What happened with Franklin Templeton and why does it matter?

In April 2020, Franklin Templeton India wound up (shut down) six of its debt fund schemes due to severe redemption pressure and illiquidity in the underlying bonds. These schemes held significant allocations to lower-rated corporate bonds that became difficult to sell during the COVID-19 market stress. Over ₹25,000 crore of investor money was locked up, and it took more than two years for most investors to get their money back through a Supreme Court-monitored process. This event fundamentally changed how distributors recommend credit risk funds — the extra yield is not worth the catastrophic risk of capital loss.

When should I recommend a Gilt Fund vs a Corporate Bond Fund?

A Gilt Fund is appropriate when the investor wants zero credit risk and has a view that interest rates will fall (rate cuts boost Gilt NAVs significantly). A Corporate Bond Fund is suitable when the investor is comfortable with high-quality corporate credit risk (AA+ and above) and wants a slightly higher yield than Gilts. For most conservative investors, a Banking & PSU Fund is the sweet spot — government-backed credit quality with slightly better yield than pure Gilts.

What is a Floater Fund and why is it useful when rates are rising?

A Floater Fund invests minimum 65% in floating rate instruments — bonds where the coupon rate adjusts periodically based on a benchmark rate (like the repo rate or T-bill rate). When interest rates rise, the coupons on these floating rate bonds also rise, which increases the income earned by the fund. This makes Floater Funds one of the few debt fund categories that actually benefit from rising interest rates. They are excellent hedges in a rising rate environment.

How does a Dynamic Bond Fund differ from other debt fund categories?

A Dynamic Bond Fund has no Macaulay duration restriction — the fund manager can hold duration at 1 year or 10 years depending on their interest rate view. In essence, the investor is trusting the fund manager to time the interest rate cycle. If they extend duration before rate cuts, returns can be excellent. If they get it wrong, losses can result. Dynamic Bond is for investors who trust the fund manager's macro view and are comfortable with variable outcomes. It is not a "set and forget" category.

What is the difference between a Gilt Fund and a Gilt Fund with 10-year Constant Duration?

A regular Gilt Fund invests 80%+ in government securities but has no duration restriction — the fund manager can hold short-term or long-term G-Secs. A Gilt Fund with 10-year Constant Duration must maintain a portfolio Macaulay duration of 10 years by investing 80%+ in G-Secs. This means the 10-year variant has a fixed and very high interest rate sensitivity, making it the most volatile Gilt category. Use the 10-year variant only for tactical bets on long-term rate cuts.

Types of Mutual Fund Schemes (6/12)

Topic 6 of 12~5 min read

Debt Funds — Medium, Long Duration, Dynamic Bond, Gilt

Definition

Under SEBI categorization, medium-to-long duration debt fund categories include: Medium Duration Fund (Macaulay duration 3-4 years), Medium to Long Duration Fund (4-7 years), Long Duration Fund (7+ years), Dynamic Bond Fund (no duration restriction — fund manager actively manages duration), Corporate Bond Fund (minimum 80% in AA+ and above rated corporate bonds), Credit Risk Fund (minimum 65% in below AA-rated corporate bonds), Banking & PSU Fund (minimum 80% in debt instruments of banks, PSUs, and Public Financial Institutions), Gilt Fund (minimum 80% in government securities), Gilt Fund with 10-year Constant Duration (minimum 80% in G-Secs with portfolio Macaulay duration of 10 years), and Floater Fund (minimum 65% in floating rate instruments).

