On 23rd April 2020 in a sudden move, Franklin (Franklin Templeton AMC) decided to wind up 6 debt mutual fund schemes because of the extreme redemption pressure and their inability to generate enough liquidity to fund the redemptions. The announcement came as a big shock as it was coming from Franklin which is regarded as one of the highly reputed fund management houses.
Franklin’s debt mutual funds have been able to beat the benchmark return by a couple of percentage points consistently and they have not hesitated to use even unconventional approaches such as the purchase of debt paper of JSPL in 2106 to manage precarious situations. A majority of the investors have never even bothered to understand why Franklin had to take this drastic step since they continued to get their desired return. The investors continued to reward these behaviours of the Fund Managers by committing more money to these funds.
Franklin had set a benchmark for high performance which was not sustainable without taking high risks. Franklin continued to feed the investors’ return expectation by living dangerously. But those were the good times when Franklin could live with sub-par credit investments.
Since 2018, multiple AAA rated companies started defaulting on the interest payment because of which the debt market started becoming edgy and the appetite for risky assets started waning. The sudden onset of the COVID crisis this year caused a flight to safety and a considerable increase in risk premium. FPI started pulling out of the debt funds particularly the ones with poor quality assets exposure. The March month saw substantial redemption and this continued in April. Franklin realized that if the redemption continued, they would be forced to sell relatively better assets and the fund would be left with only illiquid poor quality assets. This would result in distress sale of the assets and substantial loss for remaining investors. Hence, they decided to close the funds for transactions.
Why did this happen?
People started investing in debt mutual funds with an assumption that it will give guaranteed return compared to fixed deposits on a post-tax basis. The investors flocked into the funds giving higher returns ignoring the associated risks. This encouraged the fund managers to continue to take risky bets for the higher return. While the regulation provides a guideline to manage duration risk for a fund type, the investment can be done in assets with any credit quality. Post IL&FS crisis, the credit risk was getting exposed but COVID crisis brought the rare occurrence of liquidity risk to the fore and hence this debacle.
What is the impact on existing investors?
In a way, this is relatively better news for existing retail investors who were counting on the credibility of the company and did not know if they had to come out of these funds. This will allow an orderly sale of underlying assets hence avoiding significant hair-cut for the remaining investors. While Franklin will come out with the detailed plan for disbursal of the money back to the investors, most likely the money will be credited to the associated bank account as soon as the underlying assets are disposed of but the credit of the money could be in smaller chunks.
What should investors who are holding other debt funds of Franklin or debt funds from other AMCs do?
Please realize that the debt funds are not risk free. You should not expect guaranteed return as is the case with the Banks Savings Interest, Fixed Deposits and Recurring Deposits. It requires more effort to understand the nuances of debt fund investment and monitoring, hence if you do not have the time and interest, do not venture into it. For the investors who are on the top of their debt fund investments can continue to stay with the Funds with very high quality assets. The impact of COVID can further deteriorate the credit quality.
What is the learning in it for us?
The investment in debt fund is risky, will not give guaranteed return and needs to be monitored closely. Always invest in the debt mutual funds with high quality assets. The performance of debt funds may get impacted by the change in Fund Manager, interest rate, credit quality of underlying assets and liquidity, hence we always need to be vigilant.
The writer is a SEBI Registered Adviser and Founder of FinMyn (https://finmyn.com). He provides Fee-Only Financial Planning and Investment Advisory services. If you want to know more about him, click on https://finmyn.com/about/.