After the Franklin earthquake, he is in the race to fix debt funds

The biggest jolt – now the subject of concern for 300,000 investors – came on April 23, when the eighth largest asset management company (AMC) closed six of its debt schemes. Franklin Templeton’s decision in India was shocking and raised fears that debt mutual funds may not have been immune to the economic slowdown that followed the epidemic.

Franklin’s investors will be in pain because the money-back process is now mired in court battles. Last week, the Gujarat Supreme Court kept its ruling the critical electronic voting process required under the regulations of the Stock Exchange of India (sebi) at least until June 12. The Gujarat court is debating whether the way the money was closed is itself illegal.

The second case is before the Madras High Court, which issued notices to AMC and the market regulator seeking a report on the recovery process. In the coming days, the matter is likely to escalate because a group of high net worth individuals (HNIs) has filed another Supreme Court case alleging misconduct. Another case was filed in the Delhi High Court as well.

Over the past month, an initial round of frustration was directed at Franklin Templeton, and after that, investors turned their anger against the entire industry on social media. A corrupt form of the Mutual Funds slogan soon began to turn on social media platforms: #MutualFundsSahiNahiHai (Mutual Funds Not Good for Investors).

The recurring crises in India’s debt space (presumed safe haven), and the error Franklin is witnessing, are now beginning to change the landscape of debt investment funds in deep ways. One-time credit risk funds have been reduced to less than half their size in just one year. Credit risk funds are those that invest at least 65% of the money in low-rated bonds and you may not find many investors in the foreseeable future.

There are also more regulations and increased disclosures in the near future. These will focus not only on where the money is invested, but also on who are the major investors and their redemption patterns. This is to ensure that individual investors are not left with the bag after the seasoned investors withdraw their money.

The old and completely vague Sebi rules governing the termination of mutual fund plans will need major revisions.

Meanwhile, fund managers have already made a quick turnaround. They just started testing the waters with attempts to innovate in debt, but now they’re back to safer betting.

Aside from investors, what these shifts might mean for the general economy is another puzzle altogether. Business finance in India is heavily dependent on bank credit (about 60%). Private debt and corporate bond instruments began to acquire a new lease on life only in the first part of this decade. Now, bank lending has frozen, suddenly the kosher debt funds are no longer, and business has stopped.

“The fund managers have started to bet on the debts of the least exploited companies, which in turn would have increased the capacity to trade. The fallout from this crisis is the industry now returning to taking safer bets like High-grade securities or government securities. This is unlikely to change any time soon, which is definitely a pity because it will hinder the development of the debt fund industry for at least a few years. ”

Credit ratings

For years, debt funds have been transformed into being the son of the poorest equity funds. The stock market is where it shines, and the debt market, despite many white papers, is still called the “dead market” at industry conferences.

So, it should come as no surprise that research on credit risk of debt funds has taken a back seat. While stock teams were formed with full research teams at the beginning of the boom of mutual funds in India, the first debt credit rating did not begin until after the 2008 global financial crisis. But the number of AMC companies that woke up to the need for a proper credit rating was not until 10.

By the way, at that time Franklin Templeton decided to be creative in debt, with some credit research to support him.

“Franklin’s debt strategy was clear. She was taking credit risk. It would take unique calls to increase the return on investors. A sales chief at one of the leading funds said,“ Out of ten bets, two can go wrong. ”

Credit risk is when the source cannot, which leads to a loss of capital as well as interest. But the reward on receiving the right call may mean higher returns on riskier bonds.

Other fund funds that were initially nervous about this strategy lost a lot of business due to Franklin Templeton’s debt schemes. They had to change gears due to pressure from the in-house sales team.

As a result, many AMC companies rushed after 2010 to include credit risk in their fund portfolios. For more than a decade until then, debt fund managers were only exposed to interest rate risk that comes from investing in government securities (g-secs).

But as the shift towards lower-rated bonds began, additional pressure points were accumulating: the lower-rated securities market was nascent, very shallow, and found no buyers on the open market. So, even some default (a reasonable expectation in the credit risk group) can lead to a liquidity trap.

A Prasana, chief economist at ICICI Securities BDC said: “The core corporate debt market has been under development for the past 25 years, but it is still suffering from a lack of liquidity. The hope is that as recovery and solution mechanisms mature. “The market will become deep in India.”

Inevitable fault lines began to emerge in early August 2015, when JP Morgan halted redemptions on two of its plans due to the withdrawal of Amtek Auto’s underlying paper rating.

