The winding up of Franklin Templeton’s debt schemes has proved how credit risk and liquidity risk can be a lethal combination.
While the funds’ closures are an extreme event, this may be a good opportunity for you to take a relook at your portfolio – without panic, that is. The current debt market scenario is already tilted against credit as corporate credit quality comes under stress owing to the lockdown and pandemic. The Franklin issues adds to the pressure. So if you hold a fund that’s already scoring low on performance and holds credit risk, it’s best to take stock.
To guide you in this exercise, we have analysed debt fund and hybrid categories where credit risks can be masked, and listed out funds with high credit risk. We have used different cut-offs for defining high credit risk, based on the objective and timeframe of that category. We have also looked at the nature of papers and concentration to issuers.
Please note that SEBI’s category definitions do not specify credit-rating allocations other than the corporate bond and credit risk categories. Hence, the need for us to provide you with some internal risk cut offs for each category.
What we have not covered: In this exercise, we have not covered overnight, liquid, corporate bond, banking &PSU and gilt-oriented categories. Their portfolio make up does not warrant it. Redemption pressure may be a threat to some of these but we have no way of identifying whether the funds are adequately prepared for it. We have not covered credit risk category as well, because risk is the very nature of that category.
Please read the section on ‘What should you do’ at the end of the article carefully before taking any action.
What is credit risk, really?
Credit risk is the risk of the instruments that a fund holds, either not servicing the interest regularly or defaulting on principal or both. When the financials of a company which has issued a paper point to healthy business and cash flow metrics, the paper enjoys a high rating. When this deteriorates there are downgrades, which causes NAV erosion in a fund. In general, and per SEBI’s definition, funds with AA+ rating or more are typically sound in credit quality.
There is another risk which is often (not always) higher in low-quality papers. This is liquidity risk – that is, the risk that the debt paper cannot be sold quickly to other parties if there is a need to exit the paper. Such exiting will be hard or will involve having to sell on losses. The first risk (inherent in the 6 Franklin funds that wound up) coupled with the second risk has spelt downfall for the Franklin debt funds.
Why do funds opt for credit risk? Because low-rated papers deliver higher return for higher risk. If the risk transpires, a fund house can lose the money it lent (and you in turn take a NAV hit). If the risk delivers rewards, the paper gets rated higher as it steadily proves its ability to service debt. When fund houses go for these papers, they try to capture such mispriced opportunities – that is the probability of a paper improving in rating, in time. Higher coupon in early days and price appreciation later, if the paper’s credit quality improves are typically the 2 benefits. This is what Franklin did with its six funds, enjoying success for a good measure of time. Until their collapse, the Franklin funds were among the highest-returning funds and even delivered higher than equity markets in some periods.
Debt funds – Ultra-short, low duration, floater, money market
We’ve clubbed these categories together as they all serve the same timeframe, of 6 months to 2 years.
Our credit risk definition: Holding 10% or more in papers rated below AA+. We have defined this strict level because of the short holding period and the current debt market scenario that can take time to resolve.
The list of funds that had risky portfolios is tabled below. Note that several of them already have a low Prime Rating.
| Fund name | Fund category | Prime Rating | % held in papers below AA+ (Mar’20) | Mar ’20 AUM (Rs crore) |
|---|---|---|---|---|
| Baroda Treasury Advantage | Low Duration | Unrated | 58.0 | 55 |
| Franklin India Floating Rate | Floater | Unrated | 19.4 | 407 |
| HDFC Low Duration | Low Duration | 2.5 | 14.4 | 12,965 |
| ICICI Prudential Floating Interest | Floater | 2.0 | 28.3 | 6,645 |
| ICICI Prudential Ultra Short Term | Ultra Short Duration | 2.0 | 59.2 | 6,155 |
| IDBI Ultra Short Term | Ultra Short Duration | Unrated | 27.3 | 119 |
| Kotak Low Duration | Low Duration | 2.5 | 32.7 | 5,760 |
| L&T Low Duration | Low Duration | 1.5 | 30.5 | 792 |
| Nippon India Low Duration | Low Duration | 2.5 | 18.8 | 3,268 |
| Nippon India Ultra Short Duration | Ultra Short Duration | 1.0 | 69.8 | 1,012 |
| UTI Ultra Short Term | Ultra Short Duration | 1.5 | 15.5 | 1,659 |
Some observations on the funds listed above:
- Some of these funds were already poor on performance metrics; it is not just the credit risk that causes their low rating.
