On April 23, Franklin Templeton Mutual Fund announced its decision to wind up six of its schemes - 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 and Franklin India Income Opportunities Fund.
This decision has brought about a fair amount of confusion amongst retail investors who feel they must exit debt funds altogether.
Morningstar’s Investment Management team in India addresses common investor queries.
Why did the fund house decide to windup its schemes?
Last week, the fund house announced the winding up of six debt funds.
The fund house took this extreme decision in light of the severe market dislocation and illiquidity caused by the COVID-19 pandemic: 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, which intensified in the months of March and April. The fund house maintains that in this scenario, this is the best possible way to safeguard the interest of exiting investors and is the only viable means to secure an orderly realization of portfolio assets.
FT has been following a high yield strategy in these funds by investing primarily in lower credit rated papers (typically below AA rating). These papers typically are less liquid in the secondary corporate bond market vs higher (AA+ and above) rated instruments. As mentioned by FT, due to significant redemption pressures faced over the last couple of months in these schemes coupled with the illiquidity of the papers, they have been finding it difficult to fulfil the redemption requests.
Are all debt funds risky?
Debt instruments are typically subject to two types of risks – interest rate risk and credit risk. Interest rate risk relates to the impact of fluctuations or movements in interest rates on the price of the debt instruments. Bond prices and yields carry an inverse relationship, i.e. if interest rates in the economy are moving up bond prices tend to move down and vice-versa. Prices on bonds with higher tenors are more sensitive to interest rate movements vis-à-vis bonds with shorter tenors. Credit risk relates to the probability of default or delay in interest or principal repayment by the issuer of the bond. Generally, Government securities and AAA rated (or highest) instruments carry low credit risk vis-à-vis lower rated instruments.
Various debt categories carry varying levels of credit and interest rate risk. For instance, categories with portfolio maturities or duration of less than one year such as Liquid, Ultra Short Duration, etc. carry very low or negligible interest rate risk but maybe be subject to some level of credit risk depending on the credit profile of the underlying holdings. Gilt funds primarily carry interest rate risk as securities issued by the central government are considered to be credit risk free. Credit risk funds would tend carry low to moderate interest rate risk as they tend to invest in 1 to 3 year papers, but higher credit risk vs other categories as they invest minimum 65% in AA and below rated papers.
Another aspect of risk in debt funds is related to liquidity, which tends to gain prominence in market scenarios such as the current one. Most debt funds tend to maintain some portion (typically 5% to 10%) of their portfolios in liquid instruments such as Treasury bills (or T-bills), Certificates of Deposit (CDs), etc. to meet redemption requirements. Further, higher rated instruments (AA+ and above) tend to be liquid and can be sold to meet liquidity requirements. To deal with extreme scenarios, funds are also permitted to borrow money (upto 20% of their assets) for short term periods.
In summary, all debt fund categories can’t be painted with the same brush, i.e. the level & type of risk varies for each category.
Should we exit from all debt funds?
No. All debt funds are not the same.
There are 16 categories within debt mutual funds including 5 categories in the below one-year duration or maturity bucket and others holding debt portfolios with average duration or maturity of more than 1 year with various combinations such as 1 to 3 years, 4 to 7 years, etc.
Debt funds in various maturity buckets invest in a mix of corporate bonds, government securities, treasury bills, etc.
The corporate bond exposure across debt funds would vary either based on the category definition or the investment strategy followed by the fund house. For instance, funds in categories such as Banking & PSU debt need to invest minimum 80% of their assets into debt instruments issued by Banks, Public Sector Units and Public Financial Institutions. Similarly, funds in the corporate bond fund category are required to invest minimum 80% of their assets in highest rated corporate bonds (i.e. AAA or equivalent). Gilt funds invest minimum 80% of their assets in securities issued by central or state governments.
In other categories, fund managers follow varying strategies of investing across the spectrum of debt instruments and rating buckets within indicated maturity ranges.
What must we consider before exiting a debt fund?
Does the fund suit you?
Each category is suited for different investment horizon and risk appetites. For instance, an investor with a one-year investment horizon should consider only categories that maintain portfolios with duration or maturity of less than one year. For investors with a low to moderate risk appetite and 1 to 3 years investment horizon can consider Banking & PSU Debt and Corporate Bond categories.
Do you understand the credit profile of the underlying portfolio?
Fund houses are required to report details of the underlying portfolio holdings on a monthly basis (on their websites) including the credit ratings of the debt instruments held in their portfolios. As an investor, it is important to understand the credit profile of their debt funds and whether it aligns with their risk appetite and investment horizon. For instance, credit risk funds invest minimum 65% of their assets in AA and below rated papers offering higher yields (vis-à-vis government securities and AAA rated papers). Such funds are suited for investors with investment horizon of 3 years and above and moderate to high risk appetite.
Have you looked at the yield and credit risk?
High yields and credit risk go hand-in-hand. Funds offering higher yields or YTM typically invest in lower rated papers which carry higher risk vis-à-vis higher rated debt instruments. One should consider investments in such funds only if they have an above average risk appetite and an investment horizon of more than 3 years.
Along with the above, it is important to note that fund houses have been taking various measures to effectively manage credit and liquidity risk in their portfolios. Yesterday, the RBI announced a special liquidity facility of up to Rs 50,000 crores. for mutual funds to be provided via banks, with a view to easing liquidity pressures faced by mutual funds.
What measures have been taken by SEBI to protect the interest of investors?
The Indian mutual fund industry is regulated by the Securities and Exchange Board of India, or SEBI.
SEBI has taken various measures to protect investor interest including enabling debt mutual funds to create segregated portfolios where securities whose credit ratings have been downgraded below investment grade (i.e. below BBB) can be moved. Typically, securities which are downgraded see a reduction in their value (broadly determined based on valuation matrix provided by rating agencies and the regulator) and this may result in investors redeeming their investments. To meet redemptions, the fund may be required to sell better/ highly rated instruments. This may put existing investors (ones that remain with the fund) at a disadvantage as the proportion of downgraded holdings may increase in the portfolio. By creation of segregated portfolios, existing investors may not be impacted by redemptions from other investors. Further, units in the segregated portfolio are issued to existing investors, which are locked in till the AMC is able to recover some or all the monies from the bond issuer.
What measures have been taken by RBI to protect the interest of investors?
Yesterday, the Reserve Bank of India, or RBI, announced a special liquidity facility of up to Rs 50,000 crores for mutual funds to be provided via banks, with a view to easing liquidity pressures faced by mutual funds. You can read about it in Our view on the liquidity window.
