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How Franklin Templeton crisis nudged debt mutual funds to take lesser credit risks

Up until early 2020, debt funds, even other than credit risk funds, were used to investing in lower-rated securities to get a kicker in returns. But after frequent defaults and the Franklin Templeton crisis in April 2020, debt fund managers have become more careful

May 11, 2022 / 11:16 AM IST
From around 2018, debt mutual funds were rocked by frequent defaults by securities where many such funds had invested in. The crisis peaked in April 2020 when Franklin Templeton India wound up six of its debt funds because it couldn’t sell most of its underlying lower rated securities. Ever since, the capital market regulator, Securities and Exchange Board of India (SEBI) launched many measures to curb the risks that debt funds can take. And at the same time, made them more transparent. In the meantime, mutual funds too brought down their exposure to the lower-rated bonds across portfolio of their debt schemes over the last two years. Moneycontrol looked at 16 categories of debt funds (only open-ended) to check how the credit profile in debt funds changed over the years. Source: ACEMF.
From around 2018, debt mutual funds were rocked by frequent defaults by securities where many such funds had invested in. The crisis peaked in April 2020 when Franklin Templeton India wound up six of its debt funds because it couldn’t sell most of its underlying lower-rated securities. Ever since, the capital market regulator, Securities and Exchange Board of India (Sebi) launched many measures to curb the risks that debt funds can take. And, at the same time, made them more transparent. In the meantime, mutual funds, too, brought down their exposure to the lower-rated bonds across portfolio of their debt schemes over the last two years. Moneycontrol looked at 16 categories of debt funds (only open-ended) to check how the credit profile in debt funds changed over the years. Source: ACEMF.
The narrowing of spreads between government securities and corporate bonds of similar tenures, over the last 15-18 months, played a key role in nudging mutual funds to shift to higher-rated bonds. Spread is the difference in yields offered by higher-rated and lower-rated securities with same tenures. A lower-rated security offers a higher yield to compensate for its poor credit rating. But if the yield is significantly higher that what a higher-rated security offers, then the spread (the difference in yields) is high. That’s the time when some fund managers get an incentive to buy lower-rated securities, to justify the risks. But during the period of narrowing spread, fund managers prefer holding more G-secs. Lakshmi Iyer, Chief Investment Officer (Debt) & Head Products, Kotak Mahindra AMC says, “Up until 2020, the spreads were wide. But since 2020, we have seen a huge spread compression in AAA versus non-AAA assets as also G-sec versus AAA. Hence some shift towards G-sec”.
The narrowing of spreads between government securities and corporate bonds of similar tenures, over the last 15-18 months, played a key role in nudging mutual funds to shift to higher-rated bonds. Spread is the difference in yields offered by higher-rated and lower-rated securities with same tenures. A lower-rated security offers a higher yield to compensate for its poor credit rating. But if the yield is significantly higher than what a higher-rated security offers, then the spread (the difference in yields) is high. That’s the time when some fund managers get an incentive to buy lower-rated securities, to justify the risks. But, during the period of narrowing spread, fund managers prefer holding more G-secs. Lakshmi Iyer, Chief Investment Officer (Debt) and Head Products, Kotak Mahindra AMC says, “Up until 2020, the spreads were wide. But since 2020, we have seen a huge spread compression in AAA versus non-AAA assets as also G-sec versus AAA. Hence some shift towards G-sec.”
A report on “Performance of ICRA-Assigned Ratings in FY2022” by rating agency ICRA indicates that the credit quality of India Inc. improved in FY2022 after two consecutive years of slowdown in economic growth and the Covid-19 pandemic. As businesses and policymakers adapted to the challenges, and as the economic repair-work progressed, credit risks went down. As a result, fewer companies got downgraded (just 6 percent out of 184 companies) in FY2022 as opposed to previous years (13 percent in FY2020, for instance). Value of bonds increases when the rating of bonds are upgraded. Mutual funds too benefitted from such capital appreciation.
A report on 'Performance of ICRA-Assigned Ratings in FY2022' by rating agency ICRA indicates that the credit quality of India Inc improved in FY2022 after two straight years of slowdown in economic growth and the Covid-19 pandemic. As businesses and policymakers adapted to the challenges, and as the economic repair-work progressed, credit risks went down. As a result, fewer companies got downgraded (just 6 percent out of 184 companies) in FY2022 as opposed to previous years (13 percent in FY2020, for instance). Value of bonds increases when the rating of bonds are upgraded. Mutual funds too benefitted from such capital appreciation.
Mutual funds that had kept as cash equivalents were deployed into the highest rated debt instruments especially in the short end of the curve over the last 2-3 months. “Lot of incremental flows have been in low to moderate duration categories, hence MFs preference for shorter maturity assets” adds Iyer. Mutual funds flocked into money market instruments such as Certificate of Deposits (CD) and Commercial Papers (CP). “All short term rates, including CDs have been inching up in response to RBI measures. We saw introduction of SDF by RBI in April, which led to shoot up in CD rates. Then we saw an off cycle repo rate and CRR hike which will further impact CD rates on the higher side. We expect further inch up in short end rates in response to the sudden rate hike decision by RBI” Iyer explains.
