An Unusual Anniversary

No, this is not about Covid! This April marks a year of that very unusual event of Franklin Templeton deciding to freeze six of their debt funds holding close to Rs.30,000 crores of investors’ money in them. It was nothing less than an earthquake measuring 6.0 on the Richter scale. There were numerous calls made to me and my advisory team by clients after reading the headlines in the newspapers. They were a worried lot – until they were informed that we had already exited those funds and well in time.

But there are a lot of lessons from this event and they are worth recounting.

Diversification: However much one has conviction on a fund, you still have to diversify and spread your debt allocation across multiple funds. And across multiple asset management companies too!

Bonds are for safety: Allocations to bond funds are generally made for safety and stability. So, the proportion allocated to credit risk funds should be strictly controlled or avoided altogether depending on ability to take risk. As we all know, credit risk funds are those that invest in bonds that are below AA rating. There are good managers and then there are not so good managers – but caution is always better.

Too much of a good thing: Yes, when something looks too good to be true, it may not be true or sustainable. If there is a higher return accruing, it is definitely worth questioning the source and debating whether it is an acceptable risk. Higher return without a higher risk is a misnomer.

Risk in debt funds emanate from three factors:

Liquidity risk – When there is no demand for an asset the price obviously dips. So, if a fund manager is left holding a bond that no one wants, then it will be valued at a discount.

Credit risk – This is the risk of a borrower defaulting. Once a default happens unless there is a very good security that has retained value, it might as well be written off.

Interest rate risk – When interest rates change, bonds having the older coupon rate undergo a change in valuation. If rates have dropped, the bond is valued higher; if rates have increased, the bond is valued lower. In either case if one holds till maturity there is no impact on the maturity value of the bond. The bond price changes more, higher the balance years to maturity. Whenever the interest rate cycle changes, one can expect volatility in bond prices. When rates increase, the effect is not beneficial and when they drop it is beneficial.

So, does it mean that Credit Risk funds are a no-no? That would be a wrong conclusion – as they can be included in a bond portfolio but with a limited exposure. For very conservative portfolios it can be avoided. Apart from the quality of companies in the portfolio, the stage in the credit cycle, interest rate changes and spreads above AAA rated bonds need to be considered to make a decision.

T. Srikanth Bhagavat

Managing Director & Principal Advisor