In a notice dated 23rd April 2020, Franklin Templeton (FT), an asset manager with INR. 11.74 trillion assets under management (AuM) and with 4.32% of market share (AuM wise), announced the decision to wind up six schemes. Winding up of a scheme means that investors who had put money into these six debt schemes can no longer withdraw money from them and will have to wait till FT sells the debt securities held in the portfolio or till the debt securities mature and the issuer pays up whichever is earlier. The total AuM in these six schemes has reduced by 24.98% over a period of one month between Feb 2020 and Mar 2020 and 37.60% between 31 March and 23 April 2020. FT undertook sales of debt securities in their respective portfolio worth Rs35.75 billion between 18 Mar 2020 to 31 Mar 2020 to most likely meet redemption demands and rebalance the portfolio.

Source: Franklin Templeton Debt Fact sheet and reported debt transactions * Segregated portfolio is where the scheme has exposure to a debt instrument which has been downgraded to default status (where actual default occurs either on principal or interest amount due) and the scheme reports the amount separately from the main portfolio of securities.

These six funds form roughly 2.63% of the total Franklin Templeton AuM. The question that largely looms in the mind of investors is:
1.Why did FT have to take such a step?
2.Does winding up imply no return of money for investors?

Let us understand through this article what led to the wind-up and what it means for investors? First, we glance at the portfolio rating composition of these six schemes between February and March 2020.

All six schemes have negative cash, call and AAA rated securities component which suggest that the schemes borrowed in the call market and maintained these AAA rated securities in the market as a collateral to raise funds to meet the redemption demand. These schemes are now left with a major chunk (of their investments in AA- and A rated securities. While, FT was dealing with redemptions, the Indian debt market was witnessing an increase in AAA rated corporate spreads over government securities and reduction in value trades.

1.The average spread (bps) over comparable government securities for various AAA corporate rated corporate debt instruments, witnessed an increase especially in the week ending 27 March and 3 April 2020 indicating higher credit spread (i.e. credit risk) which tapered down by 24 April owing to the RBI relief measures.

2.Trades in corporate debt securities were witnessing a continuous dip between 20 March to 17 April 2020 suggesting a thinning in trade i.e. liquidity drop. ( Total trade value in INR billion during the week ended)

It is usual to witness outflows among liquid and money market funds during the month of March, due to corporate tax and other obligations. However, the magnitude of outflows may not be at a par in other debt categories. In March 2020, outflows across mutual fund debt categories was visible with outflows in categories such as Money Market funds, Ultra Short Duration, Liquid fund, Low Duration fund Floater fund etc.

The primary reason for the mutual fund cash outflows across categories may be attributed to the retail and corporate obligations arising due lockdown and the deteriorating credit profile of debt across rating categories. The diagram below indicates the Credit Default Quality Index (CARE Ratings) which suggests how the quality of debt (comprising of the dataset of 1,610 companies from CARE’s portfolio of 2,980 companies as of March 2012) has been deteriorating since April 2019 with a slight uptick between Jan-March 2020.

Source: Care Ratings – Credit Default Quality Index

From Mar 2019 to Jan 2020, the drop in CDQI was steeper compared to the drop in Sep 2017 to Nov 2017. The drop in the index during 2019 is largely attributed to the IL&FS and DHFL default, rating revision problems at various credit rating agencies (CRA) and the subsequent Securities Exchange Board of India (SEBI) intervention to tighten the rating framework process.

To deal with the ongoing demand of redemptions, FT attempted to sell their debt securities in the market and raised funds worth INR. 36.02 billion over 15 days.

Given the tight liquidity and wide corporate debt spreads over government securities, FTs move to wind down the schemes was a delayed one. Though this is not the primary focus of our analysis, the failure of the mutual fund trustees in anticipating these developments is worth thinking about. The return of invested money remains a big question mark, first of all FT will have to repay the lenders in each of these six individual portfolios, post that the investor money will be repaid which largely depends on how quickly the debt markets normalise, the appetite of the debt market for AA- and A+ rated debt securities and whether the issuers in the respective rating categories don’t lead to individual defaults in the future.