Debt Markets & COVID-19
COVID-19 has new surprises for the financial markets every day. Many of them are rude shocks. Four months into 2020 and we’ve seen negative oil prices, the swiftest bear market, sustained FII outflows, massive quantitative easing measures, and the VIX (Volatility index) crossing a record high of 80. Financial markets are breaking every assumption that previously existed.
The latest twist in the tale is Franklin Templeton AMC winding down six debt fund schemes. In this post, we’ll explore how this happened, what it means for you, and what your recourse is. Even if you don’t have exposure to Franklin Templeton funds, we would recommend carefully reading this post before making any decisions on your debt investments.
What to do if you’ve invested in Credit Risk Funds?
Talk to a financial advisor
Some credit funds are well managed, liquid, and suitable for your goals/risk profile. Watch this video to know more about the ithought approach to fixed income. We have a robust framework to select debt funds. Credit quality, investment mandates, and liquidity are a few. In an older piece, we talked about constructing credibility for credit risk.
Review your options
For some investors, an exit may not be the best strategy. For others, exiting even at a loss is non-negotiable. Every investor must know what is in their best interest before acting. Reacting blindly to market signals may cause more damage.
Net Asset Value
Understand that redemptions and NAV erosion are not the same thing. A mutual fund expert will be able to clearly explain this to you. Sometimes, even when others are exiting a fund, it may not be in your best interest to do so.
Action Plan
Chart out your plan of action with a financial advisor. Align it with the evolving market context and make informed decisions.
Context with Franklin Templeton Debt Mutual Funds
Let us rewind to the story of Icarus. King Minos of Crete imprisoned Icarus and his father Daedalus in a tower. Daedalus was a fantastic inventor and constructed the labyrinth that contained the Minotaur. Minos was opposed to revealing the secret of the labyrinth. To escape, Daedalus fashioned wings out of the feathers birds dropped in their tower. He sealed them with wax and relied on the ocean’s wind currents to carry them to freedom. He repeatedly warned Icarus not to fly too close to the sun as the wax would melt. Icarus, elated by the ability to fly, threw caution to the wind. As he rose, the wax melted, and Icarus plummeted into the ocean below them.
Similarly, Franklin Templeton has followed an extremely aggressive credit strategy across market cycles. A high YTM offering drew in many risks seeking investors. It convinced them that risks didn’t matter in debt investing, only returns did. Franklin Templeton has replicated this strategy in many of its funds.
Unfortunately, a high YTM does not indicate a high return. What it could signal is high risks like lower credit quality and illiquidity. And that is the source of today’s problem. Despite defaults and segregated portfolios, Franklin Templeton has firmly stuck to this strategy. Now it cites illiquidity as the reason to wind down funds.
Which mutual funds are affected?
The funds directly affected are:
- 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
- Franklin India Income Opportunities Fund
Franklin Templeton officially stated that its other debt funds, hybrid funds, and equity funds are unaffected by this.
Why are they winding down funds?
Franklin Templeton tried its best to honour redemptions through all other available means. They have leveraged portfolios, liquidated fair-priced bonds, and utilised cashflows.
According to Franklin Templeton, this is the only option left that acts in investors’ best interests. Recent redemption pressures have strained portfolio quality. Coronavirus related market uncertainty created a strong risk-off sentiment. Lenders are no longer interested in buying credit. If Franklin Templeton honours any more redemptions, they must sell lower-quality bonds at a deep discount. This is a double-edged sword for its investors. Either they realize deep losses on redemption, or they hold onto portfolios with declining quality.
What does winding down mean for investors?
The short and sweet version:
- The winding down strategy is to hold securities until maturity. Unitholders will receive the accrued interest. So, shorter duration portfolios will be wound up first.
- If bonds trade at a fair price, the AMC will sell. Unitholders will receive these proceeds. Franklin Templeton will not do a distressed sale of bonds. This measure prevents value erosion.
- Franklin Templeton will pass on any advance repayments to unitholders.
- No transactions are allowed in the funds after 1.00 PM on 23rd April 2020. This includes purchases (SIP/ STP) and no redemptions (sale/SWP).
- No fund management fee is applicable from now until the portfolios are fully wound down.
The risk-off sentiment is causing lower-rated bonds to trade at a deep discount. One cause for concern is whether further defaults may occur within these six portfolios. So, there is no guarantee that investors will get the closing NAV on April 23rd, 2020.
What is done cannot be undone. Going forward, keep risk management in mind while allocating capital to fixed-income investments. Safety and capital preservation are important decision considerations. Talk to a trustworthy advisor who has a clearly defined process in fund selection. This will mitigate risks and sustainably grow capital.