Franklin fiasco puts the spotlight on risks in shorter-tenure debt schemes

Crisis could trigger tweaking of categorisation norms by Sebi, say experts

The Franklin Templeton episode has brought to the fore the risks associated with shorter-tenure debt schemes that strive to eke out extra returns by taking credit risks.

The six schemes wound up by Franklin Templeton include Franklin India Short Term Income Plan, Franklin India Ultra Short Bond Fund, and Franklin India Low Duration Fund, which invested in papers of less than three years duration. 

The assets of the six schemes totalled Rs 30,854 crore as of March 31, of which 67 per cent was in the above three schemes. 

More than one-third of the amount was in the Ultra Short Bond Fund, a category that typically invests in bonds maturing in three to six months. The Low Duration Fund and Short Term Income Plan held 64.7 per cent and 58.8 per cent in papers rated A and below, respectively, according to Value Research. 

According to a report by B&K Securities, Franklin is the sole lender to 26 of the 88 issuers in the six schemes,  with papers worth Rs 8,084 crore due for maturity in a year. 

Currently, most debt fund categories do not have restrictions on the amount of credit risk they can take. Credit risk funds and corporate bond funds are the only categories that define credit exposure - for the former, 65 per cent of assets has to be in papers rated 'AA' or below and, for the latter, 80 per cent of assets has to be in the highest-rated papers. Ten of the 16 debt categories are defined based on duration alone.

“The category definitions provide the flexibility to take credit risks in shorter tenure funds. What is the point of having a credit risk category if the same risk can be taken across other categories as well? Had the current Franklin crisis been limited only to its credit risk fund we wouldn't have seen the kind of problem we are seeing now,” said Dhaval Kapadia, director (portfolio specialist) of Morningstar Investment Advisors India.

Taking credit risks in shorter-tenure funds can help jack up returns considerably, boosting sales. Until a year ago, there were a sizeable number of funds with more than 60 per cent 

 

 

in ‘AA’ and below-rated papers, according to experts. On an average, the ultra-short duration, low-duration, and short-duration categories had 26-28 per cent of their assets in 'AA'-rated papers and below as of April 2019, with several schemes having a far higher exposure, past data from Morningstar India showed. The medium-duration category had, on average, more than 50 per cent invested in these papers.

Over the past year, however, it appears that fund houses have become a lot more conservative. An estimated 80 per cent of the industry's fixed income portfolio was in high-rated papers, including those rated sovereign and AAA as of March 31. “Funds have become conservative in taking credit calls after the IL&FS fiasco and have reduced their exposure to papers rated AA and below," said Kapadia. 

Market players believe the current crisis might be a good time for the regulator to tweak its categorisation norms and define credit profiles wherever applicable. For instance, a low-duration or ultra-short duration fund could be mandated to invest 65-75 per cent in the highest-rated papers. 

The other option could be to divide each category into two - one sub-category that is allowed to take credit risks and the other that sticks to ‘AAA’-rated and sovereign portfolio. 

Kapadia, for his part, believes that the regulator could look at allowing two or three credit risk funds per fund house (instead of one currently) that would invest based on differentiated strategies and/or tenures. “The portfolio yield used to give away the kind of credit risk a fund house was taking. Setting credit limits for debt funds will make their performance more comparable and level the playing field among fund managers,” said a debt fund manager. 

On the flip side, guidelines to lower credit risk or improve liquidity could result in lower returns. Also, setting new limits might not eliminate credit risk altogether, as even ‘AAA’-rated papers face the possibility of downgrades.

“Creating credit sub-categories will help investors gauge risk better. But the question is whether such products will sustain over market cycles given that in India the bond market has very little liquidity,” said a second manager.

Sebi had introduced scheme categorisation guidelines in October 2017, with an aim to declutter the fund ecosystem and distinguish schemes based on asset allocation and investment strategy.