Franklin Templeton fiasco : Why? How? What next?
Franklin Templeton, one of the most reputed mutual fund houses in India wound up 6 of its debt schemes in April. It locked up Rs.30,000 cr of investors’ wealth. These debt funds, that are marketed as funds that are safe like FDs (so to say) and give more returns, have put investors in dire straits. Let’s look at what debt mutual funds are, and what really happened to these so called ‘safe investments.’
What are debt mutual funds?
Debt mutual funds fall in the fixed income category wherein a pool of investors’ money is invested in government securities ,debentures, corporate bonds, and other money-market instruments. The above securities are considered to be safe avenues for investors and hence in debt mutual funds, the risk factor is considerably low.
There are different types of debt funds like liquid funds, short/medium/long term funds, dynamic bond funds and fixed maturity plans.
There are many more nuances to debt fund investments. For example, a particular debt fund can buy only specific securities of specific maturity ranges — a gilt fund can buy only government bonds while a liquid fund can buy securities of maturity up to 91 days.
Though debt mutual funds are considered safe, this doesn’t mean that debt mutual funds offer assured returns. The returns fluctuate according to the market but are relatively less volatile than equity. Rising interest rates have an effect on debt funds, where the prices of the security falls and vice versa.
Why do people buy debt mutual funds?
The main reason for people to buy debt mutual funds is that these funds are considered as safe and generally give more return than a fixed deposit. The debt mutual funds have more liquidity than a FD and hence, people rate the instrument higher than a fixed deposit. It also saves tax and brings stability to an investors’ portfolio.
If all of this is good on paper and seems like a pretty safe investment opportunity, what happened to the six debt schemes of Franklin Templeton. There’s more to explore.
What happened at Franklin Templeton?
On April 24, Franklin Templeton closed 6 of its debt schemes: Franklin India Low Duration Fund, Dynamic Accrual Fund, Credit Risk Fund, Short Term Income Plan, Ultra Short Term Bond fund and Income Opportunities Fund. Together these schemes had nearly Rs 30,000 crore of investors’ assets in them, equivalent to a quarter of all assets that Franklin Templeton was managing. Such a move is unprecedented for India, where the last time a mutual fund was forced to wind up a scheme was because of regulatory and legal orders. Now, if people write it off as a bad loan, NPA, or still consider it as an investment is anyone’s guess.
Franklin Templeton is known for its ‘extra return’ on its debt mutual fund schemes. Star mutual fund manager, ‘Santosh Kamath’ manages the funds and is credited with having helped create a market for buying debt instruments that are rated below by the credit agencies, which is the safest rating for private debt. This meant that he invested in the companies that were not as safe as the leading Indian companies and there was a risk of the investor wealth being wiped out.
As we already know that the whole market works on trade off, increase in risk results in increase in the return. Buying lowly rated securities meant that the yield on those securities would be higher as companies had to pay more interest to its lenders to access credit. Hence, the fund generally generated around 1–2% more returns than its competitors and was amongst the preferred choice for the debt mutual fund investors.
The exposure to risk of these mutual funds increased as Kamath started investing in companies in which Franklin Templeton was the only lender which means that if the company goes out of the business or defaults in its payments, the entire burden will fall on the mutual fund house. This was the case for 26 out of the 88 entities in its portfolio.
The main reason behind this fiasco was the ongoing COVID-19 crisis. As the economy suffered, business took a hit and people suffered a liquidity crunch, there was a lot of negativity amongst the investors and for the worst, the companies started defaulting on their payments. The yields of debt securities rose sharply, and it diminished the ability of the companies to pay their debts. As a result, the six mutual funds started receiving a lot of redemption requests. Due to late payment from companies and a liquidity crunch, Franklin Templeton had to borrow money in order to meet the redemption requests. As the redemption requests grew, which was forcing Franklin Templeton to sell their bonds at a discount, Franklin Templeton thought that it is best to wind up the funds so that the investor wealth is protected and they get an equitable exit. The investors cannot withdraw their money from the above-mentioned schemes and Franklin Templeton will pay them as and when they receive the payment from the companies.
What next?
The economy is expected to make a V-shaped recovery with most of the lockdown rules easing, businesses getting back on track and starting to pay back their borrowed amount to the bondholders. Franklin Templeton has started receiving payments from its borrowers as the securities matured but because of pending litigations, the money has not reached the investors yet. The investors are expected to get their money back as the situation improves.
To avoid other mutual funds to follow the suit, RBI created a Rs. 50,000 Cr liquidity window, especially for mutual funds to tide the redemption pressures and keep up the status of debt mutual funds.
What should investors do to protect themselves in such situations?
An Investor should always be fully aware of risky investments and always see the risks associated with the investments that have a higher share in a portfolio, no matter what return a particular instrument is offering.
To simplify the process, an investor should analyse the mutual fund performance over the years and look for the last 5–10 years returns. The investors should at least look at the excess return a fund has given relative to the benchmark (alpha) for the given level of risk taken by the fund, the credit ratings of the companies in which the fund has been allocated, the expenses that the fund house is levying on the fund and the additional amount of return generated by a unit increase in risk. They should also look at the size of the funds they are investing in and the fund manager’s record and reputation.
In the case of Franklin Templeton, some of the above mentioned characteristics had clearly shown red flags but the greed for easy, quick, and ‘safe’ money led the investors to ignore these worrying signs and now they face the risk of losing their investments, at least partly if not fully.
By Sanket Sharma
Class of ’22 | Indian Institute Of Management Tiruchirappalli
References :
- Franklin Templeton, https://www.franklintempletonindia.com/
- Livemint (2020), Franklin Templeton MF’s six shut schemes garner ₹941 cr in fortnight,https://www.livemint.com/mutual-fund/franklin-templeton-mf-s-six-shut-schemes-garner-rs-941-cr-in-fortnight-11605684504242.html
