April 25, 2020

Franklin Templeton Debt Fiasco

We are happy to inform you that none of our clients are affected by the Franklin Templeton debt fiasco. We have been flagging the risk involved in chasing the YTM (Yield to Maturity) without properly understanding the credit risk, interest rate risk, and liquidity risk associated with the papers owned by that particular fund, and today we stand vindicated.

The cause of the fiasco is systemic with high exposure to low rated debt securities that have been impacted by the ongoing turmoil in the bond market. However, we see this as a "7500 Nifty moments" in the debt market, which if your risk appetite permits may be advisable to hold on to or increase exposure for future opportunities.

In this article, we will try to figure out "What really went wrong with the Pick of the Pack, where YTM obsessed investors always used to jump on the bandwagon".

Franklin Templeton winds-up six debt funds

Franklin Templeton MF announced that they have decided to wind-up six debt Mutual Funds with effect from April 23, 2020, with a total AUM of Rs.25,856 crore (as on April 22, 2020).

These six schemes are (AUM as on March 31, 2020):
1) Franklin India Low Duration Fund (Rs.2,737 cr)
2) Franklin India Dynamic Accrual Fund (Rs.3,119 cr)
3) Franklin India Credit Risk Fund (Rs.4,434 cr)
4) Franklin India Short Term Income Plan (Rs.7,093 cr)
5) Franklin India Ultra Short Bond Fund (Rs.10,964 cr)
6) Franklin India Income Opportunities Fund (Rs.2,506 cr)

What does this imply for you? If you are an existing investor in any of these funds, you will not be able to redeem your money and your investment is locked in these funds until the fund house makes further payments. All purchases or redemptions through SIPs / STPs / SWPs will also not be allowed henceforth.

Why did this happen?

Franklin Templeton AMC has been known for building a portfolio of debt funds having securities of companies with weak credit ratings, offering higher interest rates, but believed to have high potential as per their Fund Manager’s view. However, the strategy of delivering high returns by taking higher risk started to show vulnerabilities over the previous 20 months as we have seen in the case of IL&FS, DHFL, Vodafone, among others

The Fund Manager was finding it very difficult to sell enough bonds to meet the redemption obligations, as there is hardly any taker for these low rated bonds, in the prevailing macro-economic environment. The smart money has been continuously moving out in recent months from Franklin’s debt funds, as a couple of corporate defaults started making credit investors edgy.

They had to even borrow cash (SEBI allows up to 20% of AUM) to meet the redemption pressure. In fact, they crossed the borrowing limit of 20% in two funds, after taking permission from the regulator. It appears that even this was not enough for them to meet the redemption pressure.

Given the heightened risk aversion of banks, higher withdrawals from funds (leading to funds selling bonds at a lower price), poor appetite for various debt securities, and very thin volumes, the problem has evidently accentuated for low rated corporate bonds. Hence, they had to close these funds to protect the existing unitholders.

Some color on their debt paper quality...

These six debt funds of Franklin Templeton have a high exposure to low rated debt securities that have been the most impacted by the ongoing turmoil in the bond market.

These six debt funds had an AUM of Rs.30,855 crores at the end of March 2020. Although the reported AUM as on April 22, 2020, is Rs.25,856 crore, we will dice and slice March 2020 ending data for a better understanding of its risk profile.

These six funds accounted for almost 25% of Franklin Templeton’s total AUM and 63% of its debt AUM. At the end of March 2020, Franklin Templeton MF had borrowed Rs.2,753 crores against these six funds, almost 9% of the AUM. As per the media reports, this had gone up to almost 4,500 crores as on April 22, 2020, ~18% of their existing AUM.

Exhibit 1: Maturity Profile of Six Debt Schemes of Franklin Templeton

We have analyzed the borrowing profile of credit issuers and can conclude that Franklin Templeton AMC has taken concentrated exposure in several of the names.

Looking at the tables below, we can enumerate our observations:
1) In 23% of its credit exposure, Franklin Templeton is the sole lender
2) In 58% of its credit exposure, Franklin Templeton has lent more than 50% of the total MF industry exposure.
3) In 69% of its credit exposure, Franklin Templeton has on average >72% of total MF consortium exposure
4) Franklin Credit Risk Fund has one of the highest YTM (Exhibit 3) but it comes at the cost of lower-rated paper. It also shows that fund has borrowed 10.5% of AUM (March 31, 2020) for meeting the redemption obligation.

