Returns & Liquidity in Debt Mutual Funds might be at risk!

Have you invested in Debt Mutual Funds in India? Returns and liquidity in these funds might be at risk.

Read on to understand why, and then check your portfolio to decide if you want to stay invested or not…

Effective April 23 2020, Franklin Templeton Mutual Fund has voluntarily closed six of it’s yield-oriented, managed credit funds, citing the severe market dislocation and illiquidity caused by the COVID-19/Coronavirus pandemic.

This is the list of 6 funds that were closed:

• Franklin India Ultra Short Bond Fund (popularly known as Franklin UST)
• Franklin India Low Duration Fund
• Franklin India Dynamic Accrual Fund
• Franklin India Credit Risk Fund
• Franklin India Short Term Income Plan
• Franklin India Income Opportunities Fund.

How bad is it?

I am not sure about the number of folios in these funds, but I know for a reason that Franklin Ultra Short Bond Fund (UST) was a very popular fund, especially among retirees, because of the higher-yield returns they delivered in past few years by investing in relatively lower-rated papers (and thus more risky).

What happened?

The massive sell-off in debt markets (by FIIs, institutional investors as well as retail investors) due to Coronavirus led to a crash in prices and rise in yields.

Credit risk funds from Franklin saw reduced inflows and surge in redemption volumes. To meet redemptions, the fund house dipped into its cash reserves, sold some of its underlying scrips as well as took loans to honour redemption requests.

[UPDATED on April 28, 2020] But RBI announced Rs. 50,000 crores window of funds to lend out to Mutual Fund companies to help them out with redemption requests. That should help, right?

On 27/04/2020, RBI announced an indirect credit line (i.e. INR 50,000 crores window of funds) to mutual funds, with “indirect” being the keyword here. Here is a summary:

• What “indirect” means is that instead of lending the money directly to mutual fund companies, RBI will lend it out to banks.
• In return, RBI will only take government securities (and not bonds) as collateral from banks.
• Banks can borrow from this facility as and when they need it, at the repo rate (4.4% as of April 27, 2020) before May 11 2020 or until funds run out (whichever happens first).
• Banks will also be responsible for handling defaults from Mutual Fund companies, not RBI.

Now banks have two options to use this money:

• Option #1: Lend the money to Mutual Funds (obviously at an interest rate higher than repo rate of 4.4%, let’s take 8% as for this blogpost)
• Option #2: Purchase investment grade papers/bonds from MFs

Now mutual funds either hold high grade (i.e. AAA/AA rated) or lower grade papers.

Let’s analyze Option #1 first:
Mutual funds can take loan from banks (by giving high grade bonds as collateral to banks), and can use this money to honour redemption requests from their customers.

But who pays the interest (8%, as assumed above) that mutual funds needs to pay the banks? Well, it seems that AMC can use the returns from the fund itself, but if the returns are less than 8%, the remaining needs to be paid from AMCs pockets. If AMCs are unable to pay this out from their pockets (or are not willing to, which seems like a more concrete possibility), and the bonds default on maturity few months down the line, then people who would be invested in that fund at that time in future will take the hit and have to bear the losses (in the form of NAVs dropping suddenly in a single day causing drop in your portfolio value, which happened recently with 5 other Franklin FoFs when their NAVs dropped between 6.59% to 22.42% in a single day). So, if you decide to stay invested in Debt funds in coming months, you might have to bear the costs/losses in future.

And what will happen in case of Option #2?
If a bank was actually interested in buying good bonds, it would have bought them anyway by borrowing money via a different scheme of RBI (known as Targeted Long Term Repo Operations or TLTROs).
So, it doesn’t makes a lot of sense that banks will buy bonds from Mutual Funds, unless the mutual funds are selling them a higher discount than current market value (which should affect NAV further in near or long term).

So, if I get this correctly, this means that banks have not much to gain by borrowing from RBI and lending it to mutual fund companies?

Yes.

Unless RBI forces PSU banks to lend to mutual fund under this Rs. 50,000 window of funds, the private banks won’t be heavily motivated (especially during times of pandemic).

In current setup, I think private banks might lend to large Mutual Fund companies (AMCs to be precise) that have a past history of surviving an economic slowdown or recession. Also, private banks might buy high rated papers/bonds (AAA, maybe AA), but most debt mutual funds will still be left with lower grade papers that banks won’t buy.

In fact, some debt funds (e.g. credit risk funds) have a high concentration of riskier papers/bonds in their portfolio, which banks won’t be interested in buying altogether.  So if you have invested in one of such funds, the fund might still shutdown because of high redemption requests, causing unnecessary liquidity headaches for you.

