Let’s face it. Franklin episode is no default, but a mere postponement

J N Gupta

The current state of investors and depositors in the Indian financial market -- or for that matter, elsewhere -- is akin to that of Abhimanyu in Mahabharata, who caught in a chakravyuh struggled to find a way out.

Liquidity, returns, diversification, risk and safety are key elements of creating and managing savings and investment portfolio for any investor. Often, an investor compromises on one element for something better in the rest. In our memory, never before was there a situation where all elements across asset classes went through pain.

Nothing appears to be safe now -- be it real estate, equities and debt -- not even bank deposits. The risk-averse were choosing bank deposits for safety and liquidity, compromising returns. However, the developments at PMC Bank, Yes Bank and many PSU banks have put this notion of safety and liquidity to test.

Depositors realise that banks are no more safe havens beyond what is guaranteed under the deposit insurance provision. As for PMC Bank depositors, their money is apparently safe, but illiquid.

Similarly, stock markets these days are a scary proposition for the weak-hearted and the retired who survive on regular returns.

On the face of it, mutual fund (MF) debt schemes offered safety -- thanks to regulations mandating excellent credit rating of underlying securities -- diversification of portfolio and above all, trust that investors are handing over money to a credible and well-equipped team. But when the investor finds out that the redemption period has changed from ‘T+3 days’ to ‘T+3 years’, where should one go?

In investment language, T is the transaction date when one buys or sells a stock or redeems MF units. T+ X is the settlement date, where X is the time unit.

The recent closure of Franklin Templeton’s six debt schemes has come as a rude jolt for investors, which sent shockwaves through the MF industry, too. The funds aggregating more than ₹25,000 crore are said to have bitten the dust because of liquidity crunch. It’s the timely action of the Reserve Bank in providing a liquidity window for MFs that saved the day and averted a contagion, for now.

According to Franklin, the decision to wind up the funds in question has been taken in light of a sudden increase in redemption pressures and worsening liquidity issues.

To be fair, no one could have visualised the present situation. That’s why Franklin cannot be solely blamed for this fiasco. The schemes had invested in debt instruments of various companies that were apparently doing good before the COVID-19 attack and there was no panic in the market.

So, what went wrong and what structural changes are required? But before that, we must examine what it all means for investors.

First, three basic factors.

Returns: Investors are going to be unaffected on the returns front as long as all the bonds are held till maturity, unless there is a default.

Safety: Once again, there is no change in safety of investors’ funds so long as there is no default in payment of principal or interest. But uncertainties have increased and whether all the issuers of debt securities in these schemes would be around to pay back on maturity is anybody’s guess. Therefore, investors may be better-off being happy with a bird in hand (cash today) rather than many in the bush (promised maturity + interest). Unfortunately, one does not have any bird in hand.

Liquidity: This has been severely impacted and hurts those who want to exit. And that seems to be the trigger point for Franklin.

To be fair, the debacle has nothing to do with Franklin’s investment judgement. This is especially so when the objective of these schemes was made clear to investors beforehand, who were aware of the high risks. Additionally, the portfolio had been disclosed to them with the declaration that the investment would be in bonds not AAA rated.

So, it is not a default-like situation, but a postponement. Whether investors understood the risks or not is a different topic altogether and brings us back to the perpetual issue of investor education.

The bigger question is, can Franklin be given a clean chit? The answer is, probably not.

How it all happened then? The mess at Franklin broadly has three components.

• The lockdown: This has altered almost every projection, calculation and financial health for each one of us. None has any answer or solution to this. Hence, that discussion is for some other day.
• Systemic or structural pain: There is a problem of liquidity in the bond market, which got accentuated due to COVID. There is no regular system of providing liquidity. The current state of affairs is somewhat comparable to August 2008. Unfortunately, the same problem persists. While the industry has grown in the past 12 years, nothing seems to have changed on the ground.
• The fund-level problem: All said, Franklin cannot avoid close scrutiny on this count though other two problems may have played a critical role.

Bond market liquidity: It’s a mirage we have been chasing for the past three decades. That Franklin ignored the fact is a big mistake. Agreed, COVID has caused tremendous distress, but liquidity issues have hurt us before and will continue even after the pandemic. In hindsight, this vital aspect was overlooked while designing the product.

Product design: No level of sensitivity analysis could have budgeted for COVID-like contingencies. Still, it is imperative that MFs now must have a framework in place to budget for extremities.

The oxymoron? When we expect privately placed large-ticket bonds of non-descript companies to be liquid, it may sound as an oxymoron. The fundamental requirement of liquidity is broad ownership. This is where Franklin failed miserably as many issuer companies are non-descript. A related point is finding liquidity in illiquid bonds.

Most of these bonds are large ticket ones, hence small and retail investors are left out. Plus, other MFs, insurance companies and FIIs (foreign institutional investors) could not invest as the papers are not AAA rated.

Heat on credit rating:  Of late, credit rating agencies (CRAs) have been the favourite whipping boys for almost everyone -- probably for the right reasons. Many of them have found themselves at the receiving end after their failures at IL&FS, DHFL, Yes Bank, Ricoh and Amtek Auto, just to name a few. There is no gainsaying the fact that CRAs need to be credible, going forward. Their users must realise that credit rating is to supplement and not supplant their decision making.

In the final analysis, we must acknowledge the contribution of the MF industry in channelising investment and making Indian capital market what it is today. Therefore, one-off cases like Franklin’s cannot be seen as representing the entire industry.

Now is the time when the industry and the regulator must work hand in hand keeping growth objective intact. Let’s not waste this crisis to usher in reforms to ward off such threats in future. At the same time, CRAs need to know they are under watch. Our next note will dwell on shortcomings of a sample rating and the process involved.

J N Gupta is co-founder and Managing Director of Stakeholder Empowerment Services. Views expressed are personal.