The pain caused by coronavirus crisis in the stock market has percolated into the mutual fund industry. With US-based Franklin Templeton closing its six credit fund schemes effective from April 23, 2020, liquidity shortage in the Indian capital markets has become evident.
These six funds are-Franklin India Low Duration Fund, Franklin India Dynamic Accrual Fund, Franklin India Credit Risk Fund, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond Fund and Franklin India Income Opportunities Fund.
The MF closed these schemes during the coronavirus crisis. However, the credit risk schemes were facing redemption long before coronavirus hit India's territory. Collectively, these schemes had lost Rs 16,804 crore in form of AUMs from August 31, 2018 to March 31, 2020.
But they lost money faster when coronavirus hit Indian capital markets. From March 31, 2020 to April 20, 2020, these six schemes witnessed redemption pressure worth Rs 4,075 crore.
As coronavirus crisis squeezed liquidity from the system, corporates and HNIs who were major investors in these funds had to aggressively redeem debt mutual funds to compensate for their cash shortage.
With a majority of their funds invested in instruments rated AA or lower, the fund had no option but to close these schemes after witnessing redemption of over Rs 4,000 crore in less than a month. Papers rated AA and lower will find almost no or very few takers amid the crisis in the financial system. The six funds constitute less than 1.4% of the Indian mutual fund industry's total assets under management as of March 31, AMFI said.
This may be the first instance when a fund house has shut its schemes due to coronavirus crisis but it's not the first one where credit risk funds have found themselves in tight spot.
Apart from high returns they generate, some credit risk funds also have a history of losing money due to defaults by their borrowers.
In February 2016, Crisil downgraded Jindal Steel and Power's (JSPL) credit rating to A4+ from A3+, signaling a negative outlook.
Debt mutual funds held around Rs 3,000 crore worth of bonds at that time. Debt funds of Franklin Templeton such as Franklin Templeton Short Term Income Fund and Franklin Templeton Credit Opportunities Fund were the worst hit. Some schemes NAV fell by over 1.6% on February 15. The AMC shifted debt from the books of these funds to its own books and their NAV gradually recovered. However, investors had to suffer losses caused by the downgrade.
On September 7, 2018, DSP Credit Risk Fund which had substantial holding of IL&FS group debt had to markdown its net asset value. NAV is market value of a mutual fund unit. The fund's NAV fell from 29.06 to 28.83 in a single session, a drop of 0.8%.
DSP Credit Risk fund had exposure of Rs 445 crore or 6.47% of its portfolio to IL&FS and its group companies. On April 30, 2019, after Reliance Home Finance and Reliance Commercial Finance were downgraded to 'Below Investment grade,' net asset values (NAVs) of 38 debt and hybrid funds fell.
On June 5, 2019, Crisil lowered ratings of commercial papers (CP) issued by debt laden DHFL to default. The fund houses had lowered the NAV of the security a day before when the payments were due, but were not made. This default led to a fall in NAVs of at least 104 debt and hybrid funds.
In the corporate bond market, around 40-45% papers are rated below AAA of which 20% are not even rated. Extension of the lockdown is likely to put more pressure on credit risk funds.
Credit risk funds are debt funds that invest around 65% of their money into instruments rated AA or lower. Borrowers of these funds pay higher interest charges to compensate for their lower credit rating. Therefore, these credit risk funds end up lending a majority of their money to borrowers with whom other funds or companies won't enter any transactions.
The borrowers pay higher interest charges (high yields) as a way to compensate for their lower credit rating, which translates into a higher risk for the lender due to an increased possibility of default. Although these funds lend mostly for short duration, they are still one of the riskiest in the category.
Credit risk funds bear among the highest risks in their category but also tend to deliver higher return than fixed deposits. Generally, these funds can return up to 9% per annum with potential for capital gains in case of future upgrade in credit ratings of bonds.
They can potentially deliver up to 2-3% higher returns than liquid funds. Returns from these schemes with three years of investment are liable to short-term capital gains. After three years, returns are subject to long-term capital gains tax and indexation benefit. Dividends paid are not taxable but scheme has to pay a dividend distribution tax of 28.84%.