Recently, Franklin Templeton India decided to discontinue six debt-fund schemes and stopped redemptions for the investors who had invested in these schemes. This unprecedented step by the major global investment firm led to panic among investors in the mutual fund market. The Reserve Bank of India had to announce a liquidity scheme as a confidence-building measure for the investors as a result of the crisis.
In this article, I attempt to explain the Franklin Templeton Crisis, the reasons behind it, and its impact on the investors.
What are mutual funds?
People are very enthusiastic about investing in stocks, bonds, and debentures, but very few have the expertise to do it themselves. In such a situation, mutual funds become a decent alternative. Mutual funds are financial institutions that collect money from a large number of investors and invest it in stocks, bonds, etc. These mutual funds are professionally managed and invest the money in a diversified basket of securities. They earn money through interest, an increase in the value of shares, dividends, etc. These gains are then divided among the investors in the proportion of their holding.
[You may read: What is a Mutual Fund and how does it work?]
There are different types of mutual funds. Some invest in stocks (Equity MF); others invest in bonds (Debt MF), and a number of them invest in both (Hybrid MF). For this article, we are concerned with debt mutual funds only.
Debt mutual funds invest in bonds of different companies. These bonds then pay interest at a fixed rate over a period of time until they mature. Upon maturing, the principal amount is returned to the fund. The mutual fund then deducts a small percentage of management fees and distributes the rest among its investors.
Debt mutual funds are low-risk instruments, as a result of which, they yield lower returns compared to equity mutual funds. Depending upon the risk factor, these bonds are rated by different credit agencies. High rated bonds are secure, but again, yield lower returns compared to risky bonds.
Franklin Templeton is an example of a mutual fund. It operates several debt mutual fund schemes along with equity mutual fund schemes and hybrid mutual fund schemes.
What is the Franklin Templeton crisis all about?
Franklin Templeton is a global investment firm with a valuation of 698 Billion Dollars. Recently, they closed down 6 out of their 13 debt mutual schemes. These six schemes were- Franklin India low duration fund, dynamic accrual fund, credit risk fund, short term income plan, ultra-short bond fund, and income opportunities fund. They had combined assets of around Rs 28,000 crore, closely 25% of the total assets under management of Franklin Templeton MF in India.
According to Section 39 (2) (a) SEBI Mutual Fund Regulation 1996, a fund can close down a scheme ‘on the happening of any event which, in the opinion of the trustees, requires the scheme to be wound up.’ In this case, the trustees of Franklin Templeton India believed that closing the schemes would be in the best interest of the investors.
What were the reasons for such a step?
Franklin Templeton has a legacy of investing in high-risk, low-rated bonds. These bonds yield higher returns. This was their primary investment strategy. The strategy works quite well when the economy is doing well.
The six debt schemes which were closed down by the fund also had exposure to low-rated bonds. In a report prepared by B & K Securities, it was revealed that in 26 cases, which collectively raised Rs 7,697 crore, Franklin Templeton was the only subscriber. In a mint analysis, it was found that the schemes had huge exposure to AA-rated or below bonds. In one of these, i.e., Franklin India Low Duration Fund, the exposure was as high as 65 %.
According to the report by B&K Securities, investments in these schemes stood at Rs. 48,000 crores in August 2018. With the IL&FS default and the subsequent shadow banking crisis, the schemes had to write off investments worth Rs. 18,000 crores till March 2020. Exposure to companies like Yes Bank and Vodafone Idea also had a role to play. Therefore, the fund was already under a lot of pressure. COVID-19 delivered the knockout punch.
[You may read: About IL&FS crisis and What happened to Yes Bank?]
In April 2020 alone, Rs. 4,000 crores worth investments had to be written off in these schemes because of the pandemic and subsequent lockdown. There was a surge in redemption requests, as the investors feared that companies would not be able to meet their debt obligations if the lockdown continued. Redemption happens when investors withdraw their investments.
Due to the illiquidity in the market, the fund could not liquidate the schemes quickly enough to meet the requests of the investors. They could not find buyers for low-rated bonds, as no investor would invest money in risky bonds in these precarious times. Had they tried harder, they could have sold the bonds, but at a meager price. The investors, as a result, would have incurred huge losses.
They tried meeting some of the demands by borrowing money. The fund borrowed Rs. 2,200 crores to meet redemption requests. SEBI regulations allow MF schemes to borrow up to 20% of their total assets under management for meeting redemption demands. One of the schemes which were closed down had already borrowed close to 18%. But the requests kept increasing.
Another problem with indiscriminate borrowing is that the fund would have had to keep all its good bonds as collateral. This would have led to a problematic situation. The fund would have been left with risky bonds only. Had the bonds failed, the investors would have lost a lot of money.
Therefore, with a continuing increase in requests, the fund finally decided to close down these six schemes.
How will the investors get their money?
Since redemption is not possible, the investors will now have to wait until the bonds mature. The bonds would then payout, and the investors will get their money back. As a respite to the investors, the fund has decided not to charge any management fees from the investors while passing on the proceeds of these six schemes.
Another way in which the investors can get their money back is by selling the bonds. But the option is not feasible at the moment because the bond market is going through difficult times. An attempt to sell at the moment might lead to huge losses for the investors.
Because of the economic hardships that the companies are facing, the possibility of investors losing money cannot be entirely ruled out.
How did the RBI intervene?
The RBI recently announced a Rs. 50,000 crores liquidity scheme for mutual funds. Funds can avail of the scheme if they face extraordinary redemption pressures. The scheme is mainly a confidence-building measure among the investors, aimed at preventing further chaos in the bond market. A similar scheme was announced after the 2008 Financial Crisis, but no mutual fund availed it.
This special liquidity scheme will not be available to the six schemes which were closed down by Franklin Templeton. The fund, however, can use it for other schemes if required.
Neatly Explained. Thanks
Thanks, Sridhar 🙂
can you explain how the “write off” of investments take place??
‘Write-off’ is nothing but reducing the value of an asset. Let’s say your company ABC Ltd has invested Rs.1,00,000 in Il&FS. It is shown as an asset in the balance sheet of ABC Ltd. If IL&FS defaults, you will have to write-off investments worth Rs.1,00,000. It means you will have to remove IL&FS investments as assets in the balance sheet (in the year of its default) and show it as a loss in the profit and loss account. The effect is: Reduction in asset, reduction in profit
Note: Assets can be written off over the years also. If you have to write-off an asset worth Rs.100000 in 4 years, you will reduce your asset in the balance sheet by Rs.25000, and show it as loss each year for 4 years. At the end of 4 years, the value of the asset will become zero. Hope it helps.