Franklin AMC Shuts Down Six Debt Funds - What You Need to Know

Yesterday after hours, Franklin Templeton AMC published a notice stating the following -

Franklin Templeton Trustee Services Private Limited has decided to wind up following schemes of Franklin Templeton Mutual Fund -
• Franklin India Low Duration Fund
• Franklin India Ultra Short Bond Fund
• Franklin India Short Term Income Plan
• Franklin India Credit Risk Fund
• Franklin India Dynamic Accrual Fund
• Franklin India Income Opportunities Fund

This is effective after transaction cut-off of 23rd April, 2020.

What does this mean?

This means that these mutual fund schemes (and all their option/plan variants) are now closed for transactions - investments (lumpsum/SIP) or even redemptions.

Transactions made till cut-off on 23rd April 2020 will be processed but all further transactions will be rejected by the AMC.

So if you have any money invested in any of these funds you CANNOT withdraw that money.

Is that even legal?
Yes, it is.

Why did they do this?
Well that's the Rs. 30,0000 Crore question.
In fact, what they did is actually in the best interests of the retail investors given the mess they were already in.

Please do explain.
For the past few years, these funds were chasing a high-risk high-return strategy by investing in lower credit quality, higher yielding bonds. (In case you are wondering why they did not just invest in high credit, high yielding bonds - well there's no such thing. You can either have high credit, low returns or low credit, high potential returns.)

It worked well for them when the going was good. Their returns were higher than most other funds in their category. And this is the reason why most of you probably invested in these funds in the first place.

Things started going south when the IL&FS default happened and now because of the COVID-19 crisis, these lower credit rated companies are not in a position to repay their loans i.e. bonds. Their business have been severely impacted and they do not have much cash in their accounts. (That's why their credit rating was lower to begin with). For the same reason, no one else wants to buy these bonds in the bond market also.

Now, looking at all this, all the 'smart' investors were redeeming money out from these funds. Now how does a Mutual Fund handle redemption? It has some cash in hand for day-to-day operations but for large redemptions, it can only return money by selling off a portion of its portfolio.

Now this is a classic self-exacerbating situation. The initial spate of redemptions get honored by selling off the most liquid part of the portfolio - the portion that can be sold off easily. Usually these will be the highest rated good quality bonds. But if redemptions just keep coming, you are just left with lower rated less liquid bonds. Stuff that no one wants to buy currently.

The redemptions just kept coming. Now how do you sell something that no one wants to buy? By selling it for cheaper and hoping that the discounted price will be attractive to someone with a higher risk appetite than you. When you sell it cheaper, you are taking a loss but you don't have any other option as you need to honor the redmeptions.

With this COVID-19 situation, it reached such a stage with these funds, that they would have to take significant losses to offload the low quality bonds that they held. And investors who were not redeeming would suffer the loss AND they would be left with an even lower quality portfolio.

So they decided to shut down the redemptions. No one was investing anyway so they just decided to wind up the fund.

By stopping redemptions, they can effectively just wait for the bonds to mature - most of the bonds have a maturity of more than 1 year and hope that by that time these companies will be back on track and will be able to pay off their bonds.

Okay whatever. Is all my money in these funds gone?
No. But it is likely you are not going to get all of it back. And you are not going to get it back anytime soon.

How can I get my money back?
There is nothing that you can do as of now. As per Franklin’s communication, money will be returned to the investors as and when the underlying bonds either mature (and return the money) or if and when they can be sold to someone else. If there is a default i.e. the maturing bond's issuer (i.e. the guy who took the money as loan) can not pay back, then the investments in those bonds will be written off.

So by and large, you will get your money when these bonds mature (IF they don't default).

As discussed above, most of these funds have an average maturity (i.e average remaining maturity of the underlying bonds) of a year at least (as on March 31st 2020).

Franklin Low Duration Fund - 1.46 years
Franklin Dynamic Accrual Fund - 2.55 years
Franklin Credit Risk Fund - 3.08 years
Franklin Short Term Income Plan - 2.75 years
Franklin Ultra Short Bond Fund - 0.62 years
Franklin Income Opportunities Fund - 4.28 years

If on maturity the bond issuer is unable to repay the loan amount, then the bonds will be considered in default and their investment value will be written off as a loss. The fund may or may not create a separate segregated portfolio for defaulting securities in this case.

You can see the portfolio holdings of all Franklin Funds here.

How will it happen logistically?
One possibility is that the money received (either from bonds maturing or by selling bonds) will be returned as dividend to the investors and there will be a corresponding reduction in NAV.

These funds will keep declaring daily NAVs which will reflect the value of current holdings minus the money distributed.

Finally when everything is either sold off or matured or written off and all the proceeds have been distributed to the investors, NAV will become zero and the fund will cease to exist. More details are awaited on this.

What about other debt funds?
That's the Rs 14,00,000 Crore question.

We believe that funds holding high credit quality bonds will not need to resort to such measures. Not all AMCs took the cowboyish approach that Franklin did towards managing so many of their debt funds. For eg while Franklin Low Duration Fund has almost all of its portfolio in AA or lower rated bonds, IDFC Low Duration Fund (a fund that we have been recommending) has ZERO exposure to anything below AAA. Not 30% or 20% but zero.

Even AMFI has come out with a statement to assure all the investors that there is no need to panic and redeem -

"Fixed income schemes of most mutual funds have superior credit quality as confirmed by ratings of independent credit rating agencies and continue to remain fairly liquid even in these challenging times."

However, we have always erred on the side of caution with debt funds. Our philosophy has always been that debt funds are for safety and peace of mind. Hence, we have always chosen safety over returns for our debt fund recommendations.

This is partly the reason why we were able to sidestep all the defaults by companies like IL&FS, DHFL, Reliance Capital, Vodafone-Idea, Yes Bank (there is always some bit of luck involved).

Hence, out of abundant caution, we are currently restricting our debt recommendations to only liquid funds (at least till the COVID-19 crisis is past and things are back to normal).

You can check out the updated set of all our recommended funds here.

If you are a Goalwise investor, you can just rebalance your SIPs and portfolio to the new recommendations.

If you have any questions, please feel free to reach out to us. :)