest paid and the risk will depend on the maturity period of the bonds and also on the credit ratings of the companies. Like in equity investments, more the risk more the expected returns.

Debt Mutual funds invest in debt securities of varying risk and varying maturity periods to create a portfolio suited to the investor’s risk appetite and investment time horizon. They are permitted to invest in debt securities not normally available to individuals, like Government issued securities (GSecs) or securities issued by various medium sized businesses. There is also a secondary debt market, where bonds are traded, but have considerable lower liquidity when compared with the equity market. Just like listed stocks, listed bond prices can move up or down. The price movements majorly depend on change or expectation of change in interest rates in the economy. Suppose a bond is paying interest at 8% and there is an interest rate cut in the economy. If new bonds are issued with interest rate of 7%, then the old bond will have more demand than the new one, and the price of the old bond should go up, until the yields are the same. Bond yields and bond prices have an inverse relationship.  Please note that this is the basic explanation for bond price fluctuations, for the sake of understanding, while in reality there will be lot more factors at play to determine the bond prices like capital market conditions, supply and demand, credit ratings, age of the bond etc.

So debt funds are not a substitute for Fixed Deposits in Large Banks, if you are a zero risk investor. It is for the investor who can take a small amount of risk, with focus on capital preservation and not maximizing returns. Here again, not all debt funds are the same. There are various categories and even within the categories there could be differences in terms of credit risks and fund manager outlook.

Different types of Debt funds

  • Liquid Fund – invests in money market instruments with maturity up to 91 days. Liquid funds tend to offer better returns than savings accounts. Used to park funds for the short term and also used by STP investors for staggered investments into equity.
  • Money Market Fund – invests in money market instruments having maturity up to one year. Suitable for investors seeking low-risk debt securities for a short-term.
  • Dynamic Bond Fund – invests in debt instruments of varying maturities based on the current interest rate scenario. Suitable for investors with moderate risk tolerance and an investment horizon of three to five years.
  • Corporate Bond Fund – invests a minimum of 80% of its total assets in corporate bonds having the highest ratings. These funds are good for investors with lower risk tolerance and seeking to invest in high-quality corporate bonds.
  • Banking and PSU Fund – invests at least 80% of its total assets in debt securities of PSUs (public sector undertakings) and banks.
  • Gilt Fund – invests a minimum of 80% of its investible corpus in government securities across varying maturities. These funds do not carry any credit risk. However, the interest rate risk is high. 
  • Credit Risk Fund – invests a minimum of 65% of its investible corpus in corporate bonds having ratings below the highest quality corporate bonds. Therefore, these funds carry an amount of credit risk and offer slightly better returns than the highest quality bonds.
  • Overnight Fund – invests in debt and money market instruments with a maturity of one day. These funds are considered to be safe since both credit risk and interest rate risk is negligible. Suitable for investors who park their money for one day – one week.
  • Ultra-Short Duration Fund – invests in debt and money market instruments such that the Macaulay duration of the scheme is between three to six months.
  • Low Duration Fund – invests in debt and money market instruments such that the Macaulay duration of the scheme is between six to twelve months.
  • Short Duration Fund – invests in debt and money market instruments such that the Macaulay duration of the scheme is between one to three years.
  • Medium Duration Fund – invests in debt and money market instruments such that the Macaulay duration of the scheme is between three to four years.
  • Medium to Long Duration Fund – invests in debt and money market instruments such that the Macaulay duration of the scheme is between four to seven years.
  • Long Duration Fund – invests in debt and money market instruments such that the Macaulay duration of the scheme is more than seven years.

In a normal case scenario, the benefits of bond investing are multifold, being a defensive asset class with less volatility. It can be a way to diversify the investment portfolios, to generate income, to preserve capital and as a hedge against an economic slowdown. Investor has the option of choosing the fund based on their risk appetite and the time period they are investing for.

