Debt Funds Part 3

13.1 Setting the Scene

Imagine you’re lending money to a friend. You give him ₹10,000 today, and he promises to pay you back with interest. The way he repays you — whether in small installments or in one lump sum — determines how quickly you recover your money. Bonds work in exactly the same way. Debt mutual funds, in turn, are simply collections of such bonds managed by professionals

Now, before we dive into categories like low-duration or money market funds, it’s important to understand a few key relationships that govern how bonds behave.

Bond Price and Yield

Think of a seesaw in a playground. On one side sits the bond’s price, and on the other side sits its yield (the return you earn). When one side goes up, the other side goes down.

For example, suppose a company issues a bond at ₹1,000 with a fixed 8% annual interest. If investors suddenly rush to buy it, the price may climb to ₹1,050. But here’s the catch: the coupon is still ₹80 (8% of ₹1,000). So, at ₹1,050, your effective yield drops below 8%. That’s why bond prices and yields always move in opposite directions.

Interest Rates and Bond Prices

Now picture the Reserve Bank of India (RBI) raising interest rates. New bonds in the market start offering 9% instead of 8%. Suddenly, that old 8% bond looks less attractive, and its price falls below ₹1,000. This is why interest rates and bond prices are inversely related.

It’s similar to shopping during a sale. If new products are available at cheaper prices, older stock has to be discounted to attract buyers.

Modified Duration – Sensitivity to Interest Rates

Here’s where the concept of Modified Duration comes in. Think of it as the bond’s “shock absorber” against interest rate changes.

Suppose a debt fund has a modified duration of 3.2 years. That means:

• If interest rates rise by 1%, the fund’s value falls by about 3.2%.
• If rates fall by 1%, the fund’s value rises by about 3.2%.

It’s like driving a car on a bumpy road. A vehicle with stiff suspension (high duration) feels every bump more sharply, while one with softer suspension (low duration) absorbs shocks better. Longer-duration funds are more sensitive to rate changes, while shorter-duration funds are steadier.

Risks Beyond Interest Rates

As an investor, you must also be aware of two other risks:

• Credit risk: Imagine lending money to a friend who suddenly loses his job. His ability to repay weakens. Similarly, if a company’s financial health deteriorates, rating agencies may downgrade its bonds.
• Default risk: Worse still, what if your friend simply refuses to pay back? In the bond world, this is default — when the issuer fails to pay interest or principal.

These risks remind us that debt funds are not risk-free. Even if interest rate risk is managed, credit and default risks remain.

Transition to Debt Fund Categories

With these basics in place, we can now explore specific categories of debt mutual funds. Each category — low-duration funds, money market funds, and short-duration funds — has its own role, maturity profile, and risk-return balance.

Think of them as different parking spots for your money:

• Low-duration funds are like parking for 6–12 months.
• Money market funds are for short-term needs of up to about a year.
• Short-duration funds are for slightly longer horizons, say 2–3 years.

Each option suits a different financial goal, depending on how long you want to park your money and how much risk you can tolerate.

Note on names: SEBI’s circular of 26 February 2026 renamed several debt categories. Low Duration Funds are now called Ultra Short to Short Term Funds, Short Duration Funds are now Short Term Funds, and Medium Duration Funds are now Medium Term Funds. Their Macaulay duration limits are unchanged, and this chapter uses the familiar older names.

13.2. Low Duration Funds

Think of low duration funds as the “next step up” from ultra-short duration funds. SEBI specifies that the Macaulay duration of the portfolio must fall between 6 to 12 months. In simple terms, this means the weighted-average time in which the portfolio receives its cash flows (interest and principal) is longer than for ultra-short duration funds, but still under a year.

For example, imagine lending money to a friend for 9 months, with small interest payments every quarter. That’s roughly how the cash flows of a low duration fund work. The fund manager invests in short-term instruments like commercial papers (CPs), certificates of deposit (CDs), and sometimes even bonds with maturities of 1–2 years, but ensures the overall portfolio averages out to the 6–12 month window.

Now, the credit risk here is similar to ultra-short duration funds. Even if the portfolio is filled with AAA-rated papers, it doesn’t mean there’s zero risk. Ratings can change, and defaults—though rare—do happen. Remember IL&FS in 2018, whose AAA-rated papers were downgraded to default grade within weeks? That’s why investors must always check the quality of papers in the portfolio.

