Why Credit Risk Funds Gave Negative Returns in 2020

Most people think debt funds are safe. That belief shattered in April 2020. Understanding what is debt mutual fund and why credit risk variants lost money in 2020 starts with one blunt truth: credit risk funds are not bond-safe. They chase higher yield by holding bonds below AA rating. When markets froze during Covid, those bonds could not be sold, and investors in six Franklin Templeton schemes watched their money get locked for years. Here is what actually happened and why the damage spread.

What credit risk funds really hold

A credit risk fund is a debt mutual fund that must invest at least 65 percent of its money in corporate bonds rated below AA. Lower-rated bonds pay higher interest to compensate for their higher chance of default. Fund managers use these to push returns above a regular corporate bond fund.

Higher yield is not a gift. It is the market charging you for taking on higher credit risk.

That simple line explains the entire 2020 episode.

Why below-AA bonds get risky fast

Below-AA issuers include companies with uneven earnings, high debt, or sector-specific stress. In calm markets, they pay their coupons and everyone is happy. In stressed markets, two things go wrong at once.

1. Their ability to refinance weakens, raising default fears.
2. Liquidity dries up, so even healthy bonds cannot be sold at fair price.

The rating ladder

Credit ratings run from AAA (strongest) down through AA, A, BBB, and into speculative grades. Every notch down raises the yield but also the default probability. Credit risk funds live in this stretch on purpose.

What happened in April 2020

On 23 April 2020, Franklin Templeton Mutual Fund announced it was winding up six debt schemes in India. This was not a small event. Around 25,000 crore rupees of investor money got frozen overnight. It remains the largest debt-fund wind-up episode in Indian mutual fund history.

This was AMC-specific, not a wipeout of every credit risk fund. But the shock spread. Credit spreads widened, net asset values of similar funds dropped, and panic redemptions forced other AMCs to sell good bonds at bad prices.

Why Franklin wound up

Covid lockdowns destroyed cash flow at many mid-size corporates. Redemption requests flooded in as investors got nervous. Selling bonds to meet those redemptions was nearly impossible because no buyers were quoting sensible prices.

The AMC chose the least damaging option: freeze new transactions, wind up the schemes, and return money as bonds matured or were sold over time. Investors eventually received most of their money back over the next few years, but the lock-in pain was real.

The spiral that made it worse

Fund redemptions work on a simple loop. Investors ask for money, the fund sells bonds, the sale price sets the NAV, and that NAV attracts or scares more investors. When liquidity vanishes, this loop becomes a spiral.

• Panic selling drives bond prices down
• Lower prices push NAVs down
• Falling NAVs trigger more redemption requests
• Fund runs out of buyers and has to gate the scheme

FAQ: How could a debt fund lose money?

Because bond prices move inversely to yields, and credit spreads widen in a crisis. A debt fund's NAV is a live market-linked value, not a fixed-deposit-like promise.

FAQ: Were investors fully refunded later?

Most Franklin Templeton investors received their money back in tranches over 2020 to 2023 as the schemes monetised assets. Some shortfall versus the 2020 NAV was possible, but the recovery was substantial, not a total loss.

The side-pocket tool and what it fixes

SEBI had introduced side-pocketing in 2018 as a response to the IL&FS crisis. A side-pocket separates troubled bonds from the rest of the fund. Investors holding units on the trigger date get a claim on the side-pocket; new investors do not inherit the problem.

It limits damage but does not prevent it. During 2020, side-pocketing helped on specific defaulted papers but could not solve broad market illiquidity. You can read SEBI circulars on side-pocketing directly on sebi.gov.in.

What changed after Franklin

1. Tighter liquidity rules for debt funds, including minimum liquid asset buffers
2. Better disclosure of portfolio credit quality
3. More conservative limits on below-AA holdings
4. Stress-testing requirements on schemes

The IL&FS and DHFL aftermath

The 2020 shock did not appear from nowhere. IL&FS defaulted in September 2018. DHFL defaulted in 2019. Both events hit credit risk and corporate bond funds hard. By 2020, the sector was already fragile, and Covid pulled the last bit of liquidity out of the room.

Investors who had rotated out of credit risk funds after IL&FS dodged much of the 2020 pain. Those who stayed, chasing the extra yield, paid the price.

A real-world example you can use

Consider an investor who put 5 lakh rupees into a Franklin credit risk scheme in 2019 expecting 9 percent returns. By May 2020, their units were frozen. Over the next three years, they received staggered payouts totalling close to the original amount, with some interest. The cash came back, but liquidity was lost when they needed it most. That is the true cost nobody advertises.

What this teaches you today

Credit risk funds are not wrong. They are just misunderstood. Use them for a small slice of your debt allocation, never as a core holding, and accept that 2020-style stress can repeat. Read the portfolio sheet. Check the percentage below AA. Ask if you would be comfortable if redemptions were paused for two years. If the answer is no, pick a safer category and sleep better.