Franklin Templeton fiasco

In spite of the relative lower risk of debt funds, the Franklin Templeton (FT) fiasco has put doubts in the minds of investors. FT was one of the earliest entrants in the fixed income space with a good pedigree of company analysis and investments. Many of the fund ratings assigned were based on this fact, that the fund would deliver superior returns but with higher credit risk than its peers. Credit risk funds were required to invest at least 65% of their assets in papers rated below AA+ that tend to be highly illiquid. The fund’s risks are magnified amid adverse market conditions, when downgrades of companies and defaults become higher. The history of these funds also showed that it had successfully negotiated through adverse market conditions and downgrade of ratings of companies like JSPL etc. It was against this backdrop that FT funds still had a good rating. However, this crisis hit a little differently. The funds were already reeling under defaults post the IL&FS crisis. When credit market conditions started deteriorating and Covid-19 lockdown, the impact was felt in almost all sectors equally and that too for a prolonged time. This affected these funds to a greater extent, because of their high percentage in sub-AAA rated papers. There was also a huge rush of redemptions, which meant that funds managers had to sell the more liquid portion of their portfolios to meet the redemption pressures. This would have meant selling it at lower rates, showing deeper fund losses, which would have led to even more redemptions. This closure is extremely unfortunate for investors who are still invested in these funds, but this seemed to be the best case option in front of FT to prevent a further downward spiral.

The learning that we can gain from this incident and for the current scenario: 1) we must be more cautious in choosing funds showing marked outperformance in the peer group and understand the credit risk that these funds have taken on. These risks increase when the credit market conditions turn bad, and resulting downgrades / defaults happen. 2) The liquidity factor of a portfolio must also be looked into and extreme scenarios, like what the FT funds faced, must be factored in. SEBI has now allowed certain categories of funds, including Credit Risk funds, to hold up to 15% more in government debt, which is the most liquid. Please note that some of the more established companies may have sub-AAA ratings also and all Sub AAA rated companies cannot be treated at par.

The government proposals to boost liquidity conditions and to buy debt papers from NBFCs (which are most likely candidates for downgrades) have brought about some stability while AMCs themselves have improved their fund liquidity positions, and are focusing mainly on quality. It is especially important for short duration funds which are used for parking of funds and which may face huge corporate redemptions in one go. For funds with duration of 3 years or more, they may have exposure to low-rated papers because the time horizon of investment is for the long term. Investors can also look at G-Sec funds for a long investment horizon, say five or 10 years, as there is no credit risk in a G-Sec fund, and the potential volatility will even out over time.


  1. I am particulsrly concerned with the Repayment schedule of Franklin templeton and thier offer to repay amounts in stages over aperiod of 5 years. Iam not in favour as the petiod is too long and what will br the NAV and the losses associated with yhis windingup and repayment shedule which seems to be in thier favour n to the detriment of investors like me who have put thier hardearned money with them. The Maclays duration is 3-6 months in ultra short bond and they franklin seem to be arm twisting if voted against without proper clarity. Pls advice what i should do as need some dolid advice as yo thier intentions and ensueing losses they have convieniently not mentioned.

    • Franklin as a fund house is one of the biggest and oldest Asset Managers in India with a track record of 25 long years. The crisis that they are facing now is unprecedented and happened mainly due to the illiquidity of their papers caused due to the pandemic lead standstill in economic activity. Many AMCs are facing similar but less severe problems of illiquidity but Franklin schemes were worst hit due to their high risk exposure in sub AAA papers. All through the years, their schemes used to yield good risk adjusted returns and were well managed. The current crisis came as a blow on their portfolios.

      Franklin claims that the move to wind up the schemes was in best interest of the investors, otherwise the fund would have sold their holdings at cheaper prices causing huge losses to the existing investors. The fund management is of the view that, by winding up schemes, actually the value of investments could be protected to great extent.

      Now they seek the authorisation of investors in proceeding with the liquidation process to distribute the assets among the unit holders.

      There are two options put forward for investors to choose from.

      First step in this is to Choose between YES and NO in which an YES from the investor authorises the proceedings to liquidate the assets. Here under YES itself there are two options available.

      Option 1 authorises the Trustee to work towards liquidating the assets with the help of Franklin Templeton Asset Managers (India) with Kotak as independent advisor and

      Option 2 authorises Deliotte Tohmastu LLP (Deloitte) to take steps in liquidating / monetizing the assets.

      If the investor chooses NO as his/her choice, then the trustee will have to propose other options to unit holders with subsequent voting exercise. Advice of the Trustee to the Investors is to choose YES, to prevent further delays in liquidation process.

      Having said this, the choice of options is completely at investor’s discretion.


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