Okay but laana:
What's up with these debt funds?
3rd July 2021
Reading time ~ 3 minutes
Hi there,
If you've ever invested or are thinking of investing in debt funds - this one's for you! On Monday, the courts stayed SEBI's order barring Franklin Templeton from launching any new debt schemes for 2 years. So for this week's edition, we're going to talk about Franklin, what happened to their debt funds, risks, and what it means for you.
For this edition, we're assuming you have some basic understanding of how mutual funds work. If things are still confusing, sign up for laana's basics of investing module - we got you!
Debt, Debt, Debt!
Franklin Templeton operates mutual funds, just like HDFC, Axis, SBI Mutual fund, and the likes. Of the many funds it manages, some are debt funds. If you need a refresher - debt funds are where you're extending a loan to governments/ private sector companies/ public sector companies, etc. and they're obligated to pay you back the amount you've loaned with some interest on it. The terms of the loan also define the time period in which the amount needs to be paid back.
Depending on the likelihood of the companies being able to pay back the loan, they are given credit ratings: AAA is a good score, followed by AA, A, B, C, etc. - you get the gist. If the credit rating of the entity is not too great, that means there's a higher possibility that they will not be able to pay back the loan (which means more risk), and thus, they usually pay higher interest in order to compensate.
So, when you and I invest in these debt funds - our money gets invested in different loans + a part of it is kept as cash so that if and when we (or other investors) want to redeem any amount, the mutual fund is able to easily process the redemption.
Now, let's talk about Franklin. Franklin Templeton has been in the MF industry for quite some time. One of its key differentiators was the high rate of return it was able to provide for its debt funds. It was mostly able to do this by investing in lower-quality loans (even for the shorter-term debt funds), and as we saw above, lower-quality loans give a higher rate of returns but come at additional risk. However, they had their own risk management practices in place and pre-covid, all looked good - Franklin was able to continue giving higher returns, and carry on with this strategy.
Well, then came covid. Businesses started shutting down and folks had to dip into their savings in order to meet their daily expenses - many had no choice but to redeem their debt funds. The number of redemption requests for Franklin's debt funds became higher and higher, and while it was initially able to service these requests, it then had to dip into its cash reserves, and finally borrow money themselves in order to honor the redemption requests.
Now, the loans also had a fixed period in which they would be paid back, so it could really only get cash for the loans that were becoming due. Mutual funds are also able to sell these loans off, so that they can get cash today, and not wait for the loan tenure to get over. Unfortunately with covid, and the state of the economy, the only thing that would sell was their high-quality loans - which they did, but were only left with the riskier ones after. Things went downhill then quickly, and Franklin decided to "wind down" some of their debt funds in April 2020 - i.e it wouldn't take in any more money from investors, and it won't honor redemption requests until these loans actually get paid back. Then followed a series of litigation by investors. In Feb 2021, Franklin was instructed to pay out its entire cash reserves to the investors. The rest of the money will be paid out, if and when the other loans mature. SEBI then banned it from opening any new debt funds for 2 years, but a court on Monday put a stay on that order.
So, what does this mean for me?
Whatever happened at Franklin should not deter you from investing in debt funds - but it's a good reminder to go back to general principles while investing - which stood true before the Franklin issue and apply today as well.
First off, Debt funds are not completely "risk-free" - in fact they come with a variety of risks and it's important to be aware of them. Chasing returns (which is frankly, not in anyone's control) will only lead to more stress.
I mean, it's easier said than done - higher returns are attractive but let's remind ourselves to check if these higher returns are actually coming at additional risk. And you can make an informed decision based on the risk parameters of the fund - all of this information can be found on Morningstar/ Value Research (we won't discuss all parameters here since that would require an entire module). This is especially true when you've invested in debt funds to park and preserve your savings.
You can start by looking at the allocation of the funds - seeing what % the fund has lent to corporates vs governments (lending to governments is safer since they can't go bankrupt). Next, you can check the credit rating of the businesses - the higher the % of low-quality loans, the higher the risk. You can compare these with the category averages to understand where the fund stands. Check out how well diversified the fund is - i.e has the fund lent to any one company excessively? If there's a concentration of lending to one company, that leads to more risk since in the event that the company is unable to pay off the loan, that would have adverse consequences on the fund.
Franklin's strategy was to lend more to corporates - 70% of their lending in ultra short term and low-duration funds was to corporates (we’re talking pre-covid numbers) and in fact 30% - 40% was to those that had lower credit ratings. Now, Franklin was able to manage this pre-covid and get higher returns, but when one thing goes wrong, everything goes wrong, right? Looking at risk then, becomes even more important!
Thoughts? If you have any questions or would like to learn more about the parameters, reach out to us at rujgupta@laana.club
Please note that these are my views, and I’m more than happy to chat and discuss! I've only outlined a few parameters for the purpose of the blog - there are many more that you can look at in order to comprehensively understand the risk management of the particular fund.
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