Home >Opinion >Views >Opinion | Debt funds in the news again for the wrong reason
Mutual funds invest in lower-rated papers, which are still investment grade, to offer higher returns on some of their debt funds. (Photo: iStock)
Mutual funds invest in lower-rated papers, which are still investment grade, to offer higher returns on some of their debt funds. (Photo: iStock)

Opinion | Debt funds in the news again for the wrong reason

  • The covid-19 crisis has led to a rush to cash for both firms and us as retail investors
  • This has led to a big redemption pressure on debt funds in March when the net outflow was almost 2 trillion

The bad news just does not seem to stop for retail investors—banks that don’t seem safe, markets that drop 30% and now a mutual fund that has wound up six of its schemes that had over 30,000 crore invested in them.

On 23 April, India’s eighth-largest mutual fund, Franklin Templeton Mutual Fund, with over 1 trillion of assets under management (AUM) announced that it was winding up six of its debt schemes.

Find the names of the schemes and details in this story by my colleague Renu Yadav.

This means that you cannot exit or receive dividends from the schemes, nor can you invest into them. Your money will be returned as the papers the mutual fund holds mature over the next few years and as the fund house finds buyers for the bonds it holds.

The story, in brief, is this: the covid-19 crisis has led to a rush to cash for both firms and us as retail investors. This has led to a big redemption pressure on debt funds in March when the net outflow was almost 2 trillion ( 12 trillion was invested and 14 trillion was redeemed). Investors have held onto their equity portfolio in March that actually saw net inflows going up by about 11,000 crore displaying mature investor behaviour.

The pressure put by redemption, the lack of adequate fresh inflows into debt funds, the lack of an effective market for lower rated bonds and the uncertainty around the ability of some firms to keep making payments of interest and also return the principal made this an unstable situation. Remember that debt funds invest in papers of various kinds—let’s just call them bonds—of governments and firms. As the risk of the bond goes up, the interest that the bond pays goes up too.

Read this to understand how debt funds give you returns

Understand this better: a mutual fund buys a bond sold by a microfinance firm. The covid-19 crisis hits and the MFI begins to find it difficult to collect its instalments from the people who have borrowed from it. The MFI begins to find a cash flow mismatch and wants to borrow working capital or longer-term money to keep operations going. But there is no money to borrow now. But banks used the cash window opened by the Reserve Bank of India (RBI) for 1 trillion to invest in the super safe paper of the government and very large firms. Then RBI opened another window for banks to borrow cheaply to lend to the MFIs and NBFCs for 50,000 crore.

Read this for more on TLTRO

The first tranche of this window worth 25,000 crore had few takers and more than half this money remains unborrowed by banks who have no appetite for risk. For mutual funds, the crisis comes from several places—investors begin to withdraw fearing risk, repayments on some papers become uncertain and they are unable to sell the bonds they hold because there are hardly any buyers or liquidity left. The crisis in this case is not the credit quality of the paper but the lack of a market for the bonds of a lower credit quality.

Mutual funds invest in lower-rated papers, which are still investment grade, to offer higher returns on some of their debt funds. Some of these are clearly marked as “credit risk" funds, others carry this risk without it being reflected in the name of the fund category—for example, in ultra short-term or income funds. Franklin Templeton has decided to wind up six of such schemes where the fund house was not confident of meeting future redemptions. This is, in fact, a fair thing to do because usually the small-ticket retail investor remains in distressed funds, while institutional and HNI investors get out when the price is still high. Templeton has actually done the right thing by treating all investors equally. The debate on the credit quality of the schemes is another matter of course—but investors who seek higher returns must understand that this comes with higher risk.

The event has shaken the industry as well as the investors deeply. This is the first time in India that an asset manager has killed its own schemes and will return the money to investors as the bonds mature over the next few years. What happens next to the wider market and debt funds, in particular, depends on the regulators. A previous crisis, in 2009, saw RBI opening a liquidity window for mutual funds. Just the presence of the money was enough and almost none of it got used. Maybe RBI will need to step in again to give confidence.

What should you do? This is something I have said often in the past, and I will say it again: equity, counterintuitively, is an easier risk to handle than debt, therefore do not invest in debt funds if you do not understand the risk of what you are buying. But it is not all about buyer beware, the mutual fund industry needs to rethink what message it sends out by its behaviour on the debt part of the market. Just a year ago, it was handling the debt fund crisis caused by questionable deals with promoters of shaky companies. The regulator needs to find a way to mark the risk in debt funds much better than it does today.

Monika Halan is Consulting Editor at Mint and writes on household finance, policy and regulation.

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