Last evening Franklin Templeton decided to wind up six of their debt schemes. The details of the schemes and closure are all over the place.
Many investors do not understand what this means, why this happened, and what to do now, and what should one do about the other mutual fund schemes in their portfolio. So let’s take a deep breath. This will be a bit long.
And as usual, I will try to write with as little jargon as possible. Debt Mutual funds are schemes as which invest in the debt of companies, government, and other entities. It is supposedly and inherently less risky than equity mutual fund schemes.
Franklin Templeton is a fund house with over 25 years of presence in India. And it is no small fry. So this is a very serious unprecedented event. First, let’s understand what closure of these six debt schemes mean. They were open-ended schemes.
Which means you can invest every working day and redeem as well.
• With this winding down for investors in this scheme they cannot redeem from those schemes right away. They will not get their money immediately.
Does it mean they will lose all their money?
• No. It does not mean that. They may have to bear a loss but how much, time will tell. No use guessing right now. Why is franklin not spelling it outright we will see in later paragraphs.
When will they get their money?
• That depends on Templeton. It will be clearer in the coming days.
Is my money in other Debt Mutual funds safe?
• There is always a risk in investing. No one can say with a 100% guarantee that all monies in every instrument or an entity are safe. Because of the state of the world risks are heightened and some businesses will fold up. Depending on your profile and risk-taking capacity a call has to be taken. I am not recommending to redeem all debt funds.
Is it Franklin’s fault? Why did this happen?
It is hard not to blame Franklin Templeton’s management team. Investors entrusted their funds to them and now they say that they don’t know when and how which will they payback. But the biggest losers are they as this a virtual suicide of sorts.It will be very hard for them to recover from this debacle. They were not prudent and got a bit unlucky as well.
But,
This decision to wind down has been taken to do what they believe is best for the investors given the situation they find themselves in.
So how did this happen?
As I have explained in my earlier posts a debt mutual fund is mutual funds which invest in the debt of companies which is mainly traded. Open-ended means that some investors are investing and some are redeeming on any given day depending on their own needs.
Typically schemes have a portfolio of assets and some cash to meet normal redemptions. If the redemption is higher than the inflows and the cash in the scheme hold then either the fund manager sells something or borrows for a day or two to meet as they are obliged to pay all valid redemptions.
Now with Franklin, what happened is that they were getting continuous redemptions and no inflows. They sold bonds and also borrowed to meet redemptions. There is a limit of 20% of the schemes Assets Under management that they can borrow from banks. They did that as well. But the redemptions have continued unabated. They can meet redemptions right now but they realized that their ship is sinking and are now trying to plug the hole and look for some lifeboats.
Why did their situation get so dire while other mutual funds are still afloat?
For this, we need to understand that every scheme and every fund manager’s style of operating is different. Franklin’s debt fund managers were aggressive and decided to take a higher risk to get a higher return for his investors. These bonds are called high yielding or lower-rated bonds.
Typically higher the rating of the borrower, lower is the interest rate charged to them. To make it simpler. If today you or I went to a bank to borrow say 1crore, first of all, they may reject us outright. Or they will make us sign at 100 different places, take guarantee of stuff worth at least 2 crores. Ask us 10,000 questions on how will we payback and then maybe give us the loan at 10-15% interest.
But Mukesh Ambani can go in and borrow 1 crore by just walking in and waving a hand. At maybe half our cost. It’s a simplistic example to explain a point. He is AAA, I am probably a BBB borrower. So, depending on the financial might and the profile of the company they are rated an accordingly lent to. This is a normal business of a Bank or an NBFC.
Mutual funds started getting a lot of money and fund houses started having their credit teams and lent to all types of borrowers. If they take proper collaterals and take proper due diligence they could earn a higher interest which they could give to their investors. As a sidekick, they could also charge a higher management fee if their assets increased. This was great while the going was good. It was a known fact that Franklin takes a higher risk but also gives high returns and also attractive commissions.