On the other hand, the interest rate risk is relatively low. For instance, if Bandhan Low Duration Fund (formerly IDFC Low Duration Fund) has a modified duration of 0.802 years, it means that for every 1% change in interest rates, the NAV moves by only about 0.8%. Compare this with Nippon India’s Low Duration Fund, which at one point had a modified duration of 0.94 years—slightly higher, meaning it is a bit more sensitive to interest rate changes. Why the difference? Likely because Nippon’s portfolio had a larger share of slightly longer maturity instruments, pushing the average duration higher. These figures are illustrative and taken from past factsheets; a fund’s duration changes every month, so always check the latest factsheet.

So, who should invest? Low duration funds are ideal if you want to park money for 6–12 months with relatively low volatility, perhaps to fund a short-term goal like paying insurance premiums due next year or saving for a vacation.

Money Market Funds

Money market funds are close cousins of low duration funds but with one key distinction: they can only invest in money market instruments. SEBI caps their maturity at 1 year, so the fund manager cannot buy longer-term bonds. Instead, the portfolio is built entirely from instruments like:

• Commercial Papers (CPs):Short-term borrowings by companies, unsecured but rated.
• Certificates of Deposit (CDs):Issued by banks (and select financial institutions) as tradable short-term deposits, usually considered safe.
• Treasury Bills (T-Bills):Issued by the Government of India, backed by sovereign guarantee.

For example, if you invest in UTI’s Money Market Fund, you may see allocations of up to about 10% in a single issuer’s CP or CD (SEBI’s single-issuer limit for AAA-rated papers, which trustees can raise to 12%; the limits are 8% for AA-rated and 6% for A-rated and lower papers). Even if the rating is high, concentration risk exists—if that company faces trouble, the fund could take a hit. So yes, credit risk is present here too.

The modified duration of money market funds is always less than 1 year, which means their sensitivity to interest rate changes is even lower than low duration funds. If interest rates rise or fall, the NAV impact is minimal compared to longer-duration debt funds.

Investment philosophy here is straightforward: money market funds are best suited for investors who want to park money safely for up to a year, with liquidity and relatively low volatility. Many investors often compare them directly with low duration funds, choosing based on whether they’re comfortable with a slightly broader set of instruments (low duration) or prefer sticking strictly to money market securities (money market fund).

When we move from ultra-short and low-duration debt funds into the territory of short duration funds, the dynamics begin to shift quite noticeably. SEBI specifies that the Macaulay duration of these funds must fall between one and three years. That definition alone should immediately make you think about the implications of duration on risk. As the average maturity of the portfolio lengthens, the fund becomes more sensitive to changes in interest rates. This sensitivity is captured by the concept of modified duration—a measure of how much the price of the fund will move when interest rates change. In ultra-short or money market funds, this risk was minimal, but here it becomes more pronounced.

To illustrate, imagine you lend money to a friend for three years at a fixed interest rate. If interest rates in the market suddenly rise, new lenders can earn more, while you are locked into a lower rate. The value of your loan (if traded) would drop. That’s essentially what happens inside a short duration fund. The longer the maturity, the more exposed you are to interest rate movements. This is why a short duration fund carries higher interest rate risk compared to liquid or ultra-short duration funds.

Credit risk, however, doesn’t disappear. A typical short duration fund invests in a mix of corporate bonds, commercial papers, and government securities. For example, a fund might hold AAA-rated bonds from large banks, AA-rated papers from established corporates, and A1+ rated short-term instruments. Each rating reflects the probability of default: AAA (for long-term debt) and A1+ (the highest rating for short-term debt) are considered very safe, while AA-rated papers carry slightly higher risk. The blend of these instruments determines the overall credit profile of the fund. If a company faces financial stress, a downgrade in its rating can impact the fund’s value.

Now, let’s look at modified duration in practice. Suppose a short duration fund has a modified duration of 2.7 years. This means that if interest rates rise by 1%, the fund’s NAV could fall by about 2.7%. Conversely, if rates fall, the NAV could rise by the same proportion. This is a double-edged sword: higher risk, but also higher potential reward. Investors must be prepared for this volatility.

Given this risk-return profile, short duration funds are suitable only if you have an investment horizon of at least two to three years. If you need liquidity in a year or less, these funds are not appropriate. But if you can stay invested for two to three years or more, returns have historically been around 7% a year, depending on prevailing interest rates, which is higher than what ultra-short or liquid funds typically deliver. The trade-off is clear: more patience and tolerance for risk in exchange for better returns.

