The Franklin Debacle and Debt Funds

This is a mid-month update, to bring you up to speed on a development in Indian debt markets. A large mutual fund, Franklin Templeton India, has halted new entries and exits on 6 of it’s debt funds:

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

Please do note that Capitalmind has none of these funds in its portfolios. We are relatively unaffected, and will take more steps to protect your capital on the debt side.

But first, a quick summary of what happened:

Franklin Templeton’s debt portfolios have been aggressive on credit risk, all this time. We used to have them in the portfolio till March 2018 after which we went slow on all risky debt. Franklin has funded companies that otherwise would not easily get access to funding, and there’s a lot of low rated debt in there.

Given the Covid issues, the debt market has been getting increasingly wary and there are simply no takers for such bonds. This would usually not be a problem, since Franklin doesn’t usually sell such debt. However, right now, investors have been redeeming quite a bit of money from the Franklin funds.

At the end of last month, Franklin funds had to borrow money to meet redemptions, and to wait for proceeds (interest and principal repayments of the underlying bonds) to pay back the borrowings. The Franklin Ultra Short Bond (UST) fund saw AUM drop from around 20,000 cr. in October 2019 to 17,000 cr in Jan 2020. And as of April 22, the AUM is now below 10,000 cr. - which is half of October levels.

For meeting this redemption what could Franklin do?a

• Sell all investment grade bonds that have a sale price if they can. So the good debt goes away
• What’s left is stuff that no one else wants, and Franklin has a lot of these kind of bonds which others wouldn’t invest in
• So the remaining investors get hurt even more as they hold a degraded portfolio
• Now, Franklin will limit entries and exits completely starting today.
• So when the underlying bonds pay money, that money will be used to pay back investors proportionately.

If you own these funds, the only option is to wait out till the money comes, trickle by trickle.

However, this has a broader impact on the bond market. People will get spooked, as will corporates, and redeem their funds. This is likely to put even more pressure on the bond market, specifically corporate bonds. There is going to be less stress on PSUs and Banking bonds, and very little stress on Government bonds.

At Capitalmind, we believe in having a strong strategy for doing things. We look closely at debt markets, and things there don’t currently look very bad. So our proposed mode of action is:

• We believe Liquid funds, Government bond funds and PSU/Banking debt funds are the safest right now.
• So we’ll exit some of the others that we owned. These include corporate bond funds and some savings funds.
• There’s no deeper reason - in fact the debt holdings of these funds are sound. However we feel the market imbalance will cause jitters, so we just want to increase cash allocations at this time. When the money arrives, we will park in liquid oriented funds.
• If the situation changes, we will monitor and act, and redeploy accordingly.

We have so far avoided all debt issues in the markets, and hope to avoid this too. There is always risk somewhere, and we won’t be successful in avoiding everything, but we do expect to monitor and react appropriately.

If you own debt funds outside of the PMS, our suggestion is to look closely at the portfolio and to reduce allocations where things don’t look great. If fearful, it may be useful to reduce allocations to credit risk and corporate bond funds.

On the equity side: We discussed a few important things at the Capitalmind Wealth Webinar a few days back. Please do watch the video at https://www.capitalmind.in/webinar-capitalmind-wealth-april-2020-covid-impact/

We expect that debt markets will see some kind of regulatory action to calm things down, and that the markets will eventually return to a less fearful state. At such a time, it will be a great point to buy high quality corporate debt. We are not afraid that the whole world will collapse, but like Covid, it will feel like that for a while. The important thing is to have a strategy and prepare to change as new information comes by. Strangely, it’s a time when equity looks safer than debt, but that statement tells you we are in relatively extreme times.

As this crisis evolves, it will help build better regulations and market structure, for the debt markets. Meanwhile, we’ll act to make the best use of opportunities and address risk alongside.

Best,

Deepak