You might have heard of the Franklin India crisis that hit debt mutual funds earlier this year.
This blog explains the crisis itself and aim to help you save yourself from the next Franklin-like debacle if it strikes.
Six of Franklin India’s debt funds were wound up on 23rd April 2020. The following are the six debt funds that have been affected…
– Franklin India Low Duration Fund,
– Franklin India Dynamic Accrual Fund,
– Franklin India Credit Risk Fund,
– Franklin India Short Term Income Plan,
– Franklin India Ultra Short Bond Fund, and
– Franklin India Income Opportunities Fund
Now what do they mean by winding up of these debt funds?
In essence, if you were invested in any of these 6 funds, your investment has been locked. You cannot add to your investments in these funds nor can you redeem your existing investments in them.
So, have investors lost all their monies in these funds?
No! In fact, this is a smart step to contain damage. But investors have not actually lost money. Yet.
What Franklin India AMC now aims to do is sell the underlying securities in these 6 schemes. And pass on the amounts to the investors of the funds proportionally. Payouts likely to be staggered!
Each fund has its own cash flows and borrowings and therefore, will be able to return money at different points of time.
Illiquidity in the lower-rated debt markets.
Franklin AMC’s debt funds were particularly famous (among investors aiming for returns) and notorious (among investors who understood the underlying risks).
Franklin AMC took on substantial credit risk to earn slightly higher returns for its debt fund investors. This means it invested in bonds of entities that were not AAA rated since these offered higher interest rates.
Credit risk is one of the two primary risks in debt funds. This credit risk undertaken worked pretty well giving higher returns since it did not hurt the investors during good times. The entities whose debt these funds held were operating just about fine and were able to service their debt.
However, what has started to happen or will start to happen is these entities will start facing cash flow problems. This is because they are unable to operate properly due to the pandemic & lockdown. And as this problem becomes more and more severe, they’ll probably start defaulting on their debt.
If this happens, the investors of Franklin AMC’s debt funds lose!
In fact, a number of investors started figuring this out. So, they started to redeem their investments in Franklin AMC’s debt funds and the redemption pressures on these funds increased sharply.
The AMC had to sell their relatively good quality bonds, and this increased the percentage allocation of the lower (less than AAA) quality bonds in its portfolio. These lower quality bonds are pretty much unsellable in the current market because of the reason discussed above.
Hence, the AMC had to take the decision to lock these funds down. Simply because they would have been unable to meet the redemption demands of the investors!
In effect, Franklin took the right decision at the right time and even though was highlighted as the villain in the media & because investors’ money got stuck. In terms of prudence, they took the right steps at the right time.
It’s important to assess the cause of the issue –
It can be stated in one line – Illiquidity in lower-rated debt market!
Your debt mutual fund holding could be in trouble if it carries a substantial amount of lower-rated debt. Under no circumstance should you invest in debt funds that have substantial lower-rated papers on its portfolio. But now is absolutely the worst time to do it!
Here’s what you can do to identify such funds in your portfolio and get rid of them at the soonest –
As a rule of thumb, your debt fund should have not have less than 90% in AAA rated debt and less than 10% AA rated debt simultaneously. If it does, you are playing with fire.
Let’s see what papers one of the affected funds is holding today –
As you can see the fund’s portfolio has more than 35 % of its securities in A rated bonds!
Here’s a couple of other debt funds –
As you can see the allocation to AAA-rated securities is 90% in both the schemes shown. These funds are highly unlikely to be part of the next Franklin-like debacle if the allocation is assumed to stay constant.
One should do this exercise every few quarters with your debt portfolio so that they are not affected by the next credit crisis!
If you are retail investor and want to invest in debt mutual funds with the primary objective of capital protection, you should stick to only the following categories –
Here are the categories that will probably never add value to your portfolio rather attract risk that you may not be aware of –
If you are still not 100% about your debt mutual fund portfolio (or even equity mutual fund portfolio) simply drop us an email with your portfolio at firstname.lastname@example.org and we will respond within 48 hours with our recommendations!