Mutual funds that had kept as cash equivalents were deployed into the highest rated debt instruments especially in the short end of the curve over the last 2-3 months. “Lot of incremental flows have been in low to moderate duration categories, hence MFs preference for shorter maturity assets,” says Iyer. Mutual funds flocked into money market instruments such as Certificate of Deposits (CD) and Commercial Papers (CP). “All short-term rates, including CDs have been inching up in response to RBI measures. We saw introduction of SDF by RBI in April, which led to shoot up in CD rates. Then we saw an off cycle repo rate and CRR hike which will further impact CD rates on the higher side. We expect further inch up in short end rates in response to the sudden rate hike decision by RBI” Iyer explains.
Credit risk fund category topped the list as it held around 34 percent of the industry assets that kept in the lower rated papers (as of March 2022). Medium Duration, Short Duration and Low Duration categories held 18%, 12% and 11% of their AUM in the lower rated bonds. Following charts explain the trend in the major debt categories on allocating to different credit profile assets over the last two years.
Credit risk fund category topped the list as it held around 34 percent of the industry assets that kept in the lower rated papers (as of March 2022). Medium Duration, Short Duration and Low Duration categories held 18 percent, 12 percent and 11 percent of their AUM in the lower rated bonds. Following charts explain the trend in the major debt categories on allocating to different credit profile assets over the last two years.
Most of the schemes in the Ultra Short Duration Funds category had allocated significant portion to the bonds rated AA & Below prior to 2020. But after the Covid-19 illiquid markets’ scare, most of them pruned their exposure to the lower rated securities then and increased allocation to highest rated papers and G-secs.
Most of the schemes in the Ultra Short Duration Funds category had allocated significant portion to the bonds rated AA and Below prior to 2020. But after the Covid-19 illiquid markets’ scare, most of them pruned their exposure to the lower rated securities then and increased allocation to highest rated papers and G-secs.
Since duration based funds has no restriction to allocate to lower rated bonds, many of them prefer allocating to these assets to get a kicker in returns. Among the low duration fund category, Baroda BNP Paribas Low Duration, Aditya Birla SL Low Duration, Mahindra Manulife Low Duration and PGIM India Low Duration held some portion into AA and below asserts.
Since duration based funds has no restriction to allocate to lower rated bonds, many of them prefer allocating to these assets to get a kicker in returns. Among the low duration fund category, Baroda BNP Paribas Low Duration, Aditya Birla SL Low Duration, Mahindra Manulife Low Duration and PGIM India Low Duration held some portion into AA and below asserts.
Among the short duration fund category, Mahindra Manulife Short Term, IDBI ST Bond, Aditya Birla SL Short Term and ICICI Pru Short Term held some portion into AA and below asserts.
Among the short duration fund category, Mahindra Manulife Short Term, IDBI ST Bond, Aditya Birla SL Short Term and ICICI Pru Short Term held some portion into AA and below asserts.
Most of the medium duration funds have certain portion of their portfolio allocating to AA and below rated papers. Few schemes that held relatively higher allocation to the AA and below rated papers include Aditya Birla SL Medium Term, ICICI Pru Medium Term Bond, Axis Strategic Bond, HDFC Medium Term Debt and UTI Medium Term fund.
Most of the medium duration funds have certain portion of their portfolio allocating to AA and below rated papers. Few schemes that held relatively higher allocation to the AA and below rated papers include Aditya Birla SL Medium Term, ICICI Pru Medium Term Bond, Axis Strategic Bond, HDFC Medium Term Debt and UTI Medium Term fund.
Dynamic bond funds have leeway to churn among across maturities and various rated bonds at any period of time as per fund manager’s conviction. Few schemes that held relatively higher allocation to the AA and below rated papers include Aditya Birla SL Dynamic Bond, ICICI Pru All Seasons Bond and UTI Dynamic Bond fund.
Dynamic bond funds have leeway to churn among across maturities and various rated bonds at any period of time as per fund manager’s conviction. Few schemes that held relatively higher allocation to the AA and below rated papers include Aditya Birla SL Dynamic Bond, ICICI Pru All Seasons Bond and UTI Dynamic Bond fund.
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Post the franklin debt fund crisis, the minimum required allocation to AA and below rated papers by credit risk funds has been made to 58.5 percent (excluding the mandatory liquid holdings) from 65 percent. Kotak Credit Risk, Baroda BNP Paribas Credit Risk, L&T Credit Risk, UTI Credit Risk and IDBI Credit Risk fund were few schemes that held relatively higher allocation to the AA and below rated papers.
Dhuraivel Gunasekaran
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