Debt Funds – Are they really risky? Lessons from the Franklin Templeton Fiasco

Last week on Friday I woke up to news that had my complete attention, another unprecedented event to hit us this year, only this time, it had happened in the world of debt mutual funds. Franklin Templeton a brand that has been in the country for 25 years, did what no Indian investor in their wildest dreams would have imagined, it wound up six of its mutual funds. I knew the panic would soon follow as the news and social media had a new topic to spread and like corona virus it did spread fast along with a lot of misinformation.

Within a day, a majority of investors jumped to the conclusion that the entire debt funds category had turned risky. I saw the comments on investment portals and news channels and very quickly realized that the debt funds were not the problem, but the fiction being manufactured on WhatsApp and even reputed newspapers was causing panic. Most investors were letting their emotions get better of them and were taking decisions based on misinformation rather than a complete understanding of the situation and we all are aware how that ends eventually.

So on to some facts now, I will try to explain by using an analogy. Suppose you own an electronics store and carry different brands that you offer to customers on EMI, the interest rates differ based on credit profile of the customer which you have built over the years. You have been in business for more than 25 years and your suppliers give you credit to fund your operations on a condition that they can ask for their money back on a day’s notice. You are in 2020 and a pandemic comes along and the big suppliers suddenly want cash, they can get it from you and they want to get it now. They think you will be out of business too, forgetting that you have been in business for a long time and made the suppliers a lot of money in the past decade or so and have a lot of good inventory in stock. Anyways, you have to do something fast as all your big suppliers have started asking for all the money back in a short span of 1 month. You have 3 options to pay them. First, you get more money in by acquiring new customers, second borrow money from the banks and third, sell your top brands at distress sale prices. Option 1 does not take off as nobody is buying anymore, Option 2 runs out soon, now you have only the 3rd option left. You realize the more you sell the better brands the proportion of the not-so great brands in the overall inventory increases which has no buyers anyways, and even if you do find someone you will have to sell at distress price and the value of your inventory will start plummeting to dangerously lower levels. You also realize that the big guys will take all the money and the small guys or those unaware of your situation would be left with scraps. What do you do now? Do you blame it on the coronavirus and let the small guys suffer or do you take a legal recourse which allows you to wind off the operations? The latter allows you to wait for the markets to normalize so that you can extract the maximum value for all the suppliers as none of the suppliers can demand the money back immediately now. The electronics store in the story is Franklin Templeton and the suppliers of credit are investors who own the Franklin Funds. Is it a good situation to be in? No. Am I defending Franklin Templeton? No again. I am just trying to explain the ground reality through an analogy.

Next logical question that you may have is, whether the situation is really that bad if you hold one of the funds that were withdrawn? Well it depends, if you need all your invested money back in less than a year it is a bad situation. But if you can wait, you are going to get your money back over a period of months or a couple of years depending upon the duration of funds, a technical term I will not get in to now. The important point to note is that you are not going to lose a significant portion of your capital, which would have been the case if the fund house did not take this unprecedented action. When you hear the term liquidity risk next time this is a classic example to remember.

Now to the fear-based question, what happens if the investors make a run for their money in the other mutual fund companies irrespective of the category of debt funds?  Well it can happen, but there are 22 categories of debt funds so, highly unlikely and even if it does happen, it will not sustain as the RBI will step in and inject liquidity which it already did within a day of the event, pumped in a decent sum of 50,000 crores. Therefore, even if investors start redeeming money from other fund houses, the latter can borrow money from the banks and if that limit is breached, they also have a lot of high-quality assets that they can sell in the market at a good price in other words situation is not that dire. Also, note that the RBI and the Government cannot afford to have a similar event in the near future so they will do all it takes to restore confidence. By the way, such events have happened with regular frequency in the US and European markets over decades so this is not a new phenomenon.

In fact, the banks are at a bigger risk as they lend huge sums of money to a couple of businessmen who flee the country and you find out much later. So, what do we do? Do we start liquidating our deposits and store cash under our mattresses? I am sure you will not do that but mutual funds are risky right? Even the disclaimer in the advertisements say it too.

The risk is not in the investment, the risk is in our behaviour. We buy and sell based on emotions vs knowledge. Sometimes not giving enough time for the value to be realized. Investments are treated as commodity, we tend to do more research while buying a car or a property but do not hesitate to invest or liquidate financial assets based on a news article, tip from a friend or family who are equally clueless.

If you are flying, you do not replace the pilot when you face a turbulence do you? Neither do you jump off the plane even when it becomes dangerous. You have to just trust the pilot, his experience and instincts at that time. Investment is like flying a plane, most investors however think it is as easy as driving a car. Sorry for the candour, the intent of the article is to bring out the facts. Sometimes they are not exciting as fiction and are not pleasant to deal with, but when it comes to health or wealth, believe me, you want facts on your side and even more so in uncertain and volatile times such as what we are witnessing now.

In conclusion,

—  Debt funds will be around for a long time along with the top fund houses.

—  Investors of these funds will get their money back albeit not all at once.

—  Investing decisions have to be based on understanding and knowledge of how markets work, better left to full time professionals who make decisions based on research and experience.

 Stay Safe and Stay Wealthy!