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There is No Such Thing as Free Lunch. Higher the returns, higher the risk is a statement that applies to each asset class. Why do equities offer a higher return? Because there is RISK. DHFL and ILFS have gone to 0. Why do Co-operative Banks FD rates are~1.5%-2% higher than Private Sector Banks or Public sector Banks? Because there is RISK.
On May 1, RBI cancels license of CKP Co-operative bank with no scope of revival, if your deposit amount was greater than INR 5 lakhs, you lose on the excess. Hence chase extra returns but limit it to INR 5 lakhs insurance limit. Why did Franklin six yield-oriented schemes were able to offer higher returns as compared to peers? Because there was……
Every Incident highlights the importance of risk management, and people who are exposed to such high return investments try to assess whether they can afford to lose out on capital for those extra returns? If the answer is no, there is a flight of money to the low-risk investments.
Below chart does justice to the above statement.
|Credit Risk Fund||AUM on 23rd April||AUM on 30th April||% change|
Was there a better option available ?
Prima Facie Yes! It reminds of an event where HDFC AMC bought the troubled NCDs of Essel group on the AMC’s balance sheet and paid the Scheme to pay back to the unitholders. Even Franklin had done something similar in 2016 in respect of Jindal Steel and Power. However, such moves can be unitholder friendly but not shareholder-friendly. Why dismantle the west wall to repair the east wall.
This time probably the balance sheet strength wasn’t sufficient to bail out INR 30,000 crores worth of AUM.
Does the RBI Liquidity measure help?
The announced RBI’s Liquidity support to Mutual Funds will be of no use to Franklin since the Fund has already decided to wind up. Investors will have to wait till the Fund is able to sell underlying securities or maturity of underlying securities whichever is earlier. In a Covid-2019 environment, selling may be subject to liquidity risk and redemption may be subject to default risk. One can only be optimistic.
How to select the ‘Sahi’ Debt Scheme?
Prefer bank-backed Asset management companies since they should not face any issue in borrowing money from their parent bank. One should always look at the credit rating (minimum AA+ )of the underlying portfolio security. Although several credit ratings have collapsed in recent times, hence doing your own diligence on the underlying portfolio is a must. In the due diligence, one can skip sovereign papers or papers of public sector undertakings.
Needless to say, if the scheme has delivered higher yields over its category, higher the due diligence. It works! I avoided the Franklin Ultra short term bond fund because it had Vodafone in it. Even though it hadn’t defaulted, the news floating was enough to smell the stress. A few months later, the same fund had to mark down Vodafone exposure to the extent of 4%.
Also, make sure none of the underlying security exceeds 5% of the AUM to avoid concentration risk. To give you a perspective, Franklin Credit Risk fund’s exposure to Shriram Transport Finance is ~11%, and Fitch has downgraded on asset quality concerns since recovery from small transport operators seems to be challenging amid Covid-2019. Imagine an 11% straight hit to the NAV in case of default when you don’t even make 11% in a credit risk fund. Also, the Scheme which frequently raises money to meet redemption is a hidden time bomb. It means underlying securities are not safe enough to be liquidated quickly.
If anything, that should change post the Franklin Episode?
In India, taxes play a vital role in driving investment decisions. To give an anecdotal evidence, Insurance companies’ fourth-quarter is around a third of their full-year business since last quarter is the time when people look for tax saving products before the financial year ends. People prefer debt schemes because of its favourable tax treatment where if they are held for three years, it is taxed at 20% post indexation, however, fixed deposits are taxed at the applicable rate which can be as high as 30%. The government should consider tweaking this, to keep the tax-saving investors at bay.
Secondly, SEBI should consider having a clawback clause for Debt schemes. This clause is frequently used in Private Equity parlance, and it enables the unitholders to get back the compensation from the manager in cases of losses. This will ensure prudent investing and at the same time, will win investor confidence since even the fund manager has the skin in the game.
Lately, the yields on Public sector bank’s AT-1 bonds had spiked to the north of 10%. Such opportunities arose due to lack of liquidity, and if one is active, can consider parking their money in such bonds since any default on them would tantamount to sovereign default.
To Conclude, this episode will further weaken the borrowing capacity of the lower rung corporates in the industry. When the banks turn them away, they tap the capital markets where credit risk funds buy their papers. Post this, I wonder if the credit risk funds will be able to win back the investor confidence. With banks having turned risk-averse in order to protect their balance sheet and the Mutual funds turning risk-averse to win investor confidence, credit squeeze should be the word that might float in dailies soon.
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