Credit Risk Funds — Why This Category Carries a Distinct Warning Label (and the Franklin Templeton Lesson)

Among SEBI's sixteen debt fund categories, Credit Risk Funds occupy a distinct position: they are the one category explicitly defined not by duration, but by a deliberate decision to hold lower-rated paper in exchange for higher yield. That single design choice is what makes this category behave differently from every other debt fund an investor might casually lump it in with — and the April 2020 closure of six Franklin Templeton debt schemes remains the most consequential real-world demonstration of why.

What Defines a Credit Risk Fund

Under SEBI's categorisation framework, a Credit Risk Fund must invest a minimum of 65% of its corpus in corporate bonds rated AA and below (within investment grade) — as distinct from Corporate Bond Funds, which are required to hold at least 80% in the highest-rated AA+ and above corporate paper. This is not an accidental or occasional dip into lower-rated credit; it is the category's defining mandate. The trade-off is explicit and, in principle, transparent: lower-rated issuers pay a higher coupon to compensate investors for taking on greater default risk, and a Credit Risk Fund is built specifically to capture that spread.

Why the Risk Profile Differs From "Ordinary" Debt

The intuitive assumption many investors carry into debt funds — that they are a lower-volatility, income-generating counterpart to equity — holds reasonably well for Overnight, Liquid, Corporate Bond, Banking & PSU, and Gilt funds, where the dominant risk is interest rate movement on high-quality paper. It holds considerably less well for Credit Risk Funds, where the dominant risk is issuer-specific credit deterioration or default, and where that risk doesn't move gradually and predictably the way interest rates do — it can materialise suddenly, in a rating downgrade or a payment default, and take a meaningful chunk of the fund's NAV down in a single event.

Compounding this, lower-rated corporate bonds in India are typically far less liquid than sovereign or top-rated paper. In normal market conditions, a fund can generally sell holdings to meet redemptions without much friction. In stressed conditions — precisely when investors are most likely to want their money back — buyers for lower-rated, less-liquid paper can simply disappear at any price close to the bond's carrying value, creating a mismatch between a fund's daily redemption obligation and its ability to convert holdings into cash without a severe price concession.

The Franklin Templeton Episode

In April 2020, Franklin Templeton Mutual Fund announced the winding up of six of its debt schemes — including Franklin India Ultra Short Bond Fund, Franklin India Short Term Income Plan, Franklin India Credit Risk Fund, Franklin India Dynamic Accrual Fund, Franklin India Low Duration Fund, and Franklin India Income Opportunities Fund — collectively holding assets under management of around ₹25,000 crore at the time. The stated rationale was that severe illiquidity in the corporate bond market, sharply worsened by COVID-19-driven redemption pressure across the industry, had made it impossible for these schemes to meet redemptions without deeply discounted, forced sales that would have been unfair to remaining unitholders.

The episode was significant not just for its scale but for what it revealed about the specific vulnerability of funds holding a meaningful proportion of lower-rated, less-liquid credit: when redemption pressure met an illiquid book simultaneously, the schemes had no orderly way to raise cash without selling into a market with essentially no bids at reasonable prices. Investors' money was effectively locked in these schemes for an extended period, with recovery happening gradually as the underlying portfolio matured or was sold down, rather than being available on demand the way an open-ended debt fund is normally expected to function.

The matter also triggered extended regulatory and legal proceedings — including SEBI investigations, actions by the Enforcement Directorate, and litigation that eventually reached the Supreme Court of India over the process for winding up the schemes and seeking unitholder consent — underscoring that the consequences of an illiquidity event of this kind extend well beyond the immediate NAV impact into a prolonged period of investor uncertainty and legal process before final distributions are completed.

What Changed in Regulation Afterward

The episode accelerated and reinforced several regulatory measures aimed at reducing the odds of a repeat, and at containing the damage when credit events do occur:

• Segregated portfolios ("side-pocketing"), which allow an AMC to separate a distressed or downgraded security into a distinct portfolio from the rest of a scheme's healthy holdings, so that liquidity in the healthy portion of the fund isn't held hostage by a single troubled instrument, and losses on the distressed asset are ring-fenced to investors who held units at the time of the credit event rather than diluted across new and old investors alike.
• Enhanced disclosure requirements around portfolio liquidity, sector and issuer concentration, and stress testing for open-ended debt schemes, giving investors more visibility into how much of a fund's book could realistically be liquidated within a given number of days under stressed conditions.
• Tightened norms on investments in unlisted, structured, and below-investment-grade debt, and closer scrutiny of the credit assessment processes AMCs use before investing in lower-rated paper, rather than relying solely on external credit rating agencies.
• Stress testing disclosures for debt schemes, requiring AMCs to publish the number of days it would take to liquidate a defined proportion of a scheme's portfolio under stress, giving investors an additional, standardised lens on liquidity risk beyond the credit rating breakdown alone.

Practical Guidance for Investors Considering a Credit Risk Fund

• Understand that the category's entire premise is deliberately taking on more default and liquidity risk for yield — this is not a "slightly riskier" version of an ordinary debt fund, but a materially different risk profile.
• Check the fund's portfolio concentration — how much exposure sits with any single issuer or group, since a Credit Risk Fund with concentrated exposure to a handful of lower-rated names carries meaningfully more single-issuer risk than one with a genuinely diversified book.
• Review the liquidity/stress test disclosures now mandated for debt schemes, which give a standardised sense of how quickly the fund could realistically raise cash under adverse conditions.
• Treat a Credit Risk Fund allocation as money you can afford to have locked up or impaired for an extended period in a genuine credit event — not as a substitute for an emergency fund or short-term savings, regardless of how attractive the current yield looks.
• Diversify across AMCs and funds if allocating meaningfully to this category, since issuer and sector concentration risk compounds if a large single-fund position turns out to be concentrated in the same names that run into trouble.

Conclusion

Credit Risk Funds are a legitimate category with a genuine role for investors deliberately seeking a higher-yield allocation within their debt portfolio — but the category's design, by definition, trades safety for yield, and the Franklin Templeton episode remains the clearest illustration of how that trade-off can play out when systemic stress and portfolio-specific illiquidity coincide. Understanding that this category is fundamentally different from "debt fund" as a low-risk catch-all, and sizing an allocation accordingly, is the single most important takeaway for any investor evaluating this space.