- Nippon India Ultra Short has close to 20% of its portfolio in papers maturing in 2023 and 2024, half of which is rated below AA+. While there may be liquidity, such long-term papers in a very short-term fund is not prudent.
- While some funds like ICICI Pru Ultra Short have diffused holdings and therefore have no concentration risk, the total credit exposure is high enough to warrant caution.
Debt – Short duration
In the short duration space, our time frame for funds is 1.5-3 years, and therefore we continue to be strict in credit exposures.
Our credit risk definition: Holding 15% or more in papers rated below AA+.
The list of funds that had risky portfolios is tabled below.
| Fund name | Fund category | Prime Rating | % held in papers below AA+ (Mar ’20) | Mar ’20 AUM (Rs crore) |
|---|---|---|---|---|
| IDBI Short Term Bond Fund | Short Duration | Unrated | 54.9 | 25 |
| Baroda Short Term Bond Fund | Short Duration | 3.0 | 30.3 | 280 |
| HSBC Short Duration Fund | Short Duration | 1.0 | 24.5 | 325 |
| BOI AXA Short Term Income | Short Duration | Unrated | 17.2 | 41 |
| Aditya Birla Sun Life Short Term | Short Duration | 2.5 | 16.9 | 2,860 |
The following points need to be noted.
- While not all papers below AA+ is of poor quality, you have to draw the credit limit line conservatively as the time frame does not give you leeway to recover from any risk events.
- You need to keep track of AUM of your fund. You can see some of the funds below will very low AUM. This makes them riskier as explained in earlier categories.
- Risks for some of them stem from high exposure to single instrument. For example, Baroda Short Term Bond has a 9% exposure to AA-rated perpetual bond of IndusInd Bank.
Debt – Medium Duration
Our approach is that both medium duration and corporate bond funds roughly require a similar time frame of holding (at least 3-5 years) by investors. A corporate bond fund is required to hold over 80% in papers rated AA+ or above. Medium duration funds do not have any such criteria. We think this is one of the opaquer categories with no clear rules (other than duration) on what funds can hold.
Our credit risk definition: Holding 35% or more in papers rated below AA+. In our view, it is reasonable to expect at least 60-65% of the portfolios of these funds to be in high quality paper to prevent NAV hits.
The list of funds that had lower credit quality portfolios is tabled below.
| Fund name | Fund category | Prime Rating | % held in papers below AA+ (Mar’20) | Mar ’20 AUM (Rs crore) |
|---|---|---|---|---|
| Nippon India Strategic Debt | Medium Duration | 1.0 | 82.8 | 908 |
| HDFC Medium Term Debt | Medium Duration | 3.0 | 48.9 | 1,373 |
| Kotak Medium Term | Medium Duration | 2.5 | 46.5 | 2,896 |
| ICICI Prudential Medium Term Bond | Medium Duration | 2.5 | 39.9 | 6,627 |
| Axis Strategic Bond | Medium Duration | 3.5 | 39.5 | 1,230 |
| Aditya Birla Sun Life Medium Term | Medium Duration | 1.5 | 37.4 | 3,958 |
Some observations on the funds listed above:
- Some of the funds have taken quite a bit of hit already and have continuing uncertainty – like ABSL Medium Term’s exposure to Jharkhand Road Projects paper. This fund saw a NAV fall on Friday (April 24, 2020) on account of suddenly bringing down this paper’s valuation in tune with valuation agencies. For those who thought funds with earlier NAV hits were done with it, these kinds of further falls can come as a shock.
- Then there are funds such as Reliance Strategic Debt, which has taken earlier hits, including the most recent Yes Bank debacle. Already burdened with bad papers from DHFL and Reliance Home Finance, high concentration to a bunch of companies that are related to each other and into renewable energy, poses even higher risks.
Debt – dynamic bond
Our credit risk definition: Holding 30% or more in papers rated below AA+. In this category, we expect dynamic bond funds to take duration calls and not so much credit.
