FIXED INCOME OUTLOOK

Dear All,

Greetings!

Franklin Templeton’s (FT) winding up of six of its schemes has certainly raised valid concerns.

Let us understand the purpose with which an investor invests in debt market- principal protection while
generating post tax returns better than the Fixed Deposits. The objective of an investor in this asset class should
be to protect downside and not to chase returns. In our discussions, we have many a time, highlighted that the
process a Fund House adheres to and its people are important than the performance it generates.

In the past couple of days, we have received umpteen queries on the way forward.

• Are all debt funds going to have a similar fate?

• Are all credit risk funds going to default?
• Are my arbitrage funds safe?
• Do I need to redeem my equity exposure in FT, as well?

Let us understand it better:

What actually happened?

Franklin Templeton’s closure of schemes was a unsystematic problem. March, in particular, or any quarter
ending month has historically been a month of high redemptions - reasons being advance tax and corporate
treasuries redeeming their liquid funds to show surplus cash in their books. Covid 19 and the subsequent
lockdown led to reduced cash flows for Corporate India and that in turn, led to higher redemptions. In January,
FT decided to write down 100% of its Vodafone exposure which started redemptions from their funds. Since
most of its holdings were in lower or unrated bonds or NBFCs with high concentration in the same issuers, high
redemption pressure started creating liquidity issue. As a matter of fact, the highest non-AAA rated papers
among mutual fund houses were held by FT. In case of extreme contingencies, the regulator allows the Fund
House to process the redemption credit on a T plus 10 basis (against a T plus 1) or cap its redemptions to INR 2
lakhs per PAN for a maximum of 10 days per 90 day period. The third option that FT availed of, was borrowing
against the permissible credit line of 20%. Unfortunately, none of the three could change the fate.

In our view, where FT went wrong was having the same issuers across their bouquet of funds, high concentration
risk and taking more than average credit risk in the low duration/ ultra short funds. The corpus of ~INR 30,000
crs was spread between 88 issuers and out of this, FT was the sole lender to 26 issuers. It’s probable but not
certain that some of their borrowers might even default in coming few months. They obviously failed to
incorporate an event like this in their stress test.

Are all Debt Funds going to have a similar fate?

Indian Fixed Income is ~ INR 13 lakh crore market with more than 80% allocated to AAA rated corporates,
sovereigns and cash. We expect this problem to be more significant in the higher yield- lower rated bonds. It’s
important to analyse the fund houses in terms of their risk management framework-independence of
Investment Management Committee, individual funds sticking to their mandates, liquidity and solvency of the
underlying bonds, cash positions maintained and Assets under Management of the fund. Our detailed
understanding and analysis show no immediate threat on high quality bonds until and unless the redemption
pressures go out of control or we have some AAA rated entity like IL&FS, default. The silver lining in this has
been that RBI has stepped in yesterday and provided INR 50,000 crs Special Liquidity Facility to the Mutual Funds.

Are all Credit Risk Funds going to default?

Credit Risk = (Probability of Default*Loss given Default) by the borrower.

 FIXED INCOME OUTLOOK

On the Credit Risk Funds, it is indeed clear that the credit market in India is in its nascent stage with very limited
secondary market transactions. The total size of this industry is ~INR 55,000 crs. Post the IL&FS crisis in 2018
when liquidity became a concern, high risk aversion to not lend to financially weaker corporates by banks and
MFs alike became imminent. This led to most of the companies with weak balance sheets fail to refinance their
debt and their capacity to repay to their existing lenders dropped. This, in turn, led to very high credit spreads,
increasing yields and therefore, lowering prices. The future of the high yield bonds in the short term would
depend upon their ability to raise capital to meet refinance demands and exogenous factors like how will we
transit to normalcy, capacity utilizations, probability of a second wave of lockdown, efficacy of TLTROs, etc.

Our stand is that Credit Risk category cannot be a part of the core debt portfolio. Just the way, equities’
heterogenous nature mandates us to follow a sub allocation within itself, the same philosophy should be
adhered to, in the debt space as well.

Credit will be an interesting space to watch out, in the next year. Funds with high concentration in the same
issuer/ sector, lower quality/unrated papers, more than average redemptions, significant borrowing to meet
liquidity requirements are at high risk. It is imperative to monitor this space carefully in the coming months.

Are my Arbitrage Funds safe?

The core part (at least 65% in order to be classified for Equity taxation) of Arbitrage Funds work on spread and
is agnostic to the market cap of the company. The remaining gets deployed in fixed deposits, short term bonds
and cash. The returns primarily depend on the volatility in the markets, cash-future premium/discount and FD
interest. The equity positions are hedged all the time. Hence, there is no risk with respect to the positions held.
The reason why you see non linear returns in Arbitrage Funds on a daily basis is because of the marked to market
differential and because of roll spreads towards the latter part of the month. Most of the recommended funds
hold Fixed Deposits with large private banks. These funds have no credit risk.

It may be prudent to deploy the monies of 3 months plus in this category for an investor in the highest tax
bracket. We do not anticipate any risk in this category.

Do I need to redeem my equities in FT as well?

No.

In Debt funds, the returns an investor makes are largely dependent on the underlying bonds

• Principal and interest repayment by the borrowers

• Interest rate movement
• Credit upgrade/downgrade

In equities, the risks pertain to

• Integrity and competence of the management

• Scope of business opportunity
• Valuation

The equity markets are much more transparent compared to debt from a tracking perspective as well.

Stay safe!

Regards,

Megha Malpani, CFA

Partner, Zvest Financial Services LLP

28.04.2020