Decoding Franklin Templeton crisis

Franklin Templeton is USA based Multi-national company and India’s ninth largest mutual fund house. It has total $698 billion assets under management. On 23 rd April 2020, in a big blow to its debt fund investors, it has announced winding up of 6 of its debt fund schemes namely,

  1. Franklin India Low Duration Fund,
  2. Franklin India Dynamic Accrual Fund,
  3. Franklin India Credit Risk Fund ,
  4. Franklin India Ultra Short Bond Fund,
  5. Franklin India Income Opportunities Fund and
  6. Franklin India Short Term Income Plan

It has total Assets under Management of Rs 25856 Cr (as on April 22) for all the funds put together. This issue has raised questions over safety of investment in debt fund schemes, in general, and the company’s fund manager’s ability in particular.

So, let’s start with the basics.

How debt schemes of mutual funds work?

Debt schemes invest in financial instruments like corporate bonds, securities instead of equity stock as in case of equity mutual fund schemes. They either offer super annuity amount after a specific tenure or offer interest on intermediate basis, like quarterly or half yearly.

When can mutual fund wind up its schemes?

Whenever any mutual fund wants to shut its schemes, it has to refer the regulation of 39 2A of SEBI mutual funds regulation 1996.The regulation implies that if trustees of mutual fund feel it is required to shut the scheme, then the above mentioned act empowers them to do so, only after due compliance of the pursuant provisions of the act.

Winding up of schemes simply means that investors who had invested their money in those six debt schemes can no longer withdraw their cash based on value of underlying assets. Their money is temporarily frozen.

Why Franklin Templeton wound up 6 debt schemes?

The mutual found house did so mainly because of 2 reasons-

  1. Market sentiment – Due to Covid 19 situation, all markets in the world are in panic mode including bond market and many businesses are temporarily closed down. This situation is highly problematic especially for the companies having high debt, to survive with the existing mechanism. Thus overall market sentiment is negative.
  2. Large redemption pressure – Due to the panic created by Covid 19 in financial market and its sustenance for uncertain period, investors started selling out their units or redeeming cash but since mutual fund house has in turn invested investor’s money in debt funds which became illiquid due to negative market sentiment, now the mutual fund house has left with only three options of protecting investor’s interest, as given below:
  • First being to repay the investor’s money with existing cash flow. This would have managed had there been a small number of redemptions, but since uncertainty was prevailing in market there was large redemption pressure.
  • Secondly, the fund house can borrow money for paying investors putting the debt instruments as security against loan, but in this case the fund has invested in high risk group AA-, or below AAA rated debt instruments which bear comparatively high credit risks. Hence, even banks would have not given loan against these risky instruments in current critical situation.
  • Third and last option left was to ask investors to wait till maturity of debt schemes. Once the debt instrument matures the fund house will sell the instrument and pay the investors with the money recovered.

Right now there won’t be fresh sell of units of these 6 debt schemes and at the same time there won’t be redemption as well. Once the bond market comes back to normalcy and appetite returns, fund could look to sell the assets (debt instruments) at reasonable value and will repay the investors, which looks equally uncertain. In response to current scenario, RBI has opened its lending window with special liquidity facility of Rs 50000 crore to help rebuild investor’s confidence in Mutual Funds.

What went wrong with these debt schemes?

Franklin Templeton’s star fund manager had positive past record of betting on lower rated credit funds, with an objective of high risk, yielding higher returns but the risk exposure was to the extent that according to Mint report, Franklin Templeton was the sole lender to 26 out of 88 entities in its debt schemes portfolio.

This effectively means, if they faced trouble, the mutual fund house would have to pay heavy price of their failure. So, in a nutshell the current decision of fund house is the result of high exposure to credit risk, poor underlying asset quality, and illiquidity of bond market, and most importantly inadequate security cover for exposure.

What is the lesson for other mutual funds

In order to protect the interests of investors, fund managers should properly study the risk and return potential of debt instruments, BEFORE MAKING A DECISION TO INVEST. Fund managers should strictly abide by SEBI guidelines about investment in low rated credit instruments.

In current scenario of Covid 19  pandemic, the biggest challenge for mutual fund houses is to retain the faith of investors in debt schemes by communicating effectively that their funds do sufficient SWOT analysis of available investment options and do not invest in instruments  as risky as Franklin Templeton.

Author is a MBA Finance Specialization Student of Symbiosis Institute of Business Management, Hyderabad 

 

1 comment

  1. Abhishek Pandey

    Nicely covered !! Happy to see that students of sibm hyderabad are diving deep to analyse the topic. Just to add on here, Franklin Templeton debt fund has AAA bonds too in their portfolio which they could have sold to meet the redemption obligation but no one in the market are willing to buy those bonds as they want to buy at discounted price and also fund house should not sell it’s complete AAA bonds otherwise they would only be left with junk bonds having maximum risk. Hence freezing of 6 schemes got surfaced.

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