BT Buzz: Debt fund closure by Franklin Templeton; should you be worried?

Once bitten twice shy. It has hardly been a year and a half when Indian capital market witnessed one of the worst debt fund crises fuelled by a series of corporate defaults. It was the time when the concept of side-pocketing was allowed for the first time in the market to prevent investors from the adverse effect of a contagion. Due to coronavirus-related restrictions and interest moratorium, debt investors were already  apprehensive about corporate defaults in future. Facing the redemption pressure the Franklin Templeton Mutual Fund has decided to wind up six debt fund schemes.

As per the fund house, 'there has been a dramatic and sustained fall in liquidity in certain segments of the corporate bonds market on account of the COVID-19 crisis and the resultant lockdown of the Indian economy which was necessary to contain the pandemic'. At the same time, mutual funds, especially in the fixed income segment, are facing continuous and heightened redemptions.

As these funds are frozen for investors so the fund house will focus only on exit from its debt exposure of these funds. "There is no more investment or withdrawal possible in these six funds. The mutual fund company will do an orderly sale of their investments and return the money to investors. The timeline of this is not yet clear. This step is in a way similar to temporarily blocking withdrawals from a bank," says Sanjiv Singhal, Founder, Scripbox.

As the funds are frozen for investors there is still not much clarity about the timeline by which the investors can expect their invested money back. "For existing investors in debt funds, as redemption is stopped, how they will be paid out is still to be seen. Most likely they will be paid as and when the Franklin receives its coupon payments or investments mature. But, investors will definitely get a staggered exit. Franklin has taken the decision not because of any default from their investments, but because of liquidity and redemption pressures," points out Sousthav Chakrabarty, CEO, and Director, Capital Quotient. As per the fund house, the value of unlisted papers held by the impacted schemes as on 22 April 2020 was 32 per cent of the AUM of these funds. These are the most illiquid part of the portfolio for which the fund may have to wait till maturity.

What led to this unprecedented decision by the fund house?

There are no free lunches. High returns are hard to come without taking high risk. "Franklin Templeton AMC has had a history of high returns, by taking on higher risk in their debt portfolio. This strategy started to show cracks over the past 18 months, since defaults in IL&FS and Vodafone, etc. Franklin created side pockets in these funds to hold defaulting/suspect debt," says Singhal of Scripbox.

These funds have been facing significant redemption pressure, which intensified in March and April. The fund house maintains that in this scenario this is the best possible way to safeguard the interest of existing investors and is the only viable means to secure an orderly realisation of portfolio assets.

"Despite measures taken by the RBI, the liquidity in the Indian bond markets, especially in the lower credit space, has squeezed substantially," says a note from the Morningstar. "The fund house did take measures to meet redemption pressure by way of getting borrowers to pre-pay debt, selling bonds to banks and using the credit line provided by banks. However, with unprecedented high redemptions from these funds, it came to a situation where these were not viable options anymore. Basically, Franklin reached a stage where the manager started finding it difficult to meet the redemption demand without impacting the returns. For instance, in the month of March alone, cumulatively, these funds witnessed an estimated net outflow of Rs 9,148 crores," it adds.

When redemption volume goes out of control the fund is left with no other option but to hit the pause button. "As the portfolio shrinks, the fund is left with a higher and higher proportion of less liquid and probably riskier investments. The mutual fund borrowed money to pay off redemptions but appears to have hit the regulatory limit for borrowing. Concerned about a situation where they cannot meet redemption demands, the mutual fund company has decided to effectively side-pocket the entire funds." says Singhal of Scripbox.

Impact on other debt funds and capital market

As per the AMFI, the total assets of mutual fund industry stood at Rs 22.26 lakh crore as on March 31, 2020. Out of which debt funds had an exposure of 10.29 lakh crore. Overall debt funds saw a net outflow of Rs 1.94 lakh crore in March 2020. Credit Risk Fund category, which is currently under the radar, had a total asset worth Rs 55,380 crore.

The next question which bothers most investors is whether it will lead to another contagion resulting in higher redemption of debt funds and overall liquidity tightening in the entire capital market. "Investors in mutual fund schemes may get apprehensive and this may trigger withdrawals. Considering the liquidity crisis in Franklin Templeton schemes, full redemption of the funds may take six to 12 months. There will be huge impact on other mutual fund companies offering debt funds," says Nitin Shahi, Executive Director of FINDOC.

Market is driven by sentiments and if the redemption pressure turns into panic it may have larger contagion effect. "Logically, we feel that credit risk funds are going to face redemptions by people worried about the safety of their money. These funds take additional risk to generate additional return and the current economic environment has led to defaults. While there are some well-managed credit risk funds out there, these will get impacted as much as others," says Singhal of Scripbox.

Regulator action inevitable

To prevent the situation from escalating into a panic sell-off, market regulators may have to continuously keep a watch and act as per the need of the house. "The RBI needs to step in to open a special liquidity tap for mutual funds, lest it creates a systemic failure leading to another system collapse. The Sebi also needs to step in and recalibrate rules and regulations, so that investors of mutual funds can be saved from any future crisis," says Nitin Shahi of FINDOC.

What should investors do?

This is time for investors to be cautious with their investment. It is not the time to chase high returns especially when it comes to debt exposure. So if you are looking to invest in debt funds, you should only focus on the ones investing in high quality debt. "Explore alternate debt strategies such as peer to peer lending, venture debt, and other opportunities related to operationally cash positive companies, and high-quality borrowers with significant cash flows but with interim cash flow mismatches. We also advise investors to continue existing SIPs, especially those in equity," says Chakrabarty of Capital Quotient.

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