Lisa Pallavi Barbora
Late on Thursday night, news broke that six debt schemes from Franklin Templeton Mutual Fund are being wound up. Hitherto open-ended schemes, they will now not allow any fresh investments and any exits. What’s left in the schemes remains. As and when securities get sold, investors will get proportionate money back. Only high-risk situations warrant such a move. Hence, it’s hard to be too optimistic about the extent of recovery from individual securities.
This is not one or two or even three schemes, six schemes which have been closed for investors with the objective of winding them up. Then, there is also the Dynamic Asset Allocation Fund of Funds which invests in one of these schemes for the debt allocation.
The management had indicated COVID-19 outbreak as the trigger for redemptions. However, outflow in assets under management (AUM) for the six schemes started in the last quarter of calendar 2019 itself. Perhaps the exposure to Essel Group companies across these schemes was the trigger. By December-end, AUM for four of these schemes was lower by 15-30 percent.
Then, came a wave of markdowns through the first quarter of 2020, resulting in creation of at least one or more side pockets or segregated bad asset portions for all of these schemes. AUM kept declining. The COVID-19 outbreak was the final nail in the coffin, AUM fell another 15-30 percent in a month.
A highly static bond market, illiquid securities, no regulatory guidelines on risk management and scared investors are a heady cocktail to digest. COVID-19 undoubtedly is an external event that sped up the verdict, but chances are this would have happened sooner or later.
The management cites a sound underlying portfolio, shifting cause to a liquidity event rather than a credit issue. Five out of the six schemes have been delivering flat to negative one-year return since January 2020; the accrual part of the portfolio is not helping investor return so far. This is not a one-time negative liquidity adjustment issue that liquid funds faced; it’s been consistent for slightly over three months.
Post closure, there will be no cash flows and perhaps the accrual strategy will take over. But how does the investor gain? Winding up means the fund has to find buyers and liquidate securities to return money. In the absence of secondary market selling, focus is on the ability of the underlying companies to repay principal at maturity. If cash flows are an issue, they can simply request a rollover of the debt and the fund house won’t have much choice but to accept.
Bond fund risk – credit and liquidity – is something we used to speak about in abstract a few years ago. Over the past two years, several concrete examples of these risks playing out have spoilt one for choice. What has happened at Franklin Templeton is really the worst-case scenario. The way it has now played out looks highly like a liquidity problem as redemptions flooded the schemes, but it was always an underlying quality and credit issue. It’s not unreasonable to see that market participants are risk averse in a high-risk market situation like today.
Which brings us to questioning the risk management guidelines that govern the industry. Creation of side pockets addresses a lot of the issues by segregating the good and the bad portfolio. What happens when one or six entire schemes become side pockets?
Managing credit risk funds is not a new strategy for Franklin Templeton, it has been doing this for over a decade with an experienced team. When the credit cycle is positive and businesses are not dealing with cash flow problems, high yield portfolios remain in vogue. These were positioned to retail investors as long-term debt allocation. It was thought that secondary market illiquidity of the underlying securities will not be a problem where a majority of the AUMs are sticky, likely to remain invested for years. The distress of the credit cycle has been apparent to the lay person since the IL&FS default, nearly two years ago. There were several signals, several reasons for reconsidering strategy in the current credit cycle.
As the credit market worsened, why not improve the credit risk funds’ ability to absorb higher levels of redemption by adding more high quality, liquid securities over a period of time? Perhaps, it was already too late to sell illiquid securities in 2019.
What if there were regulatory guidelines to do this just like they exist for liquid funds, then could a changed strategy get implemented at the fund house? Capital markets regulator SEBI (Securities and Exchange Board of India) has mandated only liquid funds to keep a minimum 20 percent in liquid assets to meet redemption pressures.
Not much attention has been paid to credit risk schemes or rather the idea of credit risk. In the recategorisation process, SEBI gave guidance on the level of duration risk in at least 10 types of debt funds, but defines the credit risk level in just two of 16 categories. Thus, in the 10 defined duration categories, there can be any amount of credit risk.
Franklin India Ultra Short Bond Fund in compliance with regulation has an average maturity of just 0.62 years, but 93 percent of its current portfolio is non-AAA rated. An investor who wants to park money for 3-6 months in an Ultra Short Fund may have chosen this one for its high portfolio yield of 10.5 percent, but is now indefinitely stuck. To begin with, should 3-6-month money have been allowed in a portfolio that was illiquid? After all, the state of secondary market for Indian bond is not a secret.
Mutual funds are pass-through instruments; risks are to be borne by the investor. But what happened to fiduciary responsibility of the fund managers? SEBI has the ability to question whether this has been adhered to or not. What is the cost of going overboard at the risk of investor return and who will collect that cost?
Franklin Templeton has been upfront about its credit risk strategy from the word go. We were all convinced that it works, when performance was at a peak. Unfortunately, over the years, investing in mutual funds has been about chasing return. Fund managers are celebrated, even rewarded for return performance, distributors sell what is on top of the return charts and investors buy into the glory. Risk conversations invariably get over shadowed.
Investors must understand that this is the precise downside of a credit risk strategy, you can lose all your money, there are no guarantees, no matter what the fund manager says. In a way, most investors in the Franklin India funds understood the risk recently and exercised their sensibility the only way they could, by redeeming.
Some say closing the schemes is a good decision for retail investors. It’s unclear how, if short-term money is inaccessible indefinitely. The harsh reality is that whether the funds are closed, wound up or left as they are, the penalty of making bad decisions falls on investors not fund managers.(Lisa Pallavi Barbora is a freelance writer. Views are personal.)