Moving further, SEBI defines medium duration funds as those with a Macaulay duration between three and four years (SEBI lets this fall to one to four years when the fund manager expects interest rates to rise). Here, the interest rate risk is even more significant. Think of it like extending your loan to a friend for four years instead of three—the longer you wait, the more vulnerable you are to changes in the lending environment. A medium duration fund’s portfolio often includes longer-term corporate bonds and government securities. The ratings may still be strong (AAA or AA), but the longer maturity increases the chance that economic conditions could change, affecting issuers’ ability to repay.

If you were to analyze a medium duration fund’s fact sheet, you’d want to ask:

• What instruments does it hold?
• Are they mostly government securities, or corporate bonds?
• What is the rating profile—AAA-heavy, or does it include lower-rated papers?
• What is the Macaulay duration, and does it align with SEBI’s mandate?
• What is the modified duration, and how sensitive is the fund to interest rate changes?
• Finally, what horizon should you have as an investor?

For medium duration funds, the answer is clear: you should be comfortable locking in your money for at least four years, ideally longer, to ride out interest rate cycles.

In essence, as you progress from liquid to ultra-short, short, and medium duration funds, you are climbing a ladder of risk and return. Each step requires a longer commitment and a stronger stomach for volatility. But with that comes the potential for better yields. Understanding the interplay of Macaulay duration, modified duration, and credit risk is the key to making informed choices in this segment of debt funds.

13.3. The Shock Announcement

On 23 April 2020, Franklin Templeton India made a decision that stunned investors: it decided to wind up six of its debt schemes, including its low duration and ultra-short duration funds. Together, these funds managed about ₹25,650 crore. Imagine a trusted bank suddenly freezing withdrawals from several of its accounts — that’s how dramatic this move felt for investors.

Why Did This Happen?

The immediate trigger was not a credit default. Instead, it was liquidity pressure. The schemes held large amounts of lower-rated, thinly traded corporate bonds. During March and April 2020, as the COVID-19 pandemic rattled markets, investors rushed to redeem their money, and heavy redemptions quickly drained the schemes’ cash, forcing them to borrow.

Now, here’s the catch: India’s corporate bond market is not very liquid. Unlike equities, you can’t just sell bonds instantly at fair prices. Fund managers often hold bonds until maturity, relying on scheduled repayments. To manage daily redemptions, they use strategies like laddering — holding bonds that mature at staggered intervals. This works well in normal times, but when panic strikes and redemptions spike, the system breaks down. Franklin simply couldn’t sell enough bonds quickly without taking massive losses.

The Unprecedented Step

To protect remaining investors from a fire-sale situation, Franklin chose to lock down the funds. Investors could no longer redeem their units until the AMC gradually wound down the portfolios. By September 2023, the schemes had returned about ₹27,500 crore to investors — roughly 107% of their assets at the time of closure. This was extraordinary because debt funds were always marketed as relatively safe and liquid. The closure highlighted a risk that many investors had never considered seriously: liquidity risk.

Understanding Liquidity Risk

We often talk about credit risk (the chance that a borrower defaults) and interest rate risk (the impact of rate changes on bond prices). But Franklin’s case showed that even when interest rates are stable and most borrowers keep paying, a fund can still face trouble if it cannot meet redemption demands. Liquidity risk is like owning property in a remote area — it may be valuable, but if you suddenly need cash, finding a buyer quickly is difficult.

Should Investors Avoid Debt Funds?

Not at all. Debt funds remain an important part of asset allocation. They provide diversification and relatively stable returns, and some tax features worth knowing: units bought before April 2023 and held for more than 24 months are taxed at 12.5% without indexation, while newer investments are taxed at your slab rate, like FD interest, but only when you redeem rather than every year. What the Franklin saga teaches us is that investors must recognize all three risks:

• Credit risk (default or downgrade of issuers)
• Interest rate risk (bond price volatility when rates change)
• Liquidity risk (difficulty in selling bonds during stress)

The pandemic was a rare event, but it reminded everyone that debt funds are not substitutes for savings accounts. They are market-linked instruments, and understanding their risk profile is essential. Since then, SEBI has required most open-ended debt schemes to hold at least 10% in liquid assets, introduced swing pricing, and set up a backstop fund for the corporate bond market (the Corporate Debt Market Development Fund).

Key Lessons to Carry Forward

• Bond yields and prices move inversely.
• Interest rates and bond prices also move inversely.
• Modified duration tells you how sensitive a fund’s NAV is to rate changes.
• Low duration and money market funds carry credit risk but low interest rate risk.
• Short and medium duration funds carry both credit and interest rate risk.
• And now, investors must factor in liquidity risk as well.Liquidity risk deserves a closer look of its own.