In Simple Words

Over the past two decades, medium-to-long duration debt funds have been the source of both the biggest gains and the most painful losses in fixed income. Understanding each category from a practical perspective is essential. Medium Duration (3-4 years) and Medium to Long Duration (4-7 years) funds are the workhorses for investors with 3-5 year horizons. They invest in a mix of corporate bonds and government securities. The return potential is higher than short-duration funds, but so is the sensitivity to RBI rate actions. When the RBI was cutting rates from 8% to 4% between 2019-2020, medium duration funds delivered 9-11% returns. When rates reversed upward in 2022, the same funds saw temporary NAV erosion. Long Duration Funds (7+ years) are the most sensitive to interest rate changes. These are essentially a pure play on the interest rate cycle. When rates fall, long duration funds deliver equity-like returns. When rates rise, they can give negative returns for extended periods. These are suitable only for sophisticated investors who have a view on the rate cycle. Dynamic Bond Funds are particularly noteworthy — the fund manager has complete freedom to shift between short and long duration based on their rate outlook. If they expect rate cuts, they extend duration to 7-8 years. If they expect rate hikes, they compress to 1-2 years. The success depends entirely on the fund manager's ability to read the interest rate cycle correctly. An important nuance often overlooked about Credit Risk Funds is that they were the source of the biggest debt fund crisis in India. Franklin Templeton's six debt fund schemes (including credit risk) were wound up in April 2020 because the underlying corporate bonds defaulted or became illiquid. Credit Risk Funds invest 65%+ in below AA-rated bonds — these are companies with weaker credit profiles that pay higher interest. The higher yield is compensation for the higher default risk. After the Franklin episode, most experienced distributors recommend Credit Risk Funds only for investors who truly understand and accept the possibility of permanent capital loss. Corporate Bond Funds (min 80% in AA+ and above) are the safer alternative — they stick to high-quality issuers. Banking & PSU Funds are even safer as they invest in bank and government-backed entity debt. Gilt Funds are the purest expression of interest rate risk — they invest 80%+ in government securities with zero credit risk (sovereign guarantee). The Gilt Fund with 10-year Constant Duration is designed for investors who want consistent exposure to long-term government bonds. Floater Funds invest 65%+ in floating rate instruments — their coupons adjust with market rates, making them relatively immune to interest rate changes.

Real-Life Scenario

Consider the case of Mohan, a 55-year-old businessman in Pune, who had ₹1 crore to invest conservatively for 5 years. A financial advisor structured his debt portfolio as follows: ₹30 lakh in Banking & PSU Fund (e.g., IDFC Banking & PSU Debt Fund): This fund invests 80%+ in bonds from SBI, HDFC Bank, PFC, REC — all government-backed or top-rated banks. The credit risk is minimal, with expected returns of 6.5-7.5% over 3-5 years. ₹25 lakh in Corporate Bond Fund (e.g., HDFC Corporate Bond Fund): This invests only in AA+ and above rated corporate bonds — companies like Reliance Industries, HDFC Ltd, and Bajaj Finance. Slightly higher yield than Banking & PSU, still very high credit quality. ₹20 lakh in Dynamic Bond Fund (e.g., ICICI Pru All Seasons Bond Fund): The fund manager has flexibility to adjust duration based on rate outlook. In 2019 when rates were being cut, this fund delivered 12% by extending duration. When rates started rising in 2022, the manager shortened duration to protect capital. ₹15 lakh in Gilt Fund (e.g., SBI Magnum Gilt Fund): Zero credit risk — 100% government securities. The returns depend on the interest rate cycle, but there is no risk of loss due to corporate default. ₹10 lakh in Floater Fund (e.g., HDFC Floating Rate Debt Fund): This serves as a hedge against rising rates. When other debt funds suffer from rate hikes, floater funds actually benefit because their coupon rates adjust upward. Notably, Credit Risk Funds were deliberately excluded from Mohan's portfolio. The Franklin Templeton episode serves as a cautionary tale: in April 2020, six Franklin debt schemes were shut overnight. Investors with ₹25,000 crore could not access their money for over two years. The extra 1-2% yield from lower-rated bonds does not justify the risk of sleepless nights, especially for retirement corpus.

Key Points to Remember

Medium Duration Fund: Macaulay duration 3-4 years — suitable for 3-4 year investment horizons

Medium to Long Duration Fund: Macaulay duration 4-7 years — for investors comfortable with moderate interest rate risk

Long Duration Fund: Macaulay duration 7+ years — most sensitive to interest rate changes, suitable for rate-cycle-aware investors

Dynamic Bond Fund: no duration restriction — fund manager actively manages duration based on rate outlook

Corporate Bond Fund: minimum 80% in AA+ and above corporate bonds — high credit quality with moderate duration risk

Credit Risk Fund: minimum 65% in below AA corporate bonds — higher yield but significant default risk (remember Franklin Templeton)

Banking & PSU Fund: minimum 80% in bank, PSU, and PFI debt instruments — very high credit quality

Gilt Fund: minimum 80% in government securities — zero credit risk, pure interest rate play

Formula

Credit Risk Premium = Yield on Corporate Bond - Yield on Government Bond of similar maturity

Example:
AAA Corporate Bond yield: 7.5%
10-year G-Sec yield: 7.0%
Credit spread = 0.5% (50 basis points)

A-rated Corporate Bond yield: 9.5%
10-year G-Sec yield: 7.0%
Credit spread = 2.5% (250 basis points)

The higher spread for A-rated bonds reflects the higher default risk. Credit Risk Funds earn this spread but also bear the risk of default.

