Was Franklin Templeton riding the tiger?
© Bloomberg News
The news broke on Thursday, 23rd April evening that Franklin Templeton India, the ninth largest mutual fund house of the country has decided to wind up its 6 fixed income debt schemes and starting April 24 existing investors in the scheme will not be able to withdraw their investments, make fresh purchases, do transfers to equity schemes or make systematic withdrawals. Investors were rattled and left shell shocked.
Most of the you might have seen advertisements of ‘Association of Mutual Funds in India (AMFI)’ on TV and in newspapers with their punchline ‘Mutual Funds Sahi Hai’ convincing people to start investing in Mutual Funds with even meagre amount of Rs 500/-. The advertisement also carries a warning that, “Mutual Funds are subject to market risks, please read the offer document carefully before investing.”
However, the truth is most of the people invest their hard-earned money either on the recommendations of their acquaintances or some ill-equipped financial advisors. Not even the financially aware people who have basic knowledge of financial markets try and look up the portfolio of investments in which they have invested.
What are mutual funds in general and their types?
You all must have heard an old saying, ‘Don't Put All your Eggs in One Basket’. Similarly, what happens if an investor with limited knowledge invests all his money in shares of single company or a single type of instrument? Such an act is not considered as investing but gambling. Therefore, in order to encourage small and retail investors to start investing in financial markets mutual fund schemes were launched. A mutual fund is like a basket in which securities with different liquidity, risk profiles, tenor, etc. are all placed together to reduce capital erosion risks. SEBI has laid down specific guidelines about specific type of securities fund managers are allowed to invest in specific funds depending on the risk profile chosen by the investors.
Mutual funds are of various sorts mainly Equity MF (invests mostly in equity shares of companies), Debt Funds (Investments ranging from safest form of government, PSUs and corporate bonds to riskiest form of low rated corporate bonds) and Pension Funds (Usually investments in low risk bearing govt backed securities and RBI treasury bonds, etc.). Mutual Fund Houses are regulated by SEBI and are strictly instructed to disclose risk profile and all other important facts of the Mutual Funds at all times.
What are debt mutual funds?
Following are some popular categories of debt mutual funds currently traded in the market:
Some interesting developments regarding liquidity risks in lieu of ongoing pandemic:
Although in the most advanced countries debt funds mentioned in S. Nos. 1 to 4 above are considered safest due to sovereign guarantee. But such sovereign guarantees can also default if a regime fails to manage the country’s finances properly. Last week, Argentina’s government proposed to its creditors to accept big losses in the value of the government bonds they hold, accept lower interest payments and wait for three years to redeem them.
Short-term bonds and corporate bonds are debts to highly rated corporates but what if a fund manager fails to recognize the health of corporates in whose bonds and debenture, he has invested the fund’s money? It is bound to fail. For example, auto sector all around the world was facing slump even before the pandemic, coronavirus further aggravated their situation. Now, in India companies such as Tata Motors, Mahindra & Mahindra, etc. have planned to announce NCDs to fix the cash flow imbalances caused by lockdowns. If auto sector has a bright future, those NCDs are worth investing but since the future is bleak any fund manager investing in those NCDs and bonds without caution may fail. This is just a guess and subject to what direction growth of auto industry goes.
Dynamic bonds funds and credit risks funds usually invest in low rated corporates who offer higher interest rates. Investors were attracted to credit risk funds as this category gave 200-300 basis points higher than what a fixed deposit would give. It’s like giving money to a person who instead of paying, demands more and promises to pay soon. The schemes wound up by Franklin belonged to this category.
Where did Franklin Templeton go wrong?
Franklin Templeton wound up the schemes and also gave a blow to investors’ confidence by declaring that the fund house will proceed to liquidate the assets of the scheme without resorting to any distress sale and there is no timeline to liquidate the schemes’ assets. The unit holders will be paid as and when the securities come up for maturity in the portfolio.
Santosh Kamath, the chief investment officer of Franklin Templeton India, is reported to be a high roller, who devised strategy to gain from investing in lower-rates securities which had paid off in the past outperforming his peers but backfired after the IL&FS blow-up in September 2018.
