How the Franklin Templeton crisis led to reforms to make debt funds safer

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And we thought that debt funds were safe, almost like fixed deposits. Many investors took debt funds to be safe – probably the safest of all instruments around – even after the crisis that erupted when Infrastructure Leasing & Financial Services defaulted on its payments in 2018.

It was only when Franklin Templeton India mutual fund suddenly wound up six of its open-ended debt funds – with assets worth Rs 25,215 crore as of April 23, 2020 – that investors realised that debt funds could be as risky as equity funds, or even riskier. Two years on, although Franklin Templeton India has returned most of the money to investors, it was hardly a balm for those who needed their money back then.

On the positive side, though, that event led to new norms aimed at protecting investors. In the past two years, the Securities and Exchange Board of India, the capital market regulator, unveiled debt fund norms that not only made them safer, but also transparent. Here are a few that one must know.

Dynamic risk-o-meters

Risk-o-meters were introduced in June 2015 to replace the three-colour scheme to communicate the extent of risk to investors. However, the risk-o-meter was not dynamic. The new version launched in January 2021 not only featured six levels of risk – from low to very high – it also made the risk-o-meter formula-driven and dynamic.

Portfolios of debt schemes were assessed based on liquidity, credit and interest rate risks. In the case of equity schemes, the risk-o-meter considered the exposure to stocks of varying sizes (large, mid- and small-cap stocks) along with volatility and impact cost. The risk-o-meter, in its new avatar, is computed and announced every month and takes into account changes in portfolios. The regulator made it mandatory for fund houses to inform investors about changes in a scheme’s risk-o-meter through emails and text messages.

Risks within boundaries

One drawback of the risk-o-meter was that it only conveyed the extent of risk taken by the fund manager in the preceding month – it didn’t indicate much risk the fund could actually take. The risk-o-meter was merely a report card.

The lesson of the Franklin Templeton debt fund crisis was that it is vital for investors to know beforehand how much risk the fund manager can take. That put the risk-o-meter in perspective as the fund manager gets to work only within pre-defined boundaries.

Enter the PRCM or potential risk class matrix, a tool that was introduced on December 1, 2021. A PRCM specifies the maximum risk a debt scheme can take. Debt schemes were classified based on credit risk and interest rate risk in the nine cells of the PRCM. The graphic conveys an idea of how the nine cells connote varying levels of risks.

The PRCM is a fundamental attribute. This means that a fund house cannot redefine the boundaries without asking the permission of investors first. And if the fund house chooses to change the PRCM of the scheme, existing investors must be given an exit option.

Scheme liquidity

From February 1, 2021, open-ended debt funds were asked to maintain at least 10 percent of their money in liquid assets, including cash, treasury bills and government securities. The norm to invest a minimum 20 percent of the money in liquid assets was implemented for liquid funds from April 2020.

This announcement was a key step in the direction of ensuring that all debt funds could withstand redemption pressures and investors do not lose due to poor liquidity.

Investors’ permission for winding up

At its board meeting on December 28, 2021, SEBI made it mandatory for mutual fund trustees to seek the consent of investors to wind up a mutual fund scheme. Although existing rules make it mandatory for fund houses to seek the permission of unitholders before winding-up, Franklin Templeton’s interpretation of these guidelines pushed SEBI to come out with a clarification.

SEBI made it mandatory for officials of the asset management company responsible for fund management to invest part of their salary in the schemes they manage. This was to ensure that the interests of the fund managers are aligned with those of the investors.

SEBI also prescribed a swing pricing mechanism for debt funds. Swing pricing ensures that in case of large redemptions or large investments, the NAV is reduced or increased accordingly to bear the costs associated with such transactions and save existing investors from its impact, especially in liquidity challenged times. Swing pricing was to have been implemented on March 1, 2022, but was postponed to May 1, 2022.

Impact on MF investments

The regulatory response to the Franklin Templeton schemes closure has been good so far. Steps such as risk-o-meter, swing pricing and PRCM can make a difference to the world of mutual funds only if investors pay heed to such disclosures, said Joydeep Sen, a corporate trainer-Debt.

Roopali Prabhu, chief investment officer of Sanctum Wealth, said, “Measures such as PRCM and risk-o-meter put together are good tools for assessing risk. However, the mutual fund industry needs to spread awareness among investors about them.”

Still, investors cannot simply sit back and assume that there are no risks while investing through mutual funds, especially debt funds.

“Change in the credit rating of a bond held in the portfolio impacts the credit risk of the scheme. Besides risk-o-meter and PRCM, investors should do a concentration analysis to check that the portfolio does not have major combined exposure to any one group conglomerate and its subsidiaries or group companies,” said Roshni Nayak, founder of GoalBridge, a Mumbai-based financial planning firm.

Prabhu added: “Risks arising out of the construct of a portfolio may not be best captured by these measures. For example, two schemes with similar duration may show different volatility. One with a portfolio employing barbell strategy – wherein some bonds are too short term and some bonds are too long term – can be more volatile than a scheme that holds all bonds in line with the scheme’s duration.”

Investors have to be prudent with mutual fund investments. They should not chase returns while investing in mutual funds. While buying equity funds, it is better to stick to a diversified offering with a minimum five-year timeframe. In the case of debt funds, the investment timeframe should be matched with the duration of the debt fund.

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