Debt and Mutual Funds

Introduction

After the abrupt winding of 6 debt funds by Franklin Templeton Investments, the Reserve Bank of India (RBI) on Monday announced a special liquidity window of 50,000 crores ( Special Liquidity Fund Scheme) for mutual funds.

Under the scheme, the RBI will conduct repo (repurchase agreement) operations of 90-day tenor at a fixed repo rate of 4.40% for banks.

According to the RBI, banks can avail funds under this facility exclusively for meeting the liquidity requirements of mutual fund houses by extending loans and undertaking the outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of deposit (CDs) held by the fund houses. The scheme will be open till May 11 or up to utilisation of the allocated amount, whichever is earlier.

Need for SLF scheme

Franklin Templeton Mutual Fund’s decision to wind up six debt funds that had combined assets under management (AUM) of almost 26,000 crores.

Their value had eroded because of redemption pressures and mark-to-market losses due to lack of liquidity on account of the COVID-19 pandemic. That led to fears that the debt funds of many other fund houses could face redemption pressure accentuated by the panic sparked by Franklin Templeton Mutual Fund’s sudden move.

Are mutual funds’ debt schemes under pressure?

While the mutual fund industry clarified that what had happened at Franklin Templeton Mutual Fund was an isolated case, wider liquidity and other concerns persist.

A couple of fund houses have already seen huge erosion in the net asset values of a few debt schemes post the Franklin Templeton episode due to mark-downs of their holdings.

Market observers say debt schemes are under pressure due to a combination of factors.

How many debt assets do mutual funds manage?

The AUM of debt schemes in the mutual fund industry is about 15-lakh crore, which is more than half of the total AUM of Indian fund houses.

The worst affected sub-category of debt funds is Credit Risk funds which account for only 5% of the overall debt assets.

Investors, however, are sceptical about the overall credit quality of the assets; hence debt schemes are likely to see a spike in redemptions.

Mutual funds are allowed to borrow up to 20% of their assets to meet liquidity needs for redemption or dividend payout.

Fund managers say that while such borrowings are common in March — there are huge redemptions due to advance tax payments and other quarter-end obligations — a spillover of such borrowings to April is a cause for concern.

Quality of debt securities held by mutual funds

Fund managers are of the view that more than half of the assets in debt schemes have a rating of AA or above. They say that while about 20% to 30% of total debt AUM would be AAA rated or in cash, another 30% to 50% would be in AA+ or AA rating.

The ongoing nationwide lockdown has impacted the cash flows of most corporates, and investors are expecting defaults, especially from the mid and small-sized corporate segments.

What are the regulators doing?

The regulators are aware of the potential risk and are monitoring the situation closely. Market participants have already written to the Securities and Exchange Board of India (SEBI) to take action against Franklin Templeton Mutual Fund including appointing a high-powered committee to take over the management of the fund house while examining its investment decisions.

Quality of Franklin Templeton bonds

The Association of National Exchanges Members of India (ANMI), an umbrella body representing about 900 brokers, has written to the Ministry of Finance and SEBI that as much as 64.73% of the total AUM of Franklin India Low Duration Fund was in securities rated A or below, while in Franklin India Short Term Income Plan, such securities accounted for almost 59% of total assets.

The brokers’ association says Franklin Templeton Mutual Fund invested in long-duration securities even though SEBI norms state that ultra short-duration funds can only have bonds with a tenure between three and six months.