Franklin had exposure to most indebted groups or stressed promoters, including Anil Ambani’s Reliance group, Essel Group, DHFL among others. In addition, Franklin Templeton held nearly all of the zero-coupon bonds, a kind of debt, of Yes Capital, run by Yes Bank co-founder Rana Kapoor. Kamath completely ignored the ‘liquidity risk’ factor while taking such decisions and when the redemption pressure mounted Franklin Templeton simply decided to wind up the schemes and ask investors to wait indefinitely for redemption.
When fund managers go aggressive with a vast scale of assets under their management, quality is bound to worsen. SEBI via circular dated 28th December 2018 permitted mutual fund houses to create segregated portfolio in mutual fund schemes which comprised of money market instruments affected by a credit event in order to ensure fair treatment to the investors. A step taken by SEBI just after IL&FS financial crisis is welcome and understandable.
Therefore in simpler terms, higher the number of segregated portfolios or side pockets in a fund, greater the liquidity risk and therefore is a definite indicator of poor risk assessment and investors should avoid such funds. All the 6 credit risk debt funds shut down by Franklin Templeton had on an average 2 of such segregated portfolios or side pockets (see image), a clear indicator of poor investment decision by fund manager.
Is it a one-off incident or just the tip of the iceberg?
Many investors are afraid as if it is just a one-off event or there are more to follow. Just after the announcement was made by Franklin Templeton, all the major fund houses called up and mailed their clients assuring that their investments are safe and have enough liquidity if they seek redemption immediately.
As discussed above, debt funds other than those which include investments in government securities, treasury bills, bonds and NCDs of PSUs, etc., which have invested in low rated corporate securities, co-operative banks, NBFCs and other similar institutions are at risk.
BOI AXA mutual fund has recently marked down various debt schemes from 50 to 100 per cent due to exposure to corporates like DHFL, Avantha Holdings, RKV Enterprises, Coffee Day Natural Resources among others. As per Value Research Online, out of 20 debt mutual fund schemes, 11 schemes have provided negative returns.
Many debt mutual fund managers had invested heavily in NBFCs, HFCs and real estate firms. However, after discovery of multiple financial frauds in IL&FS (a real estate firm), negligent working style of finance companies came under lens, as a consequence of which bankers and debt mutual funds started reducing their debts to such reckless financing companies. Due to ensuing job cuts and absence of any furlough scheme in India, employees and workers are likely to default on their upcoming housing finance instalments due in next 12 months. Another, serious concern is advances to real estate firms which may suffer cash flow problems in near future due to similar reasons, although direct exposure to real estate firms is under control. (see chart below).
Mutual fund houses reassured that they have enough liquidity, but these assurances might not hold ground once those corporates in whose bonds they have invested starts defaulting. Exposure to NBFCs is another serious concern as layoffs are happening at a large scale resulting in default of corporate as well individual borrowers’ instalments to NBFCs. NBFCs which were already in cash crunch are in turn going to default in interest and loan repayments to these debt mutual funds. As a result, it would be difficult for the fund house to liquidate assets in the current market environment and at such compressed valuations. They will try to make the payments in a staggered manner through portfolio maturities, coupon and pre-payments, once the borrowings in the funds have been paid back.
Calling this as a one-off incident may not be true especially when already stressed corporate sector and NBFCs which were not prepared for another crisis which came in the form of pandemic. We are in the middle of probably the worst economic and financial crisis in recorded history and it is hard to project how badly companies will be hurt by the economic lockdown and its aftermath. GDP growth projections by IMF are not bright and god knows how many industries either would be engulfed by larger competitors or will simply go bankrupt. Therefore, considering all these uncertainties, it is hard to gauge the future of liquidity risks associated with corporate debt funds.
What lies ahead?
Bankers are facing the double whammy of
1) advancing money to such debt mutual fund houses, and
2) advancing money to HNIs and retail investors against such debt mutual fund products as collateral.
Bankers are worried that will its fund house clientele be able to honour their redemption commitments amidst great surge in redemptions by investors from credit risk debt mutual fund schemes. On the other hand, bankers are also worried on default of loans advanced to HNIs and retail investors against such debt mutual fund products as collaterals and therefore have asked such investors to replace existing collateral and top up margins to secure their advances.