Numerical Example

Seema invests ₹20,00,000 in different debt fund categories. Let us see the impact of a 1% interest rate hike:

Medium Duration Fund (duration 3.5 years):
NAV impact ≈ -3.5 x 1% = -3.5%
Temporary loss = ₹20,00,000 x 3.5% = ₹70,000

Long Duration Fund (duration 8 years):
NAV impact ≈ -8 x 1% = -8%
Temporary loss = ₹20,00,000 x 8% = ₹1,60,000

Gilt Fund 10-year Constant Duration (duration 10 years):
NAV impact ≈ -10 x 1% = -10%
Temporary loss = ₹20,00,000 x 10% = ₹2,00,000

Floater Fund (duration ~0.3 years):
NAV impact ≈ -0.3 x 1% = -0.3%
Temporary loss = ₹20,00,000 x 0.3% = ₹6,000
Plus, the coupon resets higher, benefiting the fund going forward

This illustrates a key principle for debt fund investing: Rate hike coming? Reduce duration. Rate cut expected? Extend duration. Cannot predict? Use Dynamic Bond.

Frequently Asked Questions

Test Your Knowledge

4 questions to check your understanding

Question 1 of 4Score: 0/0

A Credit Risk Fund must invest a minimum of ___% in corporate bonds rated below AA.

Summary Notes

Medium (3-4Y) → Medium to Long (4-7Y) → Long (7Y+) → each step up means more interest rate sensitivity

Dynamic Bond = no duration restriction — fund manager reads the rate cycle and adjusts; success depends on manager skill

Corporate Bond (AA+ above) is the safe corporate play; Credit Risk (below AA) is high-yield-high-risk — remember Franklin Templeton

Gilt Fund = zero credit risk (government guarantee) but full interest rate risk; 10-year constant duration variant is the most volatile

Floater Fund benefits from rising rates — floating coupons reset higher when rates increase, making it a natural rate-hike hedge

What you’ll learn in Types of Mutual Fund Schemes

Master the complete SEBI categorization of mutual fund schemes — equity, debt, hybrid, and passive funds. Understand the current 36-category framework and the upcoming 40-category expansion effective April 2026. Essential for recommending the right fund to every client.

1SEBI Categorization — From 36 to 40 CategoriesSEBI's Mutual Fund Categorization and Rationalization circular (October 6, 2017) originally classified all mutual fund schemes in India into 36 categories…2Equity Funds — Large Cap, Mid Cap, Small Cap, Flexi Cap, Multi CapUnder SEBI categorization, equity mutual funds based on market capitalization are classified into five distinct categories: Large Cap Fund (minimum 80% in top…3Equity Funds — Value, Contra, Dividend Yield, FocusedUnder SEBI categorization, strategy-based equity funds include: Value Fund (follows a value investment strategy), Contra Fund (follows a contrarian investment…4Equity Funds — Sectoral & Thematic, ELSSUnder SEBI categorization, Sectoral Funds invest a minimum of 80% in equity and equity-related instruments of a specific sector (e.g., banking, pharma, IT,…5Debt Funds — Overnight, Liquid, Ultra-Short, Low DurationUnder SEBI categorization, short-duration debt fund categories include: Overnight Fund (invests in securities maturing in 1 day), Liquid Fund (invests in…6Debt Funds — Medium, Long Duration, Dynamic Bond, GiltUnder SEBI categorization, medium-to-long duration debt fund categories include: Medium Duration Fund (Macaulay duration 3-4 years), Medium to Long Duration…7Hybrid Funds — Conservative, Balanced, Aggressive, Dynamic Asset AllocationHybrid funds are mutual fund schemes that invest in a combination of two or more asset classes — typically equity and debt, but sometimes also gold, REITs, or…8Solution-Oriented Funds — Retirement & Children's FundSolution-Oriented Funds were mutual fund schemes designed for specific financial goals — primarily retirement planning and children's education or marriage.9Index Funds & ETFs — The Passive RevolutionIndex Funds and Exchange-Traded Funds (ETFs) are passively managed mutual fund products that aim to replicate the performance of a specific market index (such…10Fund of Funds & International FundsA Fund of Funds (FoF) is a mutual fund scheme that invests in units of other mutual fund schemes — either domestic or international — rather than directly…11Choosing the Right Category for Your ClientCategory selection is the process of matching a mutual fund scheme category to an investor's specific requirements based on their risk tolerance, investment…12SEBI Categorization — Impact & Practical Tips for DistributorsSEBI's mutual fund categorization and rationalization framework was originally implemented through a circular dated October 6, 2017, mandating that every…

