Franklin Templeton Mutual Fund, on Thursday announced it would wind up six credit funds with a large exposure to higher-yielding, lower-rated credit securities. 

Why did they do so?  The Corporate Bond markets in India are fairly illiquid.   FT schemes have got impacted because they invested in papers with low credit rating (they actively took on credit risk). Even if there was no instance of credit default in the paper, lack of liquidity and investor behaviour has created an event.    During stressful conditions, there is a flight to safety of cash, so typically there are more redemptions than inflows and this corresponds with widening spreads between quoted buying /selling prices (“bid-ask” spread).   Buyers will quote prices at significant discounts to fair value knowing that sellers have no choice but to redeem.   Selling paper at distressed prices is therefore disadvantageous to unit holders who choose to remain invested as NAVs get marked down.  By shutting the fund, and redeeming holdings gradually, it is more equitable to all holders. 

What this means for Unit Holders? If you have exposure to this fund, redemptions will be halted temporarily while the Fund house sells down positions in an orderly fashion.  Your money will be returned to you gradually, but some hit on NAV is to be expected.

Other risks. This now creates a Pandora’s box for other MF schemes who hold poor quality paper.  Because of the FT experience, unit holders may rush to redeem paper they hold in other schemes causing spreads to widen further and creating a vicious cycle.

Learnings. We have written to partners before on multiple occasions that while investing in debt, “Return of Capital” is more important than “Return on Capital”. 

• Read, “Are you aware of the risk in your Debt Investments” published on 31 Aug 2017

• Another article sent out last year “Is your Debt Manager taking Equity like risks for debt like returns”

Summary message.  Stay with funds who are investing in G Secs and “genuine AAA” companies.  Don’t go down the quality curve in debt for the lure of incremental yield.