A lot has been written on this issue, but a deeper understanding of the crisis and decisions leading up to the event needs to be understood. Following, Franklin Templeton MF had shut six debt mutual fund schemes on April 23, citing redemption pressures and lack of liquidity in the bond market.
Undoubtedly, the schemes — Franklin India Low Duration Fund, Franklin India Dynamic Accrual Fund, Franklin India Credit Risk Fund, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond Fund, and Franklin India Income Opportunities Fund — together had an estimated Rs 25 thousand crore as assets under management (AUM). Check out CredCast for companies and FundSage for debt funds.
Indian Debt Market
In the Indian debt market, more than 9o% of the secondary trading in bonds is concentrated in government securities (G-Secs) of greater than 1 year maturity and T-Bills of less than 1 year maturity. So the liquidity and secondary market trading starts dropping off as we go lower down the credit curve into AAA rated corporate bonds and even lower for AA rated bonds. However, Single A rated bonds hardly trade. The equivalent of government securities is corporate bonds (NCDs), and commercial paper (issued by corporates), and certificates of deposits (issued by banks), in the less than 1 year issuance segment.
Additionally the returns in the debt market come from the most certain accrual – the coupon payments from the bonds held, and the less certain capital gains from interest rate movements. In G-Secs, accrual is the lowest and capital gains and losses are the highest. So as we go lower down the rated curve, accrual becomes the largest component and capital gains and losses becomes the smallest component. However, as we go down the rated curve, the probability of default also increases.
How did it affect?
On a pure accrual basis, G-Secs seldom compensate on the returns front for inflation. Hence mutual fund strategies concentrate on corporate issuer debt with high accruals. Since risk emanates from both – the credit quality equivalent probability of default, and liquidity, it is important to understand the trend from a macroeconomic perspective, micro economic (sectoral trends), apart from where each individual issuer dynamics are going. To be able to manage these big funds, the fund manager has to be ahead of the curve in anticipating both credit and liquidity trends.
With the outbreak of Covid 19, and shutdowns, both credits and liquidity came under stress. The corporate bond market froze and traded volumes dropped to less than 1ooo crores a day, with only the highest quality of credits being traded. Compared to the AUM of Franklin Templeton, or other big fund houses’ schemes, the liquidity in the corporate bond market is not sufficient to extinguish such large portfolios over a small period of time to pay for redemptions, even in normal times. During the Covid shutdown, the liquidity became non-existent. Even 6 months after opening up, the average daily liquidity has recovered to about 5,ooo crores a day – still a far cry from the peak of around 16,ooo crores a day.
Mutual Funds in the Indian Debt Market
Each group of entities in the bond market – banks, insurance companies, mutual funds, Provident Funds, FPIs (Foreign Portfolio Investors), and proprietary books are undoubtedly important. However, retail investors are a miniscule part of the bond market with lot sizes of Rs 5 crores for a bond, and Rs 25 crores for a money market instrument (T-Bills, CPs, and CDs), and each group tends to have a preferred habitat of securities. Hence, mutual funds tend to trade and invest in corporate bonds, CPs, and CDs, and a smaller exposure to G-Secs. So in an adverse cycle, a mutual fund is faced with a double whammy of low liquidity, and the securities they favour not finding a buyer, as other mutual funds would themselves be under liquidity pressure of redemptions.
The corporate borrowers moreover tend to arbitrage between their sources of funds from banks, mutual funds, and insurance companies through NCDs and CPs. CPs are typically borrowed for working capital requirements and rolled over continuously at a far lower cost than NCDs, and hence are attractive for corporates. It is the CP market which freezes and shows stress first as liquidity and credit tighten, as mutual funds can sell CPs at higher yields (losses) as, because of low duration, they impact less on the portfolio. In a scenario of Covid shutdown, issuer credit quality also becomes a suspect, apart from low liquidity, and hence, many CPs would not be rolled over, and corporates can also face funding stress. If the stress persists, the losses mount in a snowballing manner.
Following, in the stress of the Global Financial Crisis of 2oo8, 3 month CDs were dealt at a yield of 26%. CPs simply cannot be sold. Following at such a point, with snowballing possible losses to the underlying investors in its schemes, Franklin Templeton stood on that anvil in the 3rd week of April, 2o2o.
Unlike equity, which assumes a “going concern” for its issuers, in the corporate bond market, the major difference is time – time to maturity. However, every security (almost – except perpetual bonds) has a fixed time to maturity. So if the credit of the underlying issuer does not deteriorate, the bond will pay back interest (accrual) and the principal amount invested. Over time, the portfolio will mature, and hence the money will come back without having to sell and book losses at distress levels.
|> 5 years||0||5343||1655||3331||2450||100.00%|
|AUM as of early May 2020 (Crores.)||9627||2346||5343||1655||3331||2450||24753|
Despite the above estimate, as markets and liquidity recover, the fund house can sell these securities, if fair value is achieved.
Read more: Quasi-Sovereign Issuers Aren’t Zero-risk