The list of funds that had risky portfolios is tabled below.
| Fund name | Fund category | Prime Rating | % held in papers below AA+ (Mar ’20) | Mar ’20 AUM (Rs crore) |
|---|---|---|---|---|
| IIFL Dynamic Bond Fund | Dynamic bond | 4.0 | 65.76 | 258 |
| Aditya Birla Sun Life Dynamic Bond | Dynamic bond | 2.0 | 35.09 | 2,481 |
| ICICI Prudential All Seasons Bond | Dynamic bond | 4.5 | 34.71 | 2,997 |
| HDFC Dynamic Debt Fund | Dynamic bond | 1.5 | 30.78 | 568 |
| IDBI Dynamic Bond Fund | Dynamic bond | Unrated | 30.73 | 23 |
Some observations on the funds listed above:
- In the above cases, the papers per se may not be of low quality. But some of the funds have high concentration in individual papers. A downgrade by even a couple of notches can hurt returns. For example, the IIFL Dynamic Bond fund has 9-10% exposure in each of its top 4 papers, rated either AA or AA- and largely belonging to cyclical industries of metals and sugar. While the companies are large, JSPL experience has shown us that large cyclical/commodity companies may not be spared in a downturn.
- We look at whether the funds achieve stable returns without compromising on their primary objective. In this category, duration risk and NAV losses due to interest rate cycles are par for the course. Credit hits are not.
Hybrid funds
Hybrid funds have credit risk but rarely feature in discussions on the topic.
Our credit risk definition: Viewed on a case-by-case basis for each fund, based on nature of papers and concentration.
The list of hybrid funds that have high credit risk is tabled below.
| Fund name | Fund category | Prime Rating | % held in papers below AA+ (Mar ’20) | Mar ’20 AUM (Rs crore) |
|---|---|---|---|---|
| Aditya Birla Sun Life Reg. Savings | Conservative hybrid | 2.0 | 22.7 | 1,382 |
| DSP Regular Savings | Conservative hybrid | 1.5 | 14.7 | 212 |
| ICICI Prudential Regular Savings | Conservative hybrid | 5.0 | 51.7 | 1,622 |
| Nippon India Hybrid Bond | Conservative hybrid | 2.0 | 69.3 | 963 |
| SBI Debt Hybrid | Conservative hybrid | 2.5 | 27.2 | 948 |
| Nippon India Equity Savings | Equity savings | 1.5 | 19.3 | 476 |
- In the hybrid conservative category, there is potential for equity to push returns and provide liquidity even if some part of debt fails. This apart, funds with relatively higher credit risk are also strong performers, such as ICICI Pru Regular Savings.
- While some papers themselves may not be risky, funds may have a very high concentration. Aditya Birla Sun Life Regular Savings holds 15.7% of its portfolio in a single paper – Uttar Pradesh Power Corp. While this may be backed by guarantees in some form, resolution, if troubles arise, could take time.
- For equity savings and balanced advantage funds, the tendency to have risky papers is low. But we have highlighted funds based on their portfolio. In this respect, Nippon India Equity Savings, 18% of its portfolio is in papers maturing in years such as 2027, 2030, 2031, and 2044. These papers also carry lower credit rating.
What should you do?
If you have investments in any of the funds listed in these tables you can do the following now. Please note that the below is applicable ONLY for funds we have highlighted in this report.
Use the MF Review Tool and check our buy/sell/hold call on the fund. Many of the funds listed above are already a sell.
Where we have a sell call on any of the above funds, go ahead and sell your investments subject to your taxes and exit loads. This is especially important where you need your investment in 1-1.5 years or less.
Where we have a hold call, hold your investment in the fund but ensure that it does not form more than 10% of your total portfolio. If it is higher, gradually redeem part of your investment to bring exposure down. This will help you de-risk.
Where we have a no-opinion call, you will still know that the fund has high risk based on the data in this report. Gradually exit the fund based on your tax and exit loads. Not every ‘no opinion’ fund in the review tool is a sell. We are providing this rule only for funds with high credit exposure highlighted in this report.
Once again, please note that a sell decision will involve tax impact and may carry exit loads.
Where to invest
If you have a requirement within 1 year, reinvest any redemption proceeds in safe bank deposits. You can either hold such deposits in your own bank or choose from Prime Deposits.
If you have a longer timeframe, choose from the Prime Funds bucket that fits your requirement. Alternatively, use the review tool for the other funds you hold to check if you can buy more into these. If you are buying more into your existing funds (which are high quality in credit), ensure that the fund doesn’t wind up accounting for more than 20-25% of your portfolio.
Disclaimer: We have looked at portfolios, categories, change in exposure, AUMs and much more in our debt fund analyses and to draw up this report. This is still not a fool-proof list as there may be risks even in AAA or AA+ rated instruments that we don’t know yet and could materialize post Covid-19. But it alerts you to cases with higher risks.
