Not the time for credit risk, investors should stay away from debt funds

Given that the Covid crisis could lead to more defaults by companies, investors are better off staying away from such funds

Vivike Agrawal’s faith in debt funds has been shaken considerably since Franklin Templeton Mutual Fund (FT) suddenly declared to investors, on Thursday, that it is shutting down six schemes with assets of about Rs 26,000 crore. The 46-year-old self-employed had invested Rs 50 lakh in Franklin India Short Term Income Fund in 2015. Last month, he redeemed Rs 25 lakh and reinvested in Franklin India Liquid Fund–Super Institutional Plan. 

“The proceeds were to be utilised for my son’s higher education. Since I can’t do anything about the money frozen in the schemes, I have put redemption requests on all other debt fund investments, including liquid funds,” says Agrawal. 

Agarwal is not alone. Most debt fund investors are shocked by FT’s unprecedented decision. After all, the fund house with assets of over Rs 80,000 crore is one of the biggest names in the industry. Shutting down of schemes that constitute 25 per cent of its assets under management (AUM) has already sent shock waves across the industry. The six schemes (See: Lockdown for Franklin Templeton Investors) followed the high-risk, high-return credit risk strategy.

On Friday, the Association of Mutual Funds in India (Amfi) and leading industry players rushed to assure investors that their monies were safe. Says A Balasubramanian, managing director and chief executive officer, Aditya Birla Sun Life AMC: “FT probably chose to close the funds on the back of the illiquid nature of the bonds in their portfolios. This is an isolated case, and it should not be construed to be an industry-wide problem.”

 

 

However, this is yet another example of the mutual fund industry coming under severe pressure due to one fund house/manager’s wrong strategy. Rajiv Anand, former CEO, Axis Mutual Fund and executive director, Axis Bank, in a series of tweets explained the ramifications of FT’s move: “Templeton shutting down schemes could do to bond funds what IL&FS did to non-banking financial companies. Extreme risk aversion from fund managers as well as investors.” He went on to ask whether the regulator would ask the fund house to write back costs, or whether there would be a clawback of bonuses paid to fund managers.  

Tough times for risk takers: Axis Bank’s Anand has an interesting question: “How can you blame the system for the fund manager having built an illiquid portfolio in an open-end fund? And market disruptions have been a regular event over the last 10 years.” And it’s true. 

Franklin Templeton’s debt funds have faced several problems over the years due to defaults, whether it was Amtek Auto, Jindal Steel and Power, and in recent times, write-down of Voda Idea bonds and YES Bank AT1 bond in January 2020 and March 2020 (where it side-pocketed the bonds).

 

 

By definition, credit-risk funds are meant to do exactly that – they invest over 65 per cent in papers rated lower than AA. The idea is to get better returns from such papers when those companies’ ratings improve. However, when the whole economy is going through troubled times because of the Covid-19 crisis, many companies could possibly default. So, taking credit risk is not the best of ideas currently. Given the lockdown, many companies would be unable to meet their repayment obligations. As far as FT’s schemes go, most of them were very aggressive, with some having over 80 per cent of their assets in lower-graded papers.  

Study portfolio carefully? New investors have to be overly cautious and study the portfolio carefully. Over-exposure to lower-rated papers means that the fund manager is too aggressive. 

Many fund houses, on their part, declared the risk-profile of their funds. For example, Nippon Mutual Fund said it has less than 5 per cent exposure to such papers. “Even in the last one-and-a-half years, since the IL&FS crisis blew up and credit funds came under pressure, consequent to which our AUM in the fund reduced from a peak of Rs 11,000 crore to Rs 2,800 crore now, we have been successfully managing redemptions without having to resort to extreme measures,” said Nippon in its communication to distributors. 

Similarly, DSP Investment Managers gave this statement: “Since the credit events in 2018, we have maintained high liquidity in our credit fund. Our credit fund has 45 per cent exposure in AAA equivalent securities.” Kotak Mutual Fund and ICICI Prudential have declared that they have less than 5 per cent and 4 per cent of their fixed-income assets in AA- and unrated papers.

Even CEOs are busy placating nerves. Adds Balasubramanian: “Franklin Templeton’s closure of funds should not impact fixed-income schemes, given the high-quality and liquid nature of portfolios. Investors should not get unduly worried about their investments.”

Analyse other debt schemes ASAP: Like Agarwal, existing investors have no choice. But they should not panic and pull their money from all debt schemes. “If everyone panics and tries to exit, what is only a liquidity issue now will turn into a solvency issue,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.

Take the help of a professional financial advisor and examine the portfolios of all your debt schemes for credit risk. While professional help does cost money, that may be the best thing to do in the current situation. “In this environment of extreme risk aversion, 85-90 per cent of your debt fund portfolio should be in products that are safe and liquid and do not run credit risk,” says Arvind Chari, head-fixed income, Quantum Advisors. 

He adds that if you do not want market risk currently, stay out of debt funds altogether and stick to bank fixed deposits and Post Office small savings schemes. It really does not make sense to put your principal at risk for just a couple of percentage points of higher returns.