Frequently asked questions

Why did SEBI limit schemes to 36 categories?

Before 2017, AMCs launched schemes with fancy names that made it nearly impossible for investors to compare funds. Two "large-cap" funds from the same AMC could have completely different mandates. SEBI's 36-category framework ensures clear definitions, prevents scheme proliferation, and allows investors to make genuine comparisons across AMCs. For distributors, this is a significant advantage — it enables confident communication to clients about what a fund will and will not do. Note: From April 2026, the framework expands to 40 categories under the new SEBI (Mutual Funds) Regulations.

Can an AMC launch two Large Cap funds?

No. Under SEBI categorization, each AMC can offer only one scheme per category. The exceptions are Index Funds, ETFs, and Fund of Funds where multiple schemes tracking different indices are permitted. So an AMC can have one Nifty 50 Index Fund and one Nifty Next 50 Index Fund, but only one actively managed Large Cap fund.

What happened to existing schemes that did not fit the 36 categories?

AMCs were given time to either merge non-conforming schemes into the defined categories or wind them up. This led to a massive wave of scheme mergers in 2018-2019. For example, an AMC that had three separate large-cap-style funds had to merge them into one. Investors were given exit options without exit load during the merger period.

What is the AMFI market cap list and how often is it updated?

AMFI (Association of Mutual Funds in India) publishes a list classifying all listed stocks into Large Cap (top 100 by full market capitalization), Mid Cap (101st to 250th), and Small Cap (251st and below). This list is updated semi-annually based on average market capitalization data. All AMCs must follow this list for determining compliance with category-wise allocation norms.

Does the 36-category rule apply to passive funds and ETFs?

Index Funds, ETFs, and Fund of Funds are exceptions to the one-scheme-per-category rule. An AMC can offer multiple Index Funds tracking different indices (Nifty 50, Nifty Next 50, Nifty Midcap 150, etc.) and multiple ETFs. However, each actively managed category is still limited to one scheme per AMC.

What is the difference between Flexi Cap and Multi Cap?

This is the most commonly confused topic. Flexi Cap requires minimum 65% in equity with NO mandatory split across market caps — the fund manager has complete freedom. Multi Cap requires minimum 75% in equity with a MANDATORY minimum of 25% each in large cap, mid cap, and small cap. Flexi Cap = freedom; Multi Cap = forced diversification. Remember this distinction — it appears in almost every NISM mock test.

Why was Multi Cap introduced separately when Flexi Cap already existed?

In September 2020, SEBI noticed that most Multi Cap funds were holding 70-80% in large caps and very little in small caps, defeating the purpose of diversification. SEBI then mandated the 25-25-25 rule for Multi Cap funds. AMCs that did not want to increase small cap exposure reclassified their schemes as Flexi Cap. This is why Flexi Cap became a separate category — it was born out of the Multi Cap controversy.

Which is more suitable for a new investor — Large Cap or Flexi Cap?

For a new investor with limited market experience, starting with a Large Cap fund is generally advisable because the portfolio is anchored in well-established companies with lower volatility. Once the investor is comfortable with market fluctuations (usually after experiencing one correction), Flexi Cap can be introduced for its dynamic allocation. A common mistake distributors make is putting first-time investors directly into small cap funds — the first 20% drawdown panics them out of mutual funds entirely.

Free course · 12 topics · 75 min