Corona's market jitters

With the collapse of asset manager Franklin Templeton India’s six debt schemes sparking panic among investors, a few of my acquaintances who have invested in mutual funds are now a worried lot. Is our investment safe? Do mutual funds still make sense as an investment option?

These were a couple of rapid fire questions from them as COVID-19 induced lockdown triggered crisis in the mutual fund industry. Notably, with the closure of these six debt schemes, the COVID-19 pandemic induced lockdown has marked its first casualty in the Indian financial market. The collapse of the schemes has resulted in eroding the confidence of investors to a large extent and they now fear for their money. These six debt schemes together have Assets Under Management (AUM) worth over Rs 28,000 crore. Debt markets have been facing a lot of liquidity issues over the last month in the current uncertain economic environment.

Basically, in the pre-coronavirus period, multiple factors had led to a general lack of trust about mutual funds. The prospects of debt mutual funds were already doubtful and had created panic among investors when HDFC and Kotak Mutual Funds’ fixed maturity plans (FMPs) failed to return investors’ entire money on account of delay in repayment by two Essel group companies. Investors in various debt schemes were already affected by ratings downgrades of investments, defaults or delay in repayments.

Precisely, for the past few years, the safety of investment in mutual funds was bearing question marks as the mutual fund management was facing rough weather and most of the schemes were under-performing. Notably, most of the lay investors are into mutual fund investment as they were lured by high returns. Surprisingly, very little was talked about the risk of even losing capital investment while wooing the investors.

Now let’s come to the current crisis in the mutual fund industry which has been triggered by the Franklin Templeton, one of the largest mutual fund houses in India, managing assets worth Rs.1.16 lakh crore. The fund house has been an early and patient investor in India for over 25 years. It was very popular among investors here as they used to manage the low rated debt instruments effectively and efficiently when compared to others. These low rates instruments yield high returns and pass on to its unit holders making investors happy.

The coronavirus pandemic has exposed the wide loopholes in the investment strategy adopted by the mutual fund industry. It was believed in the investment arena that the Templeton’s strategy was all along set up for failure. Running an open-ended scheme while investing largely in low-grade i.e. below AAA, illiquid investments with the objective of earning higher returns than most peers, was a prescription for disaster.

Let’s first understand what eventually happened at Franklin Templeton. The investors started pulling their money out of these funds that invest in risky debt i.e. instruments having rating below AAA, either because they needed the cash as a result of the massive economic hit India has taken or because they were concerned about how the schemes would perform.

The company at first attempted to borrow funds to pay back investors. But the redemption pressure ended up being too high, leaving the fund house unable to return the money. Additionally, because its underlying assets were in the risky category, it was quite likely that there would have been no other takers for those instruments either.

As a result, the fund house decided to wind-up the schemes with a hope to gain back the value of the underlying assets either by selling them or waiting for them to mature.

Before deliberating further on the crisis which has hit the mutual fund industry, let me share a general trend observed among the retail investors while choosing an investment vehicle. Most of these investors show herd mentality.

They don’t bother to understand the structure and risks associated with the investment instrument before parking their money in it. They don’t question the fund managers and remain focused only on the high yield. In fact, a gullible investor is not ready to listen to the negatives and probabilities of losing entire money.

My acquaintances mentioned in the beginning have also surprised me by asking about debt funds. They have taken mutual fund route to investment, but they are now confused about the Debt Fund schemes as Franklin Templeton has closed down six Debt Schemes leaving investors clueless about their money.

So, what is a debt fund? A debt fund is an investment pool, such as a mutual fund or exchange-traded fund. Often referred as credit funds or fixed income funds, its core holdings comprise fixed income investments parked in short-term or long-term bonds, securitized products, money market instruments or floating rate debt.

In simpler terms, the funds which invest in instruments like corporate bonds and securities, not in stocks are known as debt funds.

Here it makes a sense for naïve retail investors to understand the collapse of Franklin Templeton debt fund schemes. Understanding this failure of the well-known mutual fund house can act as a guiding investment principle for the investors. Normally, people follow success stories to understand a process of achieving financial goals through investments. But in the COVID-19 induced situation, a look at the failures of even established systems and procedures can go a long way to realign the processes to mitigate risks to a large extent.

Why the schemes collapsed? There has been a dramatic and sustained fall in liquidity in certain segments of the corporate bonds market on account of the COVID-19 crisis and the resultant lockdown of the economy which was necessary to address the same. At the same time, mutual funds, especially in the fixed income segment, were facing continuous and heightened redemptions, which intensified in the months of March and April, witnessing an estimated net outflow of Rs 9,148 crore in March alone. Franklin Templeton says that in this scenario, this is the best possible way to safeguard the interest of investors and is the only viable means to secure an orderly realisation of portfolio assets.

Precisely, the fund house had taken aggressive credit calls in their portfolios. As India went into lockdown post the covid-19 crisis, these papers became largely illiquid in the debt market. At the same time investors grew jittery about credit risk and redemptions in the funds soared. This forced the fund house to borrow money from banks to honour them. However this position was unsustainable and hence the fund house took the decision to close the schemes to both inflows and outflows.

So, the investors won’t be able to withdraw money from these schemes. However, winding up of the schemes does not mean that investors’ money is lost. The schemes will continue to receive scheduled coupons and maturity payments, and the fund house will look for all opportunities to seek pre-payments from issuers or to sell portfolio holdings, without incurring a significant impact cost.

How to look at the future? The Franklin episode is an eye opener and seriously calls for a review of investment portfolio, especially investment in debt funds. It should be noted that the investors of the collapsed schemes won’t be able to get the money at the moment even if they have urgent need of money to meet some financial goals and emergencies.

(The views are of the author & not that of the institution he works for)