Franklin India winds down 6 Debt Funds: What it means for investors?

Fueled by the COVID-19 pandemic, the unprecedented times in the Indian financial markets continue. Franklin India AMC (Mutual Funds) has taken the extraordinary decision to wind down 6 of its popular debt funds.

Without a doubt, the news isn’t a positive one. So the choice of word ‘extraordinary’ in the above paragraph might seem odd. But this isn’t an ordinary event. But that’s not the point. Let me get to the core of it immediately:

So what has actually happened?

On 23^rd April 2020, Franklin India AMC announced that it is ‘winding down’ 6 of its debt funds.

Which funds? These ones:

• Franklin India Ultra Short Bond Fund
• Franklin India Low Duration Fund
• Franklin India Short Term Income Fund
• Franklin India Dynamic Accrual Fund
• Franklin India Credit Risk Fund
• Franklin India Income Opportunities Fund

In view of the AMC (and they know it best), these are the funds that carried most credit risks. But mind you. These are not small funds of a small fund house. The combined size of these funds is above Rs 25,000 crore at the time of announcement. And Franklin India AMC is one of the largest and oldest AMCs of India. So the winding down of as many as 6 funds in one go is actually unprecedented.

Also important to highlight here is that all other debt funds and equity funds from Franklin AMC will continue as usual. This issue is limited to only the 6 debt fund schemes mentioned above. In a way (and as an indirect message), the AMC feels that they don’t need to close the other debt funds as they may have access to sufficient liquidity to meet redemption needs if any.

But all this doesn’t matter as of now. What matters for the existing investors of these schemes is that what is meant by the term ‘Winding Down’ and how does it impact them.

It means 2 things:

• Existing investors in any of these funds can no longer redeem their money. Their investment are locked in these funds, until the AMC makes further payments.
• All further purchases or redemptions through SIP / SWP / STP will also not be allowed henceforth.

This is bad news. In a way, the entire scheme has been segregated into a separate portfolio.

But this doesn’t mean that all your money is lost. Stay with me.

Seemingly, this is a preventive step taken by the AMC.

Naturally, this will lead to concern in the minds of investors. Not just in these schemes but also in those of investors of other debt funds of other AMCs too.

So what made the AMC take this drastic step? Something which hadn’t happened earlier on such a large scale with big funds?

As per what the AMC is telling us, it is “In light of the severe market dislocation and illiquidity caused by the COVID-19 pandemic, this decision has been taken in order to protect value for investors via a managed sale of the portfolio.”

Now let me try and explain this in simpler words and what it really means:

The Indian financial sector is under immense pressure due to the lockdown induced liquidity crisis. To be fair, this is something that couldn’t have been predicted. This is entirely new territory for everyone. So many investors began to panic and started redeeming. Especially from the comparatively riskier funds. Now to meet these growing redemption requests, the AMC generally dip into their cash reserves or sell the underlying instruments. The AMC may also resort to borrowings within the SEBI allowed limits to meet incremental redemption demands. But such borrowings have a cap and cannot be an unlimited option.

Therefore and seemingly in this case, the redemption pressures were too high to handle.

And as a result once they used up all the reserves and liquidity to meet initial redemptions (and their borrowing limits), they were practically left with no other choice. The AMC had to take the harsh decision of winding down the 6 funds.

What if they hadn’t?

As the portfolio got smaller and smaller due to redemptions, the funds would have been left with higher proportion of less liquid and riskier papers. Now appetite for unexpected selling of riskier papers is low these days due to liquidity issues. So the fund selling the bonds/papers at very low prices would have further eroded the underlying value of the scheme’s portfolio. And the continued selling of lower-rated bonds/papers to meet redemption demands could have resulted in further and severe erosion of NAV, thereby aggravating the losses to existing investors. So the AMC took the step. According to them, redeeming the units for earlier investors (redeemers) would come at the cost of those investors who stayed longer in the fund or those who decided to redeem later. In this spirit, they decided to close the sale/purchase (and put a lock on it) to protect the interests of all unitholders alike.

In a way, it’s a good move. But it has come at an enormous cost. Making the investment in these funds illiquid for the investors who bought in at the promise of returns and liquidity.

All said and done, what happens to the investor’s money in these funds now?

Is the money lost?

The answer is no.

Can investors get the money back immediately?

The answer is no as the redemption is not allowed now.

This means that the money in these funds is stuck for now. It is illiquid.

What the AMC now plans to do is to liquidate the assets in the scheme and return the money to the investors in a staggered manner. As and when each of the underlying portfolio instruments matures or the scheme receives money in the form of interest, the money will be passed on to the investors of these funds and NAV adjusted accordingly.

But to be honest, in the current situation, finding buyers for not-so-good bonds/papers in the scheme’s portfolio will be not easy. So it will take time for things in financial markets, in general, to stabilize first. Therefore, either the fund manager will wait for maturity of each of the securities or try to sell securities at a reasonable amount without causing much impact costs.

So the schemes have shorter maturity tenure profiles are expected to return the money quickly.

