However, in a manner reminiscent of the half-built skyscrapers looming over India’s faltering real estate market, the markets regulator failed to finish what it started. When it defined categories like ultra-short, low-duration or short-duration, it specified the duration (time length) of the debt they could invest in, but remained silent about the credit quality of the papers. Some fund houses interpreted this as a free pass to take on credit risk, as they saw fit, in categories other than the credit risk one.
At the end of March 2020, the six Franklin schemes, five of which were not in the credit risk category on the face of it, had papers with ratings ranging from 88% to 100% below AA+, a parameter laid down by Sebi for credit risk funds. The six Franklin schemes were Ultra Short Bond Fund, India Low Duration Fund, India Short Term Income Plan, India Dynamic Accrual Fund, Income Opportunities Fund and India Credit Risk Fund.
When the going was good, debt schemes of Franklin outperformed their rivals handily. Franklin Credit Risk Fund delivered a compounded annual growth rate (CAGR) of 7.73% from 1 January 2014 to 31 December 2019. If you ignore the period after 31 March 2019, when defaults and downgrades hurt low-quality bonds, the CAGR climbs to 8.70%.
In the face of falling interest rates of fixed deposits (FDs) post demonetization and the tax advantage debt funds have over them, several FD investors were enticed into debt funds, across the industry, as well.
Franklin had seen some blips in its journey. Exposure to Jindal Steel and Power Ltd had gone bad in early 2016, but the fund house simply took the papers on its own books and contained the problem. In September 2018, a debt market crisis broke out due to defaults in IL&FS, but Franklin remained largely unaffected, although it did have some exposure to the Essel Group. “Assets under management (AUM) of credit risk funds grew 51% per annum since their inception in 2002 to ₹80,000 crore as of April 2019," wrote Sanjay Sapre, CEO of Franklin Templeton Mutual Fund, in a robust defence of the category in Mint. “Credit risk funds, which are believed to have higher risk, have not delivered negative returns over any three- or five-year periods in the 15 years till April 2019, besides outperforming corporate bond funds," he added. You can read the full column here.
The first big signs of trouble in Franklin emerged when an unfavourable Supreme Court decision in January 2020 on Vodafone Idea led the asset management company (AMC) to write off its exposure to the telecom provider. The AMC proceeded to also side-pocket this paper. Side-pocketing is the separation of a part of the portfolio in lieu of bad debt. It allows investors to exit the remaining portfolio without giving up on the chance of the bad debt recovering. The Yes Bank Ltd fiasco in March 2020 and the consequent write-down of its debt was another speed bump. However, the AMC was not alone in many of these debt accidents (other AMCs like UTI Asset Management Co. Ltd and Nippon Life India Asset Management Ltd also suffered) and there was little indication of the cliff edge to come.
In March, when the lockdown was announced in the wake of covid-19, India’s financial markets, which were already bleeding from a domestic growth slowdown, went into a tailspin. Equity markets dropped by 25-30% within a month and debt markets yields shot up and even temporarily hurt the ultra-conservative liquid funds. In the credit risk segment, the market simply froze.
However, savvy investors sniffed out the underlying problem and quietly began pulling out money from the six schemes. Faced with a flood of redemptions, Franklin simply borrowed money to honour them, because it was unable to sell its high-risk bonds. The fund house’s March portfolios revealed borrowing across five of the six schemes that were wound up, with one of them sitting on cash of -17.7%. In other words, it was borrowing up to 17.7% of its assets, dangerously close to the regulatory limit of 20% and the risk of leverage (borrowing) magnifying eventual losses for investors.
But the AMC put on a brave public face. An April 2020 Market Insights note from Santosh Kamath, chief investment officer (debt), Franklin, said that shorter-end products such as Ultra Short Bond Fund “provide a great investment opportunity".
Some schemes, such as Ultra Short Bond Fund, also had papers with prima facie maturity far longer than the typical maturity of papers in the ultra-short category. However, in a television interview, Sapre said that reports coming out on the papers of the six schemes have not factored in the call and put options that reduce the effective maturity.
When asked about credit risk in various categories, Sapre said, “All of these funds followed a core philosophy of generating yield by investing in papers that were investment grade but from AAA to A. Each fund then followed the regulations either in terms of portfolio composition or in terms of duration for the category in which that product was categorized."
The role of advisory
Average AUM in March 2020 showed the vast majority of the money in the six schemes was in regular plans or had come from distributors who charged commissions for providing advice to clients. “Commissions on the schemes were a league above other types of debt funds," said a compliance executive at a mid-sized AMC, who did not want to be named. Even after the winding-up announcement, the AMC kept regular and direct plan expenses separate, so the commissions would still be paid out to distributors, which would come investors’ pockets. “Much of their AUM came from IFAs (independent financial advisers) and not the big banks," said the executive.
A Pune-based mutual fund distributor, who spoke on condition of anonymity, said he had started getting his clients to exit Franklin schemes from October 2019. However, some clients stayed put till the very end, swayed by the tax burden that an exit before three years entails. “I did suggest an exit, but I should have been more insistent about it," he said ruefully.
Still other distributors were swayed by the Franklin’s brand name and its long history in India. However, the rose-tinted glasses did not stop at the humble small-town IFA. Morningstar India, a mutual fund ratings and research agency, rated four of the six schemes as “silver" and one of them as “gold" till the very end. Silver is the agency’s second-highest rating and gold is its highest. Morningstar only suspended ratings the day after the winding-up was announced. “Our conviction in these funds has stemmed from the experience of Santosh Kamath in the lower credit space, capability of the team in managing credit funds, and robust research infrastructure which has enabled them to shortlist investment worthy companies in the lower credit space for over a decade," said a note from Morningstar, explaining its ratings.
The Franklin Templeton debacle exposes a glaring loophole in Sebi’s classification of mutual funds. It has specified a host of categories that are defined by duration and not credit risk. This pins down interest rate risk for investors, but not the risk of downgrades and defaults. “The lack of any credit quality specifications for several debt categories is a major grey area. Franklin had a strategy to place aggressive credit calls in these categories. Sebi should definitely move to lay down rules for credit quality in them," said Prakash Praharaj, founder, MaxSecure Financial Planners.
This is the genesis of the problem and it needs to be fixed soon.