So, if this announcement from RBI isn’t helping, why did they do so in first place?

Two words: Public perception.
This move might be to get public opinion to sway in favor of RBI (and thus the government)… that RBI and/or government are doing something keeping investors interest in mind. So that a laymen investor would think that they are doing something to fix the situation (but in reality not doing it).

Like private banks, even RBI doesn’t wants credit risk. This is why RBI is lending to banks so that mutual funds defaulting is the problem of banks, and not RBI. When lending money to banks, even RBI does not wants these bonds (as RBI is only taking government securities as collateral). Instead, RBI should have lent directly to the Mutual Funds (or at least bought AAA bonds directly from mutual funds).

When will current investors in these 6 Franklin Templeton funds get their money back?

Current investors will not be able to withdraw their money right now. Instead, they will have to wait almost as long as the duration of the underlying schemes (which could cary from few months to few years depending on the fund). There is nothing much you can do in the interim.

Morals of the story:

1. Don’t be tempted by more returns, look at ratings of the paper that the fund is holding. Moreover, remember that even a AAA rated paper might default (especially during a pandemic).
2. A debt fund doesn’t necessarily implies lesser/zero risk.
3. A debt fund can have liquidity issues in times of crisis, so think twice before holding your cash surplus or emergency fund in Debt Funds.

I hadn’t invested in any of these franklin funds, so I have nothing to worry, right?

Wrong!

A lot of other Debt funds have Net Current Assets in negative (which means that loans have been taken by funds to honour redemption requests). In other words, these funds can also potentially wind up and might cause a liquidity crunch in coming months when Coronavirus pandemic continues. Net Current Assets/(Liabilities) of some funds as on April 23, 2020:

• Kotak Savings Fund: -7.48
• Kotak Corporate Bond Fund: -6.56
• Axis Arbitrage Fund: -9%
• Axis Liquid fund: -9.2%
• L&T liquid fund: -4.6%
• ICICI Liquid fund: -5.6%
• HDFC liquid fund: -5.1%

Whether your fund(s) is in this list or not, I will suggest analyzing your mutual find portfolio and check if your fund has riskier holdings. And if you don’t know how to weed out bad holdings/bonds from good ones, then it becomes even more important during Coronavirus crisis to stay away from Mutual Funds. Especially for debt funds, I will suggest placing a redemption request as soon as possible and keeping this money in a FD or saving bank account of a large scheduled commercial bank (until mass vaccination of Coronavirus has taken place, which in my humble opinion is at least 6-14 months away).

What about your personal portfolio? Had you invested in Debt Mutual Funds before/after Coronavirus?

Nope.

In pre-Coronavirus era, instead of Debt funds I had invested the debt component of my portfolio in FDs and RDs of two Small Finance Banks or SFBs (via accounts opened in my mother’s name, getting me 0.5% extra interest reserved for senior citizens). Why? Quoting a Reddit user srinivesh:

If people have both Equity and Debt, they have volatility in Equity anyway. Why add more on Debt side too?

Moreover, my post-tax returns from these FDs/RDs were similar to those of Debt Mutual Funds. These FDs/RDs from Small Finance Banks (regulated by RBI) were opened at 9%-9.5% interest rate (tax free as my mother has no sources of income).

But after Coronavirus started spreading in India, I wasn’t sure of Small Finance Banks’ ability to survive a pandemic/recession. So, I prematurely broke my FDs/RDs and moved this corpus to FDs of 3 different bank accounts (ICICI, HDFC and SBI). Why? Well, paraphrasing another Reddit user MialoKoukoutsi:

I’m already losing sleep over Coronavirus. I don’t want to lose sleep over fears of losing my capital.

In these trying times, I am not chasing high interest rates or returns. Instead what I look for in an investment is:

1. Capital protection/preservation, at the expense of returns or rate of interest.
2. Easy liquidity.
3. Peace of mind.

Moreover, these 3 banks (ICICI, HDFC and SBI) are the only banks classified as D-SIBs (Domestic Systemically Important Banks) in India, with higher capital adequacy requirements. In layman terms, these are banks which are “too big to fail”. For me, diversifying among these three ensures that in the worst case even if one of these 3 banks failed (due to Coronavirus), 2/3rd portion of my corpus will still be safe fetching me 5-6% per annum.

What do you say? If you disagree, leave a comment below and I will be happy to engage in a conversation.

And, don’t forget to share the post with your family and close friends. You might just save their portfolio from a potential disaster brewing in other Debt Mutual Funds in India.