As a result of the higher risks taken in the chase for yield, credit defaults that were earlier rare became increasingly commonplace
The closure of six “yield-oriented” debt schemes by Franklin Templeton marks the culmination of a process that has been under way for a few years now and not just the past couple of months. While things may have come to a head because of the health-inspired shutdown of the economy over the last month or so and the expected credit deterioration, payment delays and general risk aversion, it is completely misguided to assign all blame to these.
The decision to take credit risk is not one that can be taken lightly. It is a risk with negative asymmetry which means that one stands to lose a lot more if one is wrong than one stands to gain if right. And while probabilities are often used to portray that these risks can be measured and forecast scientifically, unless one is able to predict the future of a complex organisation with a high degree of accuracy, these measurements and forecasts are relevant only in theory and academia. In practice, the chance of each credit decision being either right or wrong is 50 percent. And even this needs a marketplace that is free from perverse incentives and all possible conflicts of interest. Unfortunately, the credit risk marketplace is not.
It is often said credit performance relies on both the ability and the willingness of a borrower to pay back debt. And while the regulatory framework surrounding the issuance of debt instruments is designed to ascertain the former, investors have nothing but history to ascertain the latter. And history does not always repeat itself. Even if we assume it does, there are a precious few borrowers who stand out as having consistently honoured their commitments.
Seen from this perspective, the taking of credit risk in the open-ended debt mutual fund structure was only justified till such time that such instruments were a small part of a larger portfolio. This not only restricted the total amount invested in such instruments, which allowed the managers to choose their credit risk carefully, but also ensured that individual investor exposure was limited. Even when dedicated credit risk funds were first launched, it was with the intention of addressing the needs of a small cross section of aware investors, both individual and institutional.
However, after a few happy years of existence in which the relatively small amounts invested in these funds generated higher returns without any significant negative credit event, retail investors observing these started to believe there was a free lunch. This impression was encouraged by distributors and fund houses alike, which saw it as a win-win situation. After all, the higher yield from these portfolios allowed the asset manager to earn a reasonable fee, the distributor to earn a reasonable commission and the investor to still earn a higher return compared to alternatives.
The resultant flow of money into these funds washed away the asset managers' ability to choose credits carefully. As a result of the higher risks taken in the chase for yield, credit defaults which were quite rare in the early years, became increasingly commonplace. The beginning of the end of this product segment had started.
The last few years have frequent instances of credit defaults which have reduced the returns delivered by these funds even as the credit quality of their portfolios deteriorated. The latter also meant that the portfolio liquidity suffered. However, till such time these funds were able to attract fresh investor inflows, fund level liquidity was managed despite low portfolio liquidity. When investor flows eventually reduced, fund level liquidity also disappeared. Franklin Templeton is just the first asset manager to acknowledge this. So, what should an investor do now?
Investors with an exposure to dedicated credit risk funds would do well to not panic. Panic has never made a situation better and while this is easier said than done, it is by far the most sensible approach. The distributor fraternity would do well to hand-hold investors through this time.
And even as other asset managers reach out to assure investors that debt funds in general and their products in particular are safe, they also need to find a way out of this for their investors and themselves. The asset management industry has the means and the ability to prevent this from becoming a crisis.
The one suggestion that would provide immediate relief as well as a sustainable solution would be for asset managers to merge their dedicated credit risk schemes with other schemes that have a better credit quality portfolio to restore the balance that once existed. This needs to be done quickly, before a large cross section of investors lose faith and panic.
Of course, the long-term sustainability part of this would need the industry to swear off this product category for good. This is something that has been in the making for some time, but if there was ever a time to do this, it’s now.(Rajiv Shastri is the former CEO of Essel Mutual Fund and a debt market specialist. Views are personal.)