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Late last week Franklin Templeton decided to wind down 6 of its Debt Funds, which had a combined AUM of more than 25000 crores. The impact of the move both on investor sentiment as well as their financial position will be significant, not only for investors in the funds wound down but also in other debt funds. In today's post we look at the key funds affected by the move, analyze the points that drove the move to wind down funds - both within and outside of the firm's control, and conclude with the systemic changes we need in our bond markets to make sure less of this happens going forward. What went wrong? We start by understanding why bond markets face the kind of illiquidity that is almost alien to most parts of the equity market. While Equity shares of a company do have classifications at times, primarily related to voting rights (one class of shares-typically held by the founding team will give you more votes per share than the other class), equity instruments are for the most part fairly standardized. This makes it easy for a large population of people to atleast take a stab at valuing these and consequently having an opinion on the prices. People express these opinions via the prices they are willing to buy or sell shares in the market. The large pool of investors taking frequent call on rates to buy the stocks ensures the spread between the rate at which you can buy and sell remains low. The debt markets, on the other hand, have a lot of complexities around tenure, risk, tranches the bonds are in, ring-fencing at various corporate levels, etc. All of this makes valuing bonds a bit more complex. This leads to bond deals often done over the call with a trader at another bank, limiting the liquidity in the system and consequently the rates you can get for your bonds. While sovereign bonds will still find good demand, the liquidity available for corporate bonds can often be extremely low. So what happens when you're running a debt fund and people begin to ask for their money back? You have to go to these illiquid markets and attempt to sell your stocks - often at unfavourable rates. The exit at unfavourable rates hurts your fund performance, further escalating the folks who want to exit, leading to a negative spiral. Was this the best way out? So what can funds do to manage this? One option at the disposal is to borrow within the SEBI mandated limits to pay the customers wanting to move out. This is equivalent to kicking the can down the road, but worse. If you find yourself unable to sell gradually at better rates and pay back the debt, you effectively end up hurting the investors who decide to stay with you, as they will now have to bear the burden of the sharp drop in value when the debt comes due. In this light, given the combination of circumstances that brought the funds to the position they were currently in, it seems like winding down was the tough but the appropriate thing to do. And while the investors will face temporary liquidity stress, which could be magnified given the times we are in, it is still preferable to the alternative - permanent destruction in wealth.
Impact and path ahead The first order impact is obviously the liquidity issues folks will face given the ~25K cr now locked in. The second-order impacts though would be much more important. Investors in debt funds will now increasingly take a relook at their investments and look to exit ones that have a shaky record. This could potentially lead to other weaker debt funds in the industry seeing a similar fate. The increased impact on debt funds via redemptions will also dent their intent on investing in firms with greater credit risk, effectively increasing the credit spread, making borrowing costlier for firms. In the short term fund managers will have to maintain healthy communication with their investor base giving them an accurate yet reassuring picture of the portfolio while also gradually managing to reduce exposure to relatively illiquid portions of their book. Long term we would need deep reforms in the bond market to enhance transparency and liquidity - something the incumbent traders might not be in favour of but would bring a lot of value to the market as a whole
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About the Author: The post is written by Ganesh Nagarsekar. Ganesh is a graduate from IIM Calcutta and has worked with J.P. Morgan and Goldman Sachs, before founding GSN Invest.