Investors were happy and so was every other stakeholder.
Unfortunately in the aftermath of IL&FS debacle many companies starting failing. Some due to regulatory issues, some due to bad luck, and some as normal businesses fail. Franklin’s name was present as an investor in many of the failed entities.
Mutual funds are not capitalized.
It means they don’t have their capital. All profits are passed through after expenses to investors. So are the losses. Banks also have loans going bad. But they have their capital so it does not get passed normally to investors. Eg: Yes bank. But sometimes they do. Like PMC bank. Why? That is a story for another blog.
Larger investors enjoyed the higher returns in Franklin s schemes but slowly started redeeming over some time as they felt that the risks were higher and the number of segregated portfolios which were troubled assets started increasing. This is also not a problem normally. You lose customers. You sell bonds from your portfolio, pay them, your fund size shrinks and it’s ok. You can gain back the customers some other time and reclaim the lost AUM. You get the gist.
The risk perception of Franklin was not very good and then came COVID. Typically a large number of inflows into equity funds can be via a SIP but debt funds are mostly lump sum. So post COVID inflows stopped into Debt Mfs. Redemptions were higher as corporates and individuals were retaining cash to meet expenses.
Debt markets are not as illiquid as they are made out to be. But yes, post-COVID activity is and was lower. One is that people want to keep cash for their own needs. Secondly, if times are bad they did not know who will stay afloat. So they adopted the COVID mantra, stay safe.
If you are a bank or an MF, at times like this who will you lend to? Me or Mukesh Ambani? No one will touch me with a barge pole. So all money started flowing towards AAA entities. I know that I am a good credit. And I am willing to pay higher interest. The lenders have a lot of money but they don’t want to touch me as they cannot differentiate between me and a rag picker and won’t take a chance.
So Franklin had a higher percentage of lower-rated borrowers in their schemes as well as had good quality ones. To meet redemptions they sold all the Muktesh Ambani’s. Borrowed as much as they could. Now they are left with a lot of lower-rated bonds and a high percentage of unlisted ones that cannot be sold as the regulator came up with a rule in September 2019 that they cannot be sold. Now before they default, they decided to close down the schemes as that was the only option for them.
With the closure, they won’t have to deal with the redemptions. They will realise the value of the portfolio as now there is no pressure on them slowly as time goes by and pay the investors. They may pay back investors as soon as possible over a period of time. They say this was the best possible solution so to minimise losses. It is an unpleasant situation. No one likes to lose hard-earned money especially when the risk was not understood or communicated. There was some hubris in the fund management team. And they are worse off for it.
Franklin and other credit schemes have lent to and invested in illiquid papers albeit profitable ones but have investors who can demand their money back anytime. And therein lies the problem. If they were closed-ended, then the problem would not have been so pronounced. Regulations will come in for sure. The other mutual funds have gotten into a huddle and are on a media overdrive to reassure their investors. As a mass scale run is unmanageable for any financial entity.
So why is this not happening all over the world?
Businesses are going bust all over the world. But the financial system is staying afloat because their central bank is coming in and buying everything in sight. For eg if Franklin type case was in the US fed is willing to come and buy the lower-rated bonds. They have virtually opened up the war chest and have given unlimited support to the markets. There was panic even in the western financial markets but got soothed when they knew Big Daddy will bail them out. There is a lender of the last resort.
Why has our RBI not done the same?
They have done something different. They have given funds to the banks and are nudging them to buy lower-rated bonds. But Banks are not taking the bait yet and are sitting on a large sum of funds. RBI and other regulators have to find a solution to this tricky problem and not let it snowball into a bigger crisis that what it is. It is a toughie but not unmanageable.
We have lost a lot of money in equity mutual funds and we have sat quietly as a COVID effect. There is hope there that there will be recovery sooner than later.
Similarly, Franklin’s debt schemes have been locked down, hopefully, they will survive to pay us back.
Amit Mehta
Nicely explained
Neeta
Very nicely explained.