winding-up-of-franklin-templetons-credit-funds

Context: Franklin Templeton, the ninth largest Mutual Fund in the country, has shocked investors with its decision to wind up six yield-oriented,managed credit funds from India.

More on the news:

  • The six schemes  are namely Franklin India low duration fund, dynamic accrual fund, credit risk fund, short term income plan, ultra short bond fund and income opportunities fund
    • These six funds have combined assets under management of around Rs 28,000 crore, that amounts to nearly 25% of the total assets under management of Franklin Templeton MF in India.
    • The decision was taken in order to protect value for investors via a managed sale of the portfolio, amid the redemption pressures due to severe market disruption in the wake of the COVID-19 pandemic.
  • The Association of Mutual Funds in India said that the credit profile and liquidity profile of investments by the industry is good and the isolated event will have no bearing on the industry’s day-to-day operations. 
    • It also reiterated that Retail investors should not panic in what we believe is a one-off incident. 
  • The finance ministry is in discussion with regulators, the RBI and the SEBI to address mutual funds in order to fill in the need for liquidity and prevent panic selling in debt funds.

Impact on investors

  • It connotes that Franklin Templeton MF will first liquidate the assets in the schemes and then return the money to investors. 
    • With the market situation being grim for now, investors may not get an immediate exit. 
    • Also, it will be difficult for the fund house to find a buyer for the low-rated assets in the portfolio, in turn increasing the wait time for investors
    • Now if the fund house pushes hard to get new buyers for those assets, it has to go for a substantial haircut, resulting in a big loss for investors on their capital investment.
  • While winding up of a scheme does not impact investment in other schemes, investors still need to assess the quality of the companies where their investments lie. 
    • If their investments have exposure to debt or equity of lower-rated companies, then reallocation of such investments should be pondered upon.

Impact on other schemes of the fund house

  • The fund house has reiterated that all other funds, be it equity, debt and hybrid are unaffected by the decision. 
    • Therefore, the winding up of these schemes will have a limited impact on investors of other schemes. 
    • Also, the ongoing liquidity crisis in the market has impacted higher yielding, lower-rated credit securities in India and, hence these six schemes have been impacted due to direct exposure to them.

Road Ahead

  • There are concerns that mutual fund problems can swiftly migrate to the entire financial services industry, and then soon take into grip the real economy.
    • In the backdrop of COVID-19, the challenges are more systemic with the liquidity issue affecting not just the mutual funds, but also many NBFCs. 
      • The RBI’s approach of persuading banks to subscribe to non-government debt papers does not seem to be a solution for now.
      • The banks largely ignored the call of RBI for Rs 25,000-crore targeted long term repo operations (T-LTRO) and subscribed for only Rs 12,850 crore (three-year tenor).
      • Central banks across the world are doing asset purchases to support the financial sector.
  • Some of the suggestions point in the direction that RBI may have to consider direct purchases of non-government securities
    • It could be either through a dedicated liquidity window or through the creation of a special purpose vehicle for some of these non-debt securities.
    • Like In 2008, at the peak of the global financial crisis, the RBI had opened a special liquidity repo window for mutual funds. 
    • Again, in July 2013, when returns on debt mutual funds dropped sharply with the rupee falling significantly against the US dollar, the RBI opened a special window to reinstate the liquidity window to mutual funds 

Response -RBI’s move to open ₹50,000 cr. liquidity tap for MFs

The RBI has announced a special window of ₹50,000 crore for mutual funds in view of the redemption pressure that the fund houses are facing.

Need for RBI’s intervention

  • The COVID-19 pandemic has heightened volatility in capital markets leading to liquidity strains on mutual funds which have intensified in the wake of redemption pressures related to closure of six debt schemes of Franklin Templeton and potential domino effects. 
    • The stress is, however, currently confined to the high-risk debt funds segment while the larger industry remains liquid.

RBI’s special liquidity fund for mutual funds

  • Under the Special liquidity fund for mutual funds, the RBI will conduct repo operation of 90 day tenor at the fixed rate repo.
  • The Special liquidity fund for mutual funds is on-tap and open-ended
  • Funds availed under this facility will be used by banks exclusively for meeting the liquidity requirements of MFs.
    • It will be done by extending loans, and undertaking outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.

Source: MInt

Impact of RBI’s move

  • It is expected to bring some degree of liquidity comfort in the debt market as the debt segment has witnessed a huge outflow in the month of March.
  • Exposures under this facility will not be reckoned under the Large Exposure Framework (LEF), thereby giving greater comfort for banks to borrow under this window. 
    • Further, with the yields dropping, banks may go down the credit curve and extend facilities, but banks seem wary of extending credits to anyone without a top credit rating.

