Franklin Templeton debt fund crisis: What should investors do now?

For investors, comprehending the various nuances of investing in debt funds and decoding the endless jargon have always been a herculean task.

It is because of this that retail investors’ interest in debt funds has been fairly tepid when compared with equity mutual funds.

The IL&FS, DHFL crises, or the more recent Vodafone debacle, have only dampened sentiments further.

But Franklin Templeton’s decision last week to wind up six of its debt funds has shaken investors’ confidence to the core. The move has left investors in these funds high and dry, as their entire investments in the schemes are locked for now.

The unprecedented move taken by one of the leading fund houses in the country, across its popular schemes, has thrown up several unsettling questions in the minds of investors. Why did the fund house resort to such a drastic measure, leaving no exit option for investors? Will investors in these funds get their money back? Do investors in other debt funds need to worry? As an investor, how can you tide over these turbulent times?

Here, we attempt to answer some of these questions.

The ongoing turmoil

Before we delve deeper into the Franklin issue, it is important to understand that debt funds are prone to market risk — credit and interest-rate risk. Hence, the NAV on your debt fund rises or falls with the underlying bond prices. Interest rates and bond prices are inversely related — hence, a rise in rates causes bond prices to fall.

Credit risk, on the other hand, arises when a debt fund invests in low-rated bonds which may default on repayment.

Amid the Covid-19 crisis, the Indian debt market has been highly volatile over the past month owing to sharp outflows by foreign portfolio investors (FPIs); thin volumes have only increased the volatility. The cash- crunch problem among corporates and institutions is leading to higher withdrawals from funds, forcing funds to sell the bonds they hold at lower prices. Importantly, there has been heightened risk-aversion among banks and other institutions, particularly towards low-quality debt papers, making it difficult for the funds to sell these securities.

Against this backdrop, let us look at what happened with Franklin’s six debt funds that were wound up last week — Franklin India Low Duration, Franklin India Dynamic Accrual, Franklin India Credit Risk, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond and Franklin India Income Opportunities.

While these debt funds are across various categories and carry varied maturity — from less than a year to four years — they have one thing in common. All these funds have high exposure to low-rated bonds (see table), which have been the worst impacted in the ongoing bond market turmoil.

Huge redemptions have been weighing on these funds for a while now.

While the fund house has tried to manage the redemptions over the past six months through borrowings and credit lines, the heightened market turbulence over the recent weeks has made matters worse.

Increased redemption pressures, limited inflows and illiquidity in the low-rated bond market have compounded the issue, forcing the fund house to close the six debt funds.

A look at the AUM (assets under management) of the funds (see table) suggests that there have been significant outflows over the past month.

If the fund house would have continued to redeem, it would have been forced to sell the bonds at very low prices, leading to a steep erosion in the underlying value of the portfolios. Hence, it decided to wind up the funds.

What this essentially implies is: there will no purchases and redemptions made in these funds post the cut-off time on April 23, 2020.

All purchases or redemptions through Systematic Investment Plans/Systematic Transfer Plans/Systematic Withdrawal Plans will also not be allowed henceforth.

What’s in store for Franklin investors?

The funds will continue to publish their net asset values daily, and investors will not be charged any investment management fee. As the bond market comes back to normalcy, the fund house would look to sell the assets at a reasonable value and pay investors.

But in the interim, there will be certain amount of money coming in every month, in the form of maturities and coupon payments. Hence investors could receive staggered payments from the wound-up funds — monthly or quarterly.

Funds with shorter Macaulay durations could get wound up faster. Hence, investors in Franklin India Ultra Short Bond Fund, having the lowest duration, could get their money back sooner.

The key risk for investors in these funds is the possibility of defaults from corporates issuing the underlying bonds. Given that the six debt funds have a high exposure to low-rated bonds, credit risk emanating in these portfolios can hurt investors. All of these six debt funds already carry segregated portfolios — after side-pocketing their exposure to Vodafone Idea and YES Bank. The winding up of the six funds does not alter the status of the segregated portfolios.

What about investors in other debt funds?

If you are an investor in other debt funds, the Franklin episode is sure to have rattled you. But it is important that you do not press the panic button and pull out money from all your debt funds in a huff. At the same time, there are key lessons that investors need to draw from this episode, and take some prudent action.

Don’t push the panic button

Data suggest that debt funds’ (all open- and closed-ended ones together) exposure to AA and below-rated bonds have fallen notably over the past year. In fact, from December 2019, funds have been increasing their holdings in cash, and as of March 2020, 81 per cent of all debt funds’ portfolios are in AAA rated bonds and government securities.

This implies that investors should not paint all debts funds with the same brush. In terms of AMC-wise exposure to AA and below-rated bonds, aside from Franklin (65 per cent) and IIFCL (48 per cent), other AMCs have much lower exposure to AA and below-rated bonds.

While there have been bouts of volatility in high-rated bonds, and in government securities, too, over the past month (and there can be near-term fluctuations in yields of these bonds), these segments of the debt market can better tide over near-term turbulence.

Hence, if you have debt funds that invest predominantly in high-quality bonds, hold on to them.

If you have a fairly longish view of over one year, don’t rush to redeem the money in these funds.

Exit high-risk debt funds

The Franklin episode brings to light the illiquidity issue in low-rated bonds. While these are extraordinary times leading to sharp rise in low-rated bond yields (fall in prices), risk-averse investors should always stay clear of funds with high credit exposure. After all, if you are an investor seeking liquidity and stability in returns, and hence have invested in low-duration/short-term debt funds, parking money in a fund with over 50-60 per cent exposure to low-rated bonds hardly makes sense.

This will be a good time to re-assess your risk- taking ability and re-jig your debt fund portfolio. Even if you are a risk-taker, limit your investments to credit-risk funds or other debt funds that have high exposure to low-rated funds, to 10-20 per cent (of your overall debt fund portfolio) at best.

If you are a conservative investor, exit debt funds that have very high exposure to low-rated bonds. The table below gives you a birds-eye view on funds with very high exposure to AA and below-rated bonds. If you are uncomfortable with the level of exposure and have a short-term horizon, exit the fund.

Check for large concentration

Aside from high exposure to low-rated bonds, also check for funds with high concentration. For instance, some funds have exposure as high as 30 per cent to a single bond paper.

Franklin Low Duration Fund has 10.79 per cent of assets (as of March 31) invested in a single paper issued by JM Financial Asset Reconstruction, and 7.93 per cent in ReNew Power. Franklin India Income Opportunities’s top holdings include Piramal Capital & Housing Finance (10.2 per cent).

High concentration towards a single bond can be risky, particularly in case of illiquid, low-rated bonds.

Investors should go for funds with wide diversification and low concentration. This can help mitigate the credit risk to some extent.

Look for sudden spurt in redemptions

Franklin funds have been seeing redemptions for a while now. The unabated outflows from its six debt funds led the fund house to ultimately close the schemes, despite having borrowings and credit lines.

Investors can look for similar signs of stress in their funds by looking at the portfolios.

For instance, in the case of most of the six Franklin debt funds, the cash component is negative. This implies that the fund has been borrowing from banks to pay off redemptions.

A continuous negative trend in the cash component can imply that a fund is seeing steady and large redemptions. This could be a warning signal for investors.

For instance, in the case of Franklin India Short Term Income Plan, the fund has a negative 17.7 per cent in cash as on March 31. Over the past month or so, the fund has seen a fall of about ₹1,300 crore in its AUM.

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