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Fixed Income

The Franklin Debacle: Six Debt Funds Shuttered, and Impact on Debt Funds

Franklin-Debacle.jpg

Franklin Templeton India has halted new entries and exits on 6 of it’s debt funds:

  • Ultra Short Bond Fund
  • Low Duration Fund
  • Short Term Income Fund
  • Credit Risk Fund
  • Dynamic Accrual Fund
  • Income Opportunities Fund

Here’s a quick summary of what happened:

Franklin Templeton’s debt portfolios have been aggressive on credit risk. Not starting yesterday, or last week, but for several years. They have flirted with disaster multiple times, taking a 25% haircut once on Jindal Steel, investing in Zee promoter companies that had no cash flow, and recently, getting hit with a Vodafone Idea bond that was likely to take a hit. 

But the returns have been juicy. At Capitalmind, we had found their risk-reward compelling at that time, and we had owned their debt.

We exited their debt funds from the CM Fixed Income portfolio back in March 2020 when we went slow on risky debt. The reason, Franklin had been funding companies that otherwise would not easily get access to funding, and there’s a lot of low rated debt in there. A couple of extra percentage points of return were not worth the added uncertainty. Additionally, as we noted in the earlier post, the AUM was dropping sharply, then:

Franklin AUM

This AUM was down to 13,000 cr. on March 12, when we decided to exit all risky debt in our core Fixed Income Portfolio at Capitalmind Premium:

Notification

We owned the Franklin Ultra Short Bond fund – for more than a year! And we aren’t married to stocks or funds so we can exit when we like. (The fund gave us a reasonable return, even after you account for the Vodafone Idea loss, of nearly 8% in fifteen months)

What seems to have happened

Over time the “slightly” lower quality investments started worsening, and even what might in a regular world be relatively safe, started unraveling. All this started putting redemption pressure on their funds. Coronavirus only accelerated the pressure by making debt markets increasingly wary.

Many Franklin debt funds have lower grade debt. That means, things that aren’t exactly rosy. That means stuff that other mutual funds wouldn’t easily buy. That means they couldn’t sell the debt easily, but usually would hold to maturity. Also complicated by the fact that in a few cases they were the largest lenders to the underlying companies, so there wasn’t usually anyone else to take their place. In usual times, they would get repaid, or roll over the debt, and things would be fine.

But not now.

Covid has hurt cash inflows. People need cash. They exit their debt funds. Even corporates. This has pushed money out of the debt fund industry, which then needs to sell their holdings to be able to pay back investors. Everyone had this problem, of course, and everyone had to sell.

But Franklin had a different issue. Some of their debt wouldn’t sell at all. No one wanted it, and in other cases, being unlisted debt, they couldn’t even sell it. (A rule in October 2019 prevents mutual funds from buying unlisted debt, though they can carry existing holdings to maturity)

When redemptions are not being canceled out by fresh additions, the fund manager has to sell underlying holdings to return the money.

For meeting this redemption what could Franklin do?

  • Sell all investment-grade bonds that have a sale price if they can. So the good bonds gets sold and goes away.
  • What’s left is the stuff that no one else wants, and Franklin has a lot of these kinds of bonds which others wouldn’t invest in
  • So the remaining investors get hurt even more as they hold a degraded portfolio

Mutual funds can borrow to temporarily meet redemptions. Imagine you have a bond maturing April 10, and you get a big redemption on March 31 – even if the bond couldn’t be sold if no one wants it, you can wait till April 10 and get the money. Funds are allowed to borrow money to meet such dislocations, since a redemption must be paid quickly.

At the end of last month, Franklin funds had to borrow money to meet redemptions and to wait for proceeds (interest and principal repayments of the underlying bonds) to pay back the borrowings.

The Franklin Ultra Short Bond (UST) fund saw AUM drop from around 20,000 cr. in October 2019 to 17,000 cr in Jan 2020. And as of April 22, the AUM is now below 10,000 cr. – which is half of October levels.

So this looked it was a long time coming, and the proverbial s*** has hit the fan. What now?

What if I own one or more of those Franklin Funds?

The only option is to wait out till the money comes, trickle by trickle. While it’s too early to comment on if and how much of the dreaded “haircut” will need to be applied.

This will take time, and some of the bonds will only pay out at maturity. However, here’s a sample of how Franklin Ultra Short Bond’s maturity dates are, with respect to their March 31 portfolio:

Franklin maturity

The “trickle” will mean that if all goes well, and everyone pays up on time, you should roughly see 35% of your money paid to you at the end of 2020, and another 37% in 2021 etc.

This assumes that all investments wait till maturity – some of them can be sold too, hopefully when this crisis ebbs. Also some intermediate interest payments will also come by. That might give investors a faster return.

Will you lose money? Let’s see what constitutes the top 90% of the Franklin Ultra Short bond portfolio: Franklin Exposure

Some of this may be in a spot of bother, like the NBFCs in the list. (Group names are shortened) But it doesn’t appear that this is totally silly portfolio – there are strong operational companies in there, and a bunch of well capitalized groups. In our view, it isn’t very likely to see a huge haircut – possibly 5% to 10% if things get really desperate. But of course, all this can change if the Coronavirus situation gets us into more unknowns.

In general, the idea is to understand this: You will get your money back. May not be all of it. But the above should help you understand where it’s been invested. You will need to do this exercise for the other funds in the list, which I’ve shown above for the Franklin Ultra Short Bond Fund.

What if I own one or more of other Franklin Funds?

If you are an investor in other Franklin funds, there is no “lockdown”. You are free to redeem or stay invested.

If there is a rush by investors to redeem their equity funds, then fund managers will need to sell what they hold. This shouldn’t be a problem except in case of smaller illiquid stocks that might be part of their portfolios. Even then, they might be too small a part of the overall holdings to matter.

What if I own other Debt Funds? Should I be worried?

There will be a broader impact of the Franklin saga on the bond market. People are likely to get spooked, or corporates could, and redeem their funds. This is likely to put even more pressure on the bond market, specifically corporate bonds.

We believe, there is going to be less stress on Liquid Funds, PSUs and Banking bonds, and very little stress on Government bonds.

If you’re feeling fearful, it may be useful to reduce allocations to credit risk and corporate bond funds.

Let’s be clear. Not because the holdings in all debt funds will suddenly default, but just the sheer lack of willingness of corporate and retail investors to take even the slightest risk. We are not saying this due to any credit risk, or default risk. We just feel it is useful to reduce your own stress when there is fear.

We expect that debt markets will see some kind of regulatory action to calm things down, and that the markets will eventually return to a less fearful state.

At such a time, it will be a great point to buy high-quality corporate debt. We are not afraid that the whole world will collapse, but like Covid, it will feel like that for a while. The important thing is to have a strategy and prepare to change as new information comes by.

Strangely, it’s a time when equity looks safer than debt, but that statement tells you we are in relatively extreme times. 

As this crisis evolves, it will help build better regulations and market structure, for the debt markets. 


Here’s a message on our subscriber slack group earlier today

The Franklin Debacle: Six Debt Funds Shuttered, and Impact on Debt Funds

Screenshot: Capitalmind Subscriber Slack Group

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