Now the pertinent question is, if you decide to stay with debt funds, how do you identify such risks? Should you learn to look for risk or should you re-assess your own approach to debt risk? Please read the second report which we will publish tomorrow to know how you can minimise your risks without the effort of pouring over fund portfolios
Data Source: ICRA MFI Database
Post script
Other reports we have done on the fallout of Franklin Templeton’s debt fund closures are as follows:
36 thoughts on “Franklin fallout: Risks in debt funds from other AMCs”
Fantastic and timely article. One suggestion. In the prime rating, is it possible to add for debt funds, percentage of AAA, AA+, AA and below papers it holds. E.g. Looking at the Aditya Birla Sunlife Dynamic Bond fund at prime rating, it is not clear it holds around 35% paper below AA+
Than you sir. It is a bit of data intense work to disaplay it as we have to do this for around 1000 schemes. If you click the scheme, we give the top 10 for now. Rest assured all of these factors go into our research and in our review tool (buy/hold/sell) as you will know if you check these funds.
thanks, Vidya
I see. I thought it is a automated process by software. If not, I agree it is tough job doing it manually.
Vidya – thanks for this article. Very informative. i had a question regarding 2 short term debt funds – Axis Short Term Debt Fund and HDFC Short Term Debt Fund. I went through the underlying portfolios of both and couldn’t see much difference between the two. Your MF rating tool has a buy rating on HDFC Short Term Debt Fund (5 stars) but a hold rating on Axis Short Term Debt Fund (3.5 stars). Can you share your rationale for the same? I’m evaluating if I should reduce my exposure to Axis Short Term Debt Fund.
Thanks
Hello Rohan, Thanks!
If you are a subscriber, request you to kindly route your product related queries to [email protected] thanks, Vidya
Would you be rating Parag Parikh Liquid Fund and Quantum Liquid Fund in the near future?
Both of them could be safe choices for short term deposits as they invest primarily in SOV, Trees and PSU Bonds.
Hello Sir, we would once they cross our gating criteria for liquid fund AUM (Rs 1000 crore). Other liquid funds also invest in similar papers. Most of their portfolios have lot of duplication given that the universe of liquid, high quality instruments and within SEBI’s maturity norms is only so much. thanks, Vidya
This is such an education for a lay person like me. Great! and timely article.
Thanks for your inputs.. do you see any visible risk in aggressive hybrid funds and more so in Franklin equity hybrid..
Hello Sir,
Well, the equity portion itself is enough to cause losses 🙂
But generally, aggressive hybrid funds do not do credit risk as debt forms a smaller part of their portfolio, and funds prefer to be more buy-and-hold quality bonds. They may take duration calls but they rarely take credit calls; even if they do, it is small at 5-6% of their portfolio and usually in AA-/AA. This apart, redemption requirements can be met through equity as well. The equity can also help recovery from any debt hit quicker. And finally, these funds also need 3-4 years to deliver properly.
In aggressive hybrid funds, Nippon was the only one to really take credit calls, and took write-offs as well. Franklin Hybrid does have some credit exposure in AA/AA- of 15%. Use the review tool and take a call as explained in the post above.
Thanks,
Bhavana
Spot on in terms of timing and content. Thank you.
Thanks!
Thank you for the insightful article. This is of immense help to understand what funds in the portfolio are risky. I have question though, the article is rating funds based on their rating, but we have seen in the recent times, where rating agencies are caught naping and ratings change overnight from AAA to lower categories. Does your team have any way of analysing this when you are providing your prime ratings, or is this a risk the whole industry is carrying, basing the purchases on rating provided by Care and Crisil.
The whole industry does not carry the risk. Some fund houses analyse on top of ratings to see. When we see unfamiliar names even in AAA (and definitely below AA+) we do look at details, rating rationale and cash flow positions of such companies or their parentage. It is intense manual work and involves some amount of judgement that can go wrong. there is no cookie cutter way to do it. thanks, Vidya
Thanks Vidya for an insight into the process. Lots of thanks to you and your team for your efforts
Thank you sir!
Fantastic work! Kudos to your team.
Thank you sir. Vidya
Fantastic review. In these uncertain times, we feel safe having been associated with prime investor . excellent example of ‘hand-holding’ by prime investor.
Thank you sir!
thanks for this quick review on debt funds…can you do a review on arbitrage fund situation too?
Following
Fantastic and timely article. I’d say this article alone is worth the annual subscription fees I paid.
Thank you! Vidya
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