The Debt Fund Saga
Debt is generally considered to be the boring cousin of Equity because the action is always in the Equity markets. However, the Debt market has not been far behind in the last 18 months and in fact has been hogging the limelight with downgrades of credit ratings and defaults (You should check The Big AAA and AA Joke for an interesting take on credit ratings).
The news of the last few days has been the 23rd April 2020 late evening announcement of Franklin Templeton to wind up six of its debt schemes. Naturally, this impacts the entire debt fund industry and thus all mutual fund industry participants have been on an overdrive to avoid more redemptions in their respective funds. A lot of mutual fund houses have come out with their announcements about having adequate liquidity, high quality bonds in their portfolio (our bonds are AAA), RBI has offered Rs.50000 Crore (as special liquidity facility) for mutual funds and that we have a solid portfolio.
So, what really happened at Franklin Templeton (FT)?
The following schemes of FT were wound down:
Franklin India Low Duration Fund
Franklin India Ultra Short Bond Fund
Franklin India Short Term Income Plan
Franklin India Credit Risk Fund
Franklin India Dynamic Accrual Fund
Franklin India Income Opportunities Fund
According to the fund house press release “There has been a dramatic and sustained fall in liquidity in certain segments of the corporate bonds market on account of the Covid-19 crisis and the resultant lock-down of the Indian economy which was necessary to address the same. At the same time, mutual funds, especially in the fixed income segment, are facing continuous and heightened redemptions.”
These funds have been facing significant redemption pressure in the last 2 months. In the month of March, all the above funds witnessed a redemption of Rs.9148 Crore.
The fund house further added that this was the best possible way to safeguard the interest of existing investors as it was the only way to realize an orderly sale of assets.
The decision to wind up these schemes is because of extreme liquidity and redemption pressures (and not because of any default).
Let us take the case of 3 of the strongest Indian Banks HDFC Bank, ICICI Bank and Kotak Mahindra Bank. Now imagine that all the depositors of these banks queue up tomorrow morning outside these bank branches for their money.
What do you think would happen? Would all depositors get their money? You do not need to even think because the answer is NOPE. A big resounding NO.
Why may you ask?
The simple reason is because this money (rather majority of the money) has been lent (I am being simplistic here without getting into the details, but you get the point). There are some liquidity ratios every bank is supposed to maintain (prescribed by RBI) but most of the money is lent.
So, if every depositor queue outside the strongest of these institutions, they would not get their money back.
Now Franklin Templeton was facing a similar scenario. It was like every investor wanted their money back. This has not happened yet, but it was going in that direction so they honoured the initial redemptions of thousands of crores but if this trend continued it would not be in the best interest of investors who stayed on. Thus, they had to take a decision to shut down these schemes.
The current strategy is not to allow any redemptions or purchases to be able to maintain the current portfolio (without any liquidity pressures) and to pay investors back as soon as the investments from the portfolio start maturing.
The Scheme NAV’s will be announced daily until all investments in the portfolio mature.
The Indian Debt market is not a very liquid market. The Fund managers address these issues in the following manner
- Having investments of different maturities in the portfolio (commonly known as laddering of investments). For example, Bond A matures in April 2020, Bond B in June 2020, Bond C in August 2020 and so on.
- Short Term Maturity (Duration of most funds in this space is between 2-3 years)
- Bank Borrowing Lines.
- Diversified Investor base so no one investor impacts the portfolio in any way
Besides this, there are exit loads to discourage investors from exiting.
Because of the above measures, the fund manager is generally able to manage liquidity comfortably in normal times. However, these are unprecedented times and fear abounds.
Thus, there was a rush to exit. If all investors stay put just like bank depositors stay put, there is no reason to exit.
So, what happens Next?
The Fund house will liquidate the investments and give the proceeds to investors. Given the construct of the portfolio, the bonds will be due for payment (interest as well as principal) at different maturities. Thus, repayments will happen as the investments in the portfolio mature. The Fund House will also look to liquidate the bonds in the secondary market once the bond market stabilizes. In short, investors should receive their principal as well as interest.
Let me know if you have any questions… Happy to answer them for you.
P.S. In case you have missed it above, do read: The Big AAA and AA Joke