Dr. Madhavankutty G
Head – Banking, Economy & Policy – ET Prime, Times Group
Remember the campaign:
“Mutual Funds Sahi Hain?”
Probably it is time to re-think now!
By a communication dated April 23, 2020, Franklin Templeton, one of the well-known Asset Management Companies (AMCs) announced the voluntary winding up of its six high profile and high yielding credit schemes in response to the Covid-19 pandemic. The Franklin Trustees also stated that except these six specific funds all other equity and debt funds remained unaffected.
What are credit funds and why six of them were wound up?
Credit funds defined: Credit funds invest in debt instruments issued by Non-banking Finance Companies (NBFCs), Micro Finance Institutions (MFIs), Corporates etc. These debt instruments can be Bonds or Debentures.
THE FLOW CHART
The sequence: So in a nutshell, NBFCs and MFIs issue bonds to MFs and use the proceeds to lend to SME retail and corporates. Mutual Funds in turn float debt schemes using these debt instruments from NBFCs as the base that are in turn subscribed by retail, FIIs etc.
Why NBFCs issue debt? This is because except a handful, say 100 out of a total of 11000, other NBFCs are not allowed to access public deposits. This deprives them of long term funds and hence are riskier.
The chain reaction of defaults: So it is easy to understand that if SMEs or corporates default, a chain reaction results. NBFCs will be hit and they won’t be able to repay MFs who have subscribed to their bonds which will in turn impact MFs’ repayments to their clients.
The reason for the crisis:
Following the crisis which hit IL&FS, investors lost faith in NBFCs and corporates. Even highly rated (AAA) entities found it difficult to raise funds at attractive yields. The scenario was much worse for those rated below AAA. This was made worse by the fact that credit extended by NBFCs (to SMEs, auto etc) turned bad which meant these NBFCs were unable to get their money back. Also these NBFCs floated short maturity bonds to MFs. But lending was for much longer tenures. So NBFCs had to honour commitment to MFs even before receiving money back from their borrowers. (Known as Asset – Liability Mismatches)
Why only six credit funds wound up?
The six credit schemes in question specialized in investing only in instruments rated below AAA floated by such NBFCs/ MFIs/ Corporates. The reason was that though rated lower and risky, the yield on these instruments were also higher enabling Franklin to in turn offer attractive rates to the investors in these schemes. When the economy was booming everything went smoothly. But the ILFS crisis and now Covid disrupted the situation and suddenly faced with the prospect of the below rated NCDs and bonds becoming less liquid, Franklin has decided to wind up these six schemes.
Table 1: The six credit funds and their exposures are as below
| S. No | Name of the fund | Exposure (Rs. Crore) |
|---|---|---|
| 1 | Franklin India Low Duration Fund | 2737 |
| 2 | Franklin India Dynamic Accrual Fund | 3119 |
| 3 | Franklin India Credit Risk Fund | 4434 |
| 4 | Franklin India Short term Income Plan | 7093 |
| 5 | Franklin India Ultra Short Bond Fund | 10964 |
| 6 | Franklin India Income Opportunity Fund | 2506 |
Implications
1) Exposure limits reached: Until end March 2020 these funds have borrowed 17.70% of their portfolio size which could have gone up and reached the SEBI mandated 20% sectoral cap by April 23. This makes the outlook uncertain for investors as Franklin will no longer be able to borrow more through these schemes. Thus inability to sell illiquid paper and sectoral cap could have been a major reason prompting a wind up. Almost Rs.30,000 Crores of investor money (as shown in table above) is stuck.
2) Investors won’t be able to withdraw: Redemptions will not be allowed and it is highly uncertain till when. Given the deep economic slowdown and extreme distress investors might have to take a hair-cut assuming they are able to redeem their investments in these funds at a later date.
3) Other Mutual Funds to be impacted: This will have a cascading impact on other Mutual Funds as well. Investors will rush to redeem their investments in similar schemes floated by other mutual funds sparking a huge liquidity crisis in the mutual fund industry. Many might be even forced to close down.
4) People may avoid Mutual Funds: There will be a flight to safety, especially to fixed deposits with Public sector banks. The Yes bank crisis and negative outlook on some other private banks have already caused this. The Franklin incident will accelerate this trend. Investors already sold Rs.1.9 Lakh Crore of debt papers in March 2020. Total investments in AA, A and BBB rated papers are around Rs.1.2 Lakh Crore.
5) What RBI did to help MFs: On April 28, RBI opened a Rs. 50,000 Crore special window for mutual funds. Banks can borrow funds from RBI for 90 days at 4.40% using this facility and these have to be used to give loans or to buy MF papers. However, being risk averse it is uncertain if banks will invest in or buy these papers.
6) What SEBI can do? Alternatively, SEBI may increase the 20% investment cap on a case –to-case basis. They had done so for mutual funds during the 2008 financial crisis.
Table 2: Daily average Assets of certain credit funds (in Rs. Crores)
| Scheme | As on 24 Apr ’20 | As on 28 Apr ’20 | % VaR |
|---|---|---|---|
| HDFC Credit Risk Fund | 11,935 | 9,451 | -20.8 |
| ICICI Pru Credit Risk Fund | 10,641 | 8,668 | -18.5 |
| SBI Credit Risk Fund | 4,660 | 4,248 | -8.8 |
| Kotak Credit Risk Fund | 4,147 | 3,042 | -26.6 |
| Aditya Birla Sun Life Credit Risk Fund | 3,981 | 2,976 | -25.2 |
| Nippon India Credit Risk Fund | 2,771 | 2,347 | -15.3 |
| IDFC Credit Risk Fund | 1,382 | 1,079 | -21.9 |
DISCUSSION QUESTIONS
1) Given the current situation which is a riskier investment?-a bond issued by a deposit-taking NBFC or a non-deposit taking one? (Hint: why NBFCs issue debt?)
2) Why did non-banks face fund flow issues after the ILFS crisis? (Hint: reason for the crisis)
3) Due to low economic growth, ABC Fincorp has seen increase in default by its clients. Is it wise to invest in a Mutual Fund with exposure to ABC Fincorp? (Hint Chain reaction)
4) In the current scenario given an option between bank fixed deposits and a mutual fund which one would be preferable to you? (Hint implications Point 4).
5) RBI decided to give more funds directly to banks so that they can help mutual funds. But will banks utilize this window? (Hint point No 5 in implications)
REFERENCES
- Franklin Templeton communication dated April 23, 2020
- bloombergquint.com
- Twitter thread by Abhishek Bhuwalka
- economictimes.com
Disclaimer
- All rights are reserved. No part of this publication may be reproduced or copied in any form by any means without written permission.
- The views expressed in this publication are purely personal judgments of the authors and do not reflect the views of The Icfai Society
- The views expressed by the contributors represent their personal views and not necessarily the views of the organizations they work/represent
- All efforts are made to ensure that the published information is correct. The Icfai Society is not responsible for any errors caused due to oversight or otherwise