Redemptions pressure triggers liquidity squeeze

Last week, Franklin Templeton (FT) India announced closure of six of its debt funds. This is an unprecedented event in India. Debt markets have remained in turmoil ever since the debacle of IL&FS and the resultant non-banking financial companies (NBFCs) turmoil in 2018.

Moreover, since the formalization of economy post-demonetization, there have been defaults by corporates particularly in the small and medium enterprises (SME) segment.

The mutual fund (MF) industry, which provides a sizable liquidity to corporates through their debt offerings, has taken a big hit during this period. The current pandemic and the subsequent lockdown of the country has worsened the liquidity situation.

The Reserve Bank of India (RBI) partly sensing this possibility or being aware of the situation has launched various measures to bring in liquidity into the system. While announcing moratorium on loans across the term loans for a period of three months and added with other monetary measures of cutting interest rates.

Also, RBI has cut the cash reserve ratio to multi-decadal lows so that the obligation of banks to preserve cash is condensed. Further, it has reduced the reverse repo so as to disincentivize the banks from hoarding the cash with the central banker.

Topping up with these, RBI also announced two rounds of Targeted Long-Term Repo Operation (TLTRO) to inject liquidity into the system as well as to ensure the transmission of rates. This is beyond the traditional ways of reducing the rates and conducting open market operations to infuse liquidity into the system.

Despite all these measures, the uncertainty of the crisis unravelling and the investors' increased preference for cash have resulted in higher redemptions in debt markets.

This has put the debt mutual funds in cross hairs along with the periodic quarter-ending liquidity squeeze. Though these are generic concerns for all the debt MFs, the quality and tenor of the securities held by the FT funds have had an adverse impact on the liquidity.

The reason for the closure as per the spokesperson of the fund house is that considering the immediate illiquidity of the investments, these funds were fair valued.

It felt that the situation requires these schemes to be wound up and that this is the only viable option to preserve value for unitholders and to enable an orderly and equitable exit for all investors.

The fund house said it would pay investors as and when these papers mature, and the fund house manages to recover the amount. The woes arose with the concentration of these funds to the troubled sectors of NBFC, power, realty and infrastructure.

The sudden development has caught the Systematic Transfer Plan (STP) investors unaware as many of the investors use the short-term funds to enter equity in staggered way. Also, the investors who've recently turned risk-off and moved from equity.

FT has said that it would publish the Net Asset Value (NAV) of these funds on a daily basis and also eliminated the management costs along with the exit loads on these funds. For investors already in these funds.

For instance, the average maturity of Franklin Ultra Short Bond Fund is 0.62 i.e. about seven months, though the actual amount received at the exit would come mostly at the time of the maturity of the securities or when traded, likely be at a discount.

The fund house which is ninth largest in terms of assets managed in India has repeatedly reiterated its commitment of its business in India. This episode, however, cast doubts on the entire market participants and created a trust deficit.

Despite the SEBI's categorization, a lot of debt schemes take on risks that aren't reflected in the typical category. Fund managers often in a bid to generate better returns tend to take higher risks. Although, a one-off event, this could trigger run-on the other schemes further worsening the sentiment.

Most fund houses have voluntarily started to communicate about the quality of securities they own across the schemes and the liquidity position they hold in their portfolios to alleviate the investors' concerns.

This event also raises a pertinent question of the risk investors are either ignorant of while investing in debt mutual funds and hence should seek professional help.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)