Risk aversion on part of Banks

Going back, the risk aversion of banks can be traced to be soaring after the IL&FS crisis in 2018.

Debt markets are faced with lack of risk appetite in the market. Liquidity is not much of a concen

However, due to the uncertainty around the COVID-19 on the economy and sustainability of businesses in terms of repayment of debts, there is risk aversion among investors.

Road Ahead

  • Good quality non-AAA papers are not finding any takers either, regulatory support in the non-AAA segment would help the market. 
    • Similar to the targeted long-term repo operations (TLTROs) announced by the RBI for investment grade papers, there is also a need for a specific action on the non-AAA segment. Unless banks are not incentivised for investing in other than investment grade papers, the current issue might sustain for a longer period of time.
  • Liquidity window via banks may not be effective in resolving the problem as banks are unwilling to take any credit exposure on their books like in case of TLTROs in which banks were not willing to buy anything except for a few top rated corporate bonds.
    • Active participation from the banks will be key to the success of this scheme.

 

Credit risk funds

About

Simply put, Credit risk funds are debt funds that play on the principle of high-risk-high-reward. 

  • By definition, credit funds are funds that invest 65 percent of the portfolio in bonds that are AA rated or below.
  • While higher-rated bonds of companies are more secure and offer lower interest rates, credit risk funds generally invest in lower-rated bonds which offer higher return but also carry a higher risk.

Why are they risky?

  • The managers of most credit risk funds have gone behind high yields and ignored the associated higher risk.
  • This strategy worked well when the external economy was doing good and witnessing higher growth rates, and there were no undue pressures on the liquidity front. 
    • In such times, when credit funds were exposed to companies with a weaker balance sheet, there were low chances of default.
  • However, when the economy is under stress, and even strong companies are finding it tough to raise funds, companies with a weaker balance sheet and higher leverage (AA rated and below) are most vulnerable. 
    • At such a time, banks, mutual funds and financial institutions that have lending exposure to such companies are at higher chances of default.
    • Borrowers will not be able to service the interest and principal payment then.

Role of Fund Managers

  • While all credit risk funds invest up to 65 per cent in bonds rated AA or below, fund managers can lower their risk by following a higher diversification strategy
    • If the scheme is diversified significantly on the asset side where there is no large exposure to a few companies, then even if there is a default by one or two companies, the entire portfolio does not get affected. 
    • Similarly, if the scheme is well diversified on the liability side by not having just a few large investors, then even if one or two investors seek redemption, it does not push the fund house to sell the scheme.

Haircuts

  • The term haircut can be defined as the percentage difference between an asset's market value and the amount that can be used as collateral for a loan.
  • The difference between these values occur because market prices undergo change over time, which needs to be accommodated by the lender.
    • For instance, if a person needs an INR 20,000 loan and wants to use their INR 20,000 stock portfolio as collateral, the bank is likely to recognize the INR 20,000 portfolio as worth only INR 10,000 in collateral. 
    • The INR 10,000 or 50% reduction in the asset's value, for collateral purposes, is deemed as the haircut.

Mutual Funds

A mutual fund is a pool of money managed by a professional Fund Manager.Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund.

  • It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities. 
  • And the gains generated from this collective investment is distributed proportionately amongst the investors after deduction of applicable expenses and levies, by calculating a scheme’s Net Asset Value or NAV. 

Net Asset Value

  • The NAV is the combined market value of the shares, bonds and securities held by a fund on any particular day. 
  • NAV per Unit represents the market value of all the Units in a mutual fund scheme on a given day, net of all expenses and liabilities plus income accrued, divided by the outstanding number of Units in the scheme.

Source: amfiIndia

Image Source: TradingCampus

Association of Mutual Funds in India

AMFI, the association of all the Asset Management Companies of SEBI registered mutual funds in India, was incorporated on August 22, 1995, as a non-profit organisation. 

  • As of now, all the 45 Asset Management Companies that are registered with SEBI, are its members.

Redemption

  • It can be defined in the financial realm as the repayment of any money market fixed-income security at maturity date or before the maturity date.
    • Redemptions can be made by selling part or all of their investments such as shares, bonds, or mutual funds

Source: https://indianexpress.com/article/explained/what-franklin-templeton-winding-up-credit-funds-means-6377113/

https://www.livemint.com/market/stock-market-news/risk-aversion-of-banks-may-deepen-liquidity-crisis-of-debt-funds-11587993160017.html

https://www.thehindu.com/news/national/rbi-opens-50000-liquidity-tap-for-mutual-funds/article31447414.ece

https://indianexpress.com/article/explained/explained-what-rbis-rs-50000-crore-boost-means-for-mutual-funds-6381134/

Image Source: Mint