What Franklin Templeton winding up credit funds means to investors 

#GS3 #Economy 

Franklin Templeton Mutual Fund, the ninth largest in the country, has jolted investors with its decision to wind up six yield-oriented managed credit funds from Friday(24 April)  

  • The six schemes — Franklin India low duration fund, dynamic accrual fund, credit risk fund, short term income plan, ultra short bond fund and income opportunities fund — have combined assets under management of around Rs 28,000 crore, nearly 25% of the total assets under management (Rs 116,322 crore) of Franklin Templeton MF in India. 
  • The fund house has said it took the decision in order to protect value for investors via a managed sale of the portfolio, amid the severe market dislocation and illiquidity caused by the COVID-19 pandemic. Investors, however, are bracing for substantial losses. 

What does the winding up of schemes mean for investors? 

  • It essentially means that Franklin Templeton MF will first liquidate the assets in the schemes and then return the money to investors.  
  • With the market situation tough for now, investors may not get an immediate exit. Industry insiders say the fund house may find it difficult to get a buyer for the low-rated assets in the portfolio, so investors may have to wait.  
  • On the other hand, if the fund house pushes hard to get new buyers for those assets, it will go at a substantial haircut, which would mean a big loss for investors on their capital investment. 

Will this decision affect other schemes of the fund house? 

  • The fund house has said that all other funds it manages — equity, debt and hybrid — are unaffected by the decision.  
  • So, the winding up of these schemes will have a limited impact on investors of other schemes.  
  • The fund house said the ongoing liquidity crisis in the market has impacted higher yielding, lower-rated credit securities in India and, since these six schemes had direct exposure to them, they have been impacted. 

What are credit risk funds? 

  • Credit risk funds are debt funds that play on the principle of high-risk-high-reward.  
  • By definition, credit funds invest 65 per cent of the portfolio in bonds that are AA rated or below, and investors must be aware that they are investing in schemes that are investing in lower-rated papers.  
  • While higher-rated bonds of companies are more secure and offer lower interest rates, credit risk funds generally invest in lower-rated bonds which offer higher return but also carry a higher risk. 
  • Shutting down six schemes is unprecedented and can break investor confidence in mutual funds. 

Why are they risky? 

  • The managers of most credit risk funds have been seen chasing high yields and ignoring the associated higher risk.  
  • This strategy worked well when the external environment was good — the economy witnessing higher growth rates, and no undue pressures on the liquidity front.  
  • In such times, when credit funds were exposed to companies with a weaker balance sheet, chances of default were low.  
  • However, when there is stress in the economy, and even strong companies are finding it tough to raise funds, companies with a weaker balance sheet and higher leverage (AA rated and below) are most vulnerable.  
  • At such a time, banks, mutual funds and financial institutions that have lending exposure to such companies will see stress building in their books, and borrowers will not be able to service the interest and principal payment.  
  • Investors are now questioning why only Franklin Templeton was unable to read the writing on the wall and act early. 

How important is the role of the fund manager? 

  • While all credit risk funds invest up to 65 per cent in bonds rated AA or below, market experts say that fund managers can lower their risk by following a higher diversification strategy.  
  • If the scheme is diversified significantly on the asset side (not given large exposure to a few companies), then even if there is a default by one or two companies, the entire portfolio does not get affected.  
  • Similarly, if the scheme is well diversified on the liability side (not having just a few large investors), then even if one or two investors seek redemption, it does not push the fund house to sell — as has happened with Franklin Templeton. 
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