Exhibit 2: Franklin Templeton is sole lender to several of the credit names

How it will impact my other debt funds?

Now the question arises – will this episode also impact investments in other debt funds? The answer is Yes!! This episode is likely to have an adverse impact on the entire debt mutual fund industry, especially in the near term.

Several of the existing investors are likely to get nervous and redeem their debt mutual funds especially the credit risk funds, in a hurry. Hence, it will put extra pressure on the debt market.

We at DreamLadder Capital don’t recommend exotic products like Credit Risk Funds to investors, who don’t understand the credit risk, interest rate risk, and liquidity risk associated with the scheme holdings.

Just like deposits moved out of mid-size banks like RBL, Bandhan, or IndusInd to a few large banks post Yes Bank crisis, we can see redemption pressure on smaller fund houses and market share gains for HDFC/ICICI/Kotak AMCs. It could translate into NAV haircuts for smaller fund houses if they don’t maintain enough liquidity. Here we are talking about the direction but it is difficult to predict the extent of the impact.

Exhibit 3: Borrowing profile of Credit Risk Funds - Peer comparison

Will it also impact existing Franklin FoF?

There are six such FoFs that saw sharp declines (Exhibit 4) on account of their holding of those 6 Franklin debt schemes which are being wound up. On April 24, 2020, NAV of Franklin India Multi-Asset Solution Fund fell by 22.5% while NAV of Franklin India Dynamic Asset Allocation Fund fell by 16.6% as they have allocations of 50% and 46% respectively to Franklin Short Term Income Plan, one of those unlucky 6 debt schemes as of March 31, 2020.

Franklin Templeton MF also has four other FoFs which allocate assets between equity and debt as per the customer’s age. They are Franklin India Life Stage Fund of Funds 20s, 30s, 40s, and 50s. They have exposure to the Franklin India Dynamic Accrual Fund (12.5%, 29.0%, 38.1%, 52.2%, respectively), one of the 6 schemes being wound down.

The four life stage schemes were down 6.6%,13.5%, 17.8%, and 25.2%, respectively. Although asset allocation is towards debt as well as equity, a large cut in NAVs have come due to markdowns in Franklin India Dynamic Accrual Fund.

Exhibit 4: Ripple effect on existing six FoFs of Franklin Templeton MF

Will this also impact Franklin Templeton - US Equity Opportunity Fund

Our answer is No. We have been recommending our clients to allocate a small percentage of the portfolio towards this fund. This fund is a feeder fund that invests in a diversified fund managed by Franklin Templeton in the US. We recommend our clients to continue holding this fund and do not suggest any action.

Conclusion

All these six debt funds of Franklin Templeton already carry segregated portfolios, after side-pocketing their exposure to Vodafone-Idea and YES Bank. While the winding up of the six funds does not alter the status of the segregated portfolios, investors will now have to watch for recovery in both regular and segregated portfolios of these funds.

At the same time, due to an increase in risk aversion, corporate bond spreads over G-Sec have widened sharply and are significantly higher than their long term averages. Nonetheless, several steps taken by RBI like ensuring adequate liquidity, targeted LTRO, operation TWIST, etc. are likely to improve the credit environment and as a result spread is likely to compress over the next few months.

In few months down the line, we may equate this opportunity as a “7500 Nifty moments” in the debt market. Hence, it is advisable not to reduce exposure to quality debt funds, rather increase it if your risk appetite permits.

About The Author

Saday Sinha

Mr. Saday Sinha is Founder & CEO of DreamLadder Capital, a boutique wealth advisory firm. He is a seasoned investment professional with over 15 years of experience in the Indian Equity market. He has spent a decade tracking the banking and NBFC sector as part of the Equity Research team at Kotak Securities. He also worked with IDFC as an Analyst with the India Equity Strategy team. He holds a Master's degree in Economics from Delhi School of Economics and is an alumnus of Jamnalal Bajaj Institute of Management Studies, (Mumbai), with specialization in Finance. He writes for various magazines & Newspapers and his valuable opinion has also been sought by news channels like CNBC, ET Now or Bloomberg, in the past. He also speaks at seminars & conferences and lectures at Management institutes.