But Sujoy Das, head of (fixed income) at Invesco Mutual Fund, said that the real rude awakening was the sudden drop and default in the rental and financial services infrastructure (IL&FS), which until September 2018 was a highly rated paper. After IL&FS, a group of cards – mutual fund investments in Dewan Housing Finance Ltd securities, Yes Bank Ltd, Essel Group companies were unsuccessful.

“Most stakeholders understand justice appropriately because of its long history. But on the credit side (risks), there is a lack of understanding. A fund manager at a leading financing house said:“ Fund managers were usually experts in interest rate risk, not credit risk. ”

This lack of experience in assessing core risks has almost entrusted AMCs to key external functions. The rule of investing in securities was left almost entirely to rating agencies and not on the basis of internal due diligence.

Until the wrong mechanisms inherent in the ratings game exploded alongside the crash of IL&FS, the risk assessment in many AMCs was just a one-man division. Sometimes equity research is asked to rate the credit risk of debt securities as well. This was a fundamentally flawed strategy. While shares relate to retained earnings in the future, debt is about continuing cash flows sufficiently sufficient to be paid off regularly. “The credit decision cannot be left ideally for one person (fund manager) because the cost of error is too high. A mid-size AMC credit officer said the rating is just one entry.

At the end of 2018, Sebi advised companies not only to rely on credit rating agencies, but instead, try to rate their credit.

“After IL&FS, we have added parameters such as the borrower’s ability to constantly raise new money; whether investors are increasing overtime hours; secondary market liquidity (tradability) of the underlying paper,” said Dves of Invesco.

But what Franklin’s saga revealed is that these initial steps toward conscious risk-taking came a little late. While converting investor money into high-risk high-risk debt was essential to expanding the corporate debt market base in India, it was assumed to be accompanied by better systems for assessing core risk. But over the past ten years, investors have largely gone blind. Will that change?

Organizational gap

While Sebi directed AMC to consider their own credit risk assessment research, it is not yet mandatory. Sepi regulations still require finance houses to use ratings agency ratings when making investment decisions.

Sebi rules specify that liquid funds must hold at least 25% of their assets in cash and cash equivalents in order to meet recovery pressures. But this is not required from other funds.

Sebi allowed credit risk funds, corporate bond funds, program support units, and bank funds to maintain an additional 15 percent in g-secs. “We are thinking about whether it could be made mandatory during credit events,” said a regulatory official, who did not want to be named.

Another big gap is the Sebi rating of funds. In October 2017, the agency decided to reclassify funds to reduce “I, too” money chaos. The initial intent was to cut the 2000 individual funds to exactly half. But the final form created many categories. In debt funds, the issuance is issued where one class is determined on the basis of when the bonds will reinvest and another group is identified through the paper’s rating or credit profile.

In Franklin’s case, she took out credit bets on income funds and even bonds maturing in 2029 in her very short-term fund, which needed an average of 3-6 months (the time it takes for bonds to pay).

“Mutual funds need to invest in specific medium maturities to be called short-term or very short-term, etc. They instead repackage long-term bonds as short-term bonds using floating rate bonds that reset the interest rate owed, Deepak Shinoy says, Capitalmind Wealth CEO: “Every six months, this will meet regulatory standards.”

Sippy also provided the funds on the condition of escaping using the mid-term classification, which allowed the funds to average long and short term notes while meeting the fund’s investment criteria.

Pankaj Patak, Fund Manager – Fixed Income at Quantum Mutual Fund: In the future, both the credit profile and paper duration should be used to classify funds to avoid fund managers bearing credit risk in funds they are not supposed to do.

Introduction to the road

Shah said: “Besides the point, a lot of prescriptions will lead to dying capital markets, the allocation of ineffective capital and a lack of product innovation to meet the different desire to return risk. Let’s have a mix of risks and return to satisfy investor appetite.”

The only thing Sebi can do right away is to authorize fund houses to have internal credit rating systems and to cancel the obligation to move to ratings agency ratings.

Sebi can also take advantage of this opportunity to remove dust and update provisions regarding termination of plans. While Sebi allowed listing units to be closed out, a lack of liquidity in the underlying paper would make this exit inapplicable for the majority of investors.

The 1996 rule that Franklin used to finish his plans is vague and unclear. What if Franklin does not get the required 50% stake from unit owners to start the termination process? Will Franklin have to go to unit holders with a new proposal? Will Sepi step in? Shouldn’t Sebi guarantee a fixed-term refund?

When an investment of 300,000 investors valued at Rs. 25,658 crore is at stake, this ambiguity in the law and regulations is a cause for concern. Since the mid-1990s, a lot has changed with the India mutual fund industry. Perhaps it is time for the regulator and regulations to wake up to these changing realities.

(Neil Porat contributed to the story.)

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