The Reserve Bank of India on Monday announced that it was opening up a special window of liquidity worth Rs 50,000 crore for mutual fund institutions. The move, an echo of what India’s central bank did in 2009, was aimed at calming fears days after Franklin Templeton, one of India’s top ten mutual fund houses, shut six of its debt schemes, locking up nearly Rs 30,000 crore of investor money.
Franklin Templeton’s surprise decision sent shockwaves around the markets and the public at large, already reeling from the impact of a five-week coronavirus lockdown with little in the way of support from the Centre. The Reserve Bank’s efforts may have come too late for investors of the six Franklin Templeton schemes, but the central bank hopes it will reduce the chances of other mutual fund houses being forced into a similar situation.
Despite this, analysts fear that the effects of the coronavirus are only beginning to play out in the financial sector and that more stories like this will continue to emerge. Mutual funds have been a significant source of investment in India’s markets since 2016, and any changes to those trends could have a number of side-effects for companies hoping to raise money.
Here’s what we know:
What did Franklin Templeton do?
Franklin Templeton is the country’s ninth-largest mutual fund house. On Friday, April 24, it announced that it was winding up six debt schemes: Franklin India low duration fund, dynamic accrual fund, credit risk fund, short term income plan, ultra short bond fund and income opportunities fund.
Together these schemes had nearly Rs 30,000 crore of investor assets in them, equivalent to a quarter of all assets that Franklin Templeton was managing. Such a move is unprecedented for India, where the last time a mutual fund was forced to wind up a scheme was because of regulatory and legal orders.
In this case, Franklin Templeton chose to voluntarily wind up the schemes.
It also marked down investments in six other schemes, which were fund-of-funds, since they had investments in the schemes that were now wound-up. A fund-of-funds scheme is a mutual fund that invests only in other mutual fund schemes.
What does ‘wind up’ mean and what will happen to investor money?
First off, it is important to understand that these are debt schemes. They invest in instruments like corporate bonds and securities, not in stocks. Schemes that invest directly in stocks come under the “equity” category, and are unlikely to be affected right now.
“Winding up” in this case means that investors who had put money into those six Franklin Templeton schemes can no longer simply withdraw their cash based on the value of the underlying assets. Instead, the money is now frozen.
Franklin Templeton will now attempt to get back the value invested in those schemes either by selling the underlying assets, such as corporate bonds, or waiting for them to reach maturity, when those companies will have to pay back what is owed.
“Each scheme has its own maturity profile,” wrote Sanjay Sapre, president of Frankin Templeton’s Indian unit in a letter to investors, adding that “the schemes will explore all opportunities to monetize the underlying assets in the portfolio, without resorting to any distress sales, such that it can return investor monies at the earliest possible time. It will be the endeavor of the schemes to return these monies well in advance of the maturity dates of the underlying securities.”
CapitalMind calculated that, for one of the schemes, “if all goes well, and everyone pays up on time, you should roughly see 35% of your money paid to you at the end of 2020, and another 37% in 2021”.
In the face of the massive publicity campaign that mutual funds have had over the last decade, this is, for investors, as stark a reminder of the often-parodied statutory disclaimer that “mutual fund investments are subject to market risks. Please read the offer document carefully before investing.”
What actually happened at Franklin Templeton?
As MoneyControl and Bloomberg have reported, all six wound-up schemes were managed by Santosh Kamath, a “star” fund manager who is also chief investment officer for fixed-income at Franklin Templeton. Kamath is credited with having helped create a market for buying debt instruments that are ranked below AAA, the safest rating for private debt.
This means that Kamath’s funds would put money into companies that did not have as good of a rating for their debt as the top Indian companies, and as a result, had to pay much higher interest rates to access credit. These higher rates translated into better returns for investor that are willing to hold these instruments, albeit with a bigger risk if those companies are unable to pay in time.
Bloomberg, citing Value Research Data, said that “Kamath’s bets on lower-rated credit have paid off in the past, helping him outperform peers. Franklin’s India Ultra-Short Bond Fund has delivered a 7.7% annual return over five years, beating 80% of rivals.”
Some of these investments were particularly risky. Mint reports that Franklin Templeton was the only lender to 26 out of 88 entities in its debt schemes’ portfolio, meaning if they faced trouble, the mutual fund house would face the entire brunt of their failure.
Bloomberg’s Andy Mukherjee also wrote, in 2018, of how Franklin Templeton held nearly all of the zero-coupon bonds, a kind of debt, of Yes Capital, run by Yes Bank co-founder Rana Kapoor. Yes Bank has since fallen apart, only to be put back together by the State Bank of India. Mukherjee has pointed out that this sort of investment by the mutual fund is effectively a loan, but not by a bank or a non-banking financial company, the sort of transaction that should have been flagged by regulators.
What eventually happened at Franklin Templeton was that investors started pulling their money out of these funds that invest in risky debt, 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, eaving 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 and hope to gain back the value of the underlying assets either by selling them or waiting for them to mature.
What does this mean for mutual funds in general?
Not many analysts expect the pain to be limited to just Franklin Templeton. Investors have been withdrawing money from credit-risk funds in general, and the move to wind-up the schemes – leaving money frozen – will likely prompt many others to pull their money out.
Other fund houses have been at pains to convince investors that their debt funds do not invest in instruments that are as risky as Franklin Templeton’s, but it remains to be seen how effective this communication will be.
Systematic Investment Plans, in which retail investors put in set amounts into mutual funds, have kept India’s markets going for some time now, with a huge surge beginning in the aftermath of demonetisation.
A large part of that has gone into equity, which does not suffer from the same problem that debt funds have in this case. But if investors get spooked about mutual funds in general, that could have a major impact on investment in Indian companies, even as the economy is going through tremendous distress because of Covid-19 and the Great Lockdown.
Has RBI solved the problem? And what other side-effects may crop up?
RBI’s liquidity fund is aimed at reassuring investors and ensuring that funds have access to money to meet redemption pressure if people try to pull out their money. A similar effort back in 2009 is said to have calmed the industry, without actually needing to be used much. The fund offers cheap money to banks as long as they loan it out to mutual funds.
But not everyone is convinced this will work.
There is a chance that banks, which are clearly risk-averse right now, will not do enough to spread this cheap money around. As the central bank has learnt over the past week, increasing access to money alone has not been enough to convince banks to take on more risk.
Moreover, Moneylife’s Debashis Basu argues that this will certainly not be the last such fiasco, because of the way the mutual fund industry works and is regulated.
That might add to the woes of companies that have anything below the safest credit rating. Already accessing money is extremely expensive for these corporates. If mutual fund houses also stay away from them, it will add to India’s economic woes.
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