Bankers are trying to assess the liquidity gap their mutual fund clientele can face due to rise in redemption. Even, SEBI and RBI has sought details from the mutual fund houses about their liquidity positions of their debt schemes’ portfolio, as Franklin’s decision has spooked the investors which will result in mass redemption from similar product categories across the industry. Both, SEBI and RBI wants to know whether mutual funds would be able to handle probable mass redemption. RBI had sought details on the ‘lines of credit’ used by asset management companies and the ‘undrawn lines’ for March 31 and April 24. Normally, mutual fund houses are allowed to borrow up to 20% of their assets from banks for six months to meet redemption and other pay-out demands and a fund house on basis of merit can borrow up to 40%. It is a good sign that majority of the funds have not even utilised the 20% limit, but this sign may be temporary depending on attitude of bankers towards such reckless debt fund managers. If bankers are not comfortable with fund manager’s conduct or they don’t have enough merit, they may squeeze the unutilised credit lines to such mutual fund houses sanctioned earlier.
Since, the times are tough government and regulatory bodies have to come forward to avoid another crisis during an ongoing crisis. Some experts have suggested that the government and RBI shall create a fund like the Troubled Asset Relief Programme (TARP), similar to one created by the US during the 2008 financial crisis, to buy the illiquid assets that MFs and other investors are stuck with.
SEBI and RBI taking stock of the situation after Franklin Templeton decided to scrap its six debt schemes and taking investors by surprise is a wake up call on how regulatory bodies are failing in fulfilling one sole objective of serving as a watchdog to their citizens. A watchdog should be proactive not reactive to events. Further, RBI has offered liquidity line of Rs 50,000/- crores to the mutual fund houses when they still have unutilized sanctioned credit limits with their banks. Instead of creating a bailout package for MSMEs, such a haphazard allocation of Rs 50k crores by the Finance Ministry and RBI shows lack of insight and has led to mishandling of taxpayers’ money.
How investors should prevent themselves?
Many people who invest in financial markets are either investing in financial instruments on the recommendations of their acquaintances (who may not have enough experience of the field) and financial advisors (whose quality and integrity vary greatly). This is not an attack on any sort of financial advisory firms but one thing on all must agree equivocally is awareness of one’s own investments. Following practises can help investors to avoid surprises market has for them:
Choose a financial advisor based on merit not merely because he is an close acquaintance: The first mistake people commit is give their finances to a person who is either a close acquaintance or close acquaintance of someone you know may be from neighbourhood, work, etc. One must strictly choose financial advisor based on merit or a strong recommendation. One must also vet the background of the person who has recommended you that financial advisor. If his investment practices are good enough then maybe he has a good recommendation too.
Know your portfolio: Merely choosing a sound investment advisor isn’t enough. One must also be aware of their portfolios, their holdings, etc. Not knowing your investment details is like giving money to a reckless bank who advances to everyone who shows up at their door.
Stay in touch with your financial advisor: Once, you are aware of your investments you must keep yourself abreast of basic developments happening on a daily basis and how those events are going to impact their portfolio of assets in the long and short term.
Financial markets are riskier than ever as in the current scenario fundamentals are thrown out of the window and the market operators are ballooning the stock market. As one prominent wall street expert commented that, ‘Today the global economy is witnessing job losses on a vast scale, no signs of a immediate rebound and the worst economic depression since 1930s, but the stock markets are rising. It seems that the markets have divorced the fundamentals.’
 Franklin Templeton to Wind Up 6 Fixed-income Debt Schemes by Prashant Mahesh, ET, 24/04/2020  Motown Takes Corporate Bond Route to Raise Funds by Nehal Chaliawala, The Economic Times, 29/04/2020  What happened at Franklin Templeton and what that means for Indian mutual funds by Rohan Venkataramakrishnan, Scroll.in, 29/04/2020  Debt funds are facing the heat due to increased risk of defaults by NBFCs by Sanket Dhanorkar and Narendra Nathan, The Economic Times  Wary Banks Review Credit Lines to Funds by Sugata Ghosh, The Economic Times, 27/04/2020  Credit Risk Funds Lose a Fifth of Their Assets in Just 3 Days by Prashant Mahesh, The Economic Times, 30/04/2020  Lenders Seek Top-ups, Replacements for Debt Schemes Given as Collateral for Loans by Rajesh Mascarenhas & Saikat Das, The Economic Times  Sebi, RBI Take Stock of Situation by Nishanth Vasudevan & MC Govardhana Rangan, The Economic Times, 27/04/2020