If you read about the debt fund categories in detail, you will know that most of the impacted 6 funds belonged to the following categories:

• Ultra Short Duration debt funds invest in bonds/papers maturing in 3 to 6 months time. That is average maturity is between 3 to 6 months.
• Low Duration debt funds invest in bonds/papers maturing in 6 months to 1 year time. That is average maturity is between 6 to 12 months.
• Short Duration debt funds invest in bonds/papers maturating in 1 to 3 years. That is average maturity is between 1 to 3 years.
• Medium Duration debt funds invest in bonds/papers maturing in 3 to 4 years time. That is average maturity is between 3 to 4 years.

The real keyword here is the ‘Average Maturity’

So shorter the average maturity of the fund being winded down, the faster it could get wound up and pay the money back to the investors.

There is no timeline for the return of money offered by the AMC. But to roughly estimate by when the money will be paid back is to broadly look at the average maturity of the paper held in these schemes. Here is the latest available average maturity data of the 6 schemes:

• Franklin Ultra Short Bond Fund – 0.62 years
• Franklin Low Duration – 1.46 years
• Franklin Income Opportunities – 2.55 years
• Franklin Short Term Income – 2.75 years
• Franklin Credit Risk Fund – 3.08 years
• Franklin Dynamic Accrual Fund – 4.28 years

But remember that we are talking about the average maturity and SEBI’s guidelines for that. So this means that some bonds/paper will mature even after that specified limits as the limits are applicable to only the average and not each of the individual bonds/papers.

As an example, see below a screenshot of the (partial) portfolio of Franklin Ultra Short Bond Fund. It’s an ultra-short duration fund, that means has an average maturity of 3 to 6 months. But not all bonds are maturing in this period. Some have maturity much later as is highlighted in few of the red coloured texts:

If you are interested, then you can check the full detailed portfolio (as of 31st March 2020) of all these 6 effected schemes here – Franklin 6 Debt Fund Detailed Portfolio 31032020 (excel download).

The fund manager has stated that the investors would not have to wait until all the money in the funds is recovered. As the portfolios of these debt funds run on staggered maturities, so as and when the funds receive a certain amount of money in the form of maturities and coupon payments, the payments to investors in these funds could be made in a staggered (monthly or quarterly) manner. At times, some bond issuers make prepayment as well. But that’s rare. And please do remember that if some of the bond issuers face problems themselves, then the money you get back will be hit by defaults in the portfolio. Or it’s also possible that the AMC may sell some of the holdings at lower prices to cut the losses. In that case, too, the money received will be lower than what you invested.

By the way, investors in these funds will not have to pay any exit load. The AMC will also not charge any expense (ratio) on these schemes.

Some more thoughts that I have regarding this whole event:

• If you are not an investor in these funds, you did well (or you were advised well). If you reduced exposure to these schemes (even if not fully exited), then that is good too. But it’s a good eye-opener for all of us to have a relook, and I mean a serious relook at debt fund portfolios that we have. Talk to an investment advisor if need be.
• Franklin is a large AMC and faced issue. Imagine the problems of smaller AMCs. It is always better to stick with the larger AMCs which have a better capacity-to-suffer in times like these.
• Debt funds that take a tad higher credit risk aren’t suitable for most investors. They are still ok for small exposure for many others. But if in doubt, don’t invest in such funds.
• I have never been a fan of taking the extra risk for marginal extra return in debt. Though at times I have swayed from this but in general, it’s not worth it. It’s best to keep risk-taking to the equity side of your portfolio. Peace-Of-Mind and Good-Night’s-Sleep are much better filters for picking debt funds.
• This event doesn’t mean that the entire debt market is in distress. The funds that have higher % of better AAA-rated securities and cash reserves should remain safe.
• Many of you may feel that there is no point being in debt funds and better to live with bank FDs. But that is not fully correct in my view. If you are a conservative investor, it’s no doubt best for you to stick with FDs and RDs. But for those who are moderate risk-takers, the fact still remains that the Debt funds on average offer higher post-tax returns than fixed deposits as taxation of debt funds are favourable for holding periods over 3 years. But since you are getting better than FD returns, some risk is bound to be taken by debt funds. In most years, this risk is not realized. But in one of these years, it can face troubles as has happened in this event.
• Many had been under the impression that only credit risk funds (category aptly named) were the only one taking credit risk. But that is a misunderstanding. By definition, credit funds invest 65 per cent of the portfolio in bonds that are AA rated or below. But the Credit risk affects all types of mutual funds. Some have higher and some have it lower.
• SEBI needs to bring in better definitions for a more water-tight running of the debt fund portfolios now. This will take time. But this is one learning for the regulator to take in from this episode and demands better categorization of mutual funds (or at least the definitions of these categories)
• Some of these funds were rated very well in their respective categories by MF rating agencies. But still, this happened. This shows that you can never blindly trust Star Ratings for mutual funds. You need proper advice to pick the right funds.

That’s it. I have tried to put down what I had to say about this event. I understand your pain if you have invested in these funds. But it’s a wait-and-watch mode for you and many others for now. Depending on the maturity timeline profile of the funds’ underlying portfolio, you will get your money back in a staggered manner in times to come.