Have you heard the statements before: Debt funds are safe. Are they?

It is mere propaganda

Debt funds are not safe. I wrote an article in this Blog that gave proof that debt funds are not safe as it is made out to be by financial advisors. Read The Proof is Here on Debt Funds. Now we have one more catastrophe about to hit innocent mutual fund investors in Debt funds of mutual funds. Well here is one more proof that the propaganda of mutual fund advisors is wrong.

Financial Advisors are Struggling to Deal with the Market Crisis

Ever since the share market crashed in March 2020, and the high degree of volatility that the market is experiencing since then, the advice of financial advisors has been either the investor should hold on and hope for the best in the long term or; transfer funds from equity schemes to debt schemes of mutual funds. The assumption being that debt funds are safe.

The thrust of all financial advisors is that in mutual funds you will earn a higher rate of return than any other form of investment. This is far from the truth.

There are no Free Lunches

In financial investments the saying that holds true is: There are no free lunches. If a company is offering a higher rate of interest on a loan to them, the rate of interest is higher because the risk on that investment is higher. That is why companies that issue a higher rate of interest. It is to tempt the investor to take the risk. It is not because they want to give more money to investors.

Investors May Not Get the Higher Rate

But will the investor actually get the higher rate for the tenure of the investment? This depends on the investor’s luck. In most cases investors do not earn the higher rate. For if the investment did not carry a higher risk, there was no need to offer a higher rate of interest to tempt the investor. A higher risk also means a higher possibility of losing your money, not just a possibility of earning more money.

The Case of Franklin Templeton

The case of Franklin Templeton debt mutual funds is proof of this this point. In April 2020, Franklin Templeton closed 6 debt funds. Why? According to them liquidity was the reason. Liquidity constraints in this context means that the debt instruments (of companies) that Franklin bought with the mutual fund investors’ money were worthless. That is the money invested by investors in Franklin mutual funds, were invested by Franklin in the debt of companies. It now turns out that most of that debt is worthless and Franklin took too much of risk in choosing companies that were not credit-worthy. (Why Franklin choose such a set of worthless companies? My next article in this Blog will answer this question. It is important to deal with the question in a detailed manner to understand the risks of investing in mutual funds.)

Franklin could not pay their investors

When investors started to sell their units to Franklin and wanted cash, Franklin could not redeem the investments. The concerned company where Franklin had invested the money could not repay the debt or the interest. The companies were in no position to pay Franklin the interest or the principal. Nor could Franklin sell the debt in the markets to recover the investments, say like you can sell shares. Franklin was in no position to redeem the units on demand of unit holders.

6 Debt Funds were Closed

The result was that the investors in the 6 debt funds were left high and dry. They could not redeem. The value of the reported NAV of the funds was not what was reported. It was much less. Franklin took the option of just closing the funds. Now the investors’ money is blocked. The customers cannot sell their units and get their money back. They are on indefinite hold.

Franklin even tried borrowing to repay

Before closing the funds, Franklin was reported to be borrowing money to redeem the units that some unit holders were selling. Money Control (25 April 2020) estimated that the borrowing could be in the region of Rs. 3000 to Rs. 4000 crores. The borrowing has added to the problems of the remaining unit holders. Now, they can be paid only after the lender of that Rs. 3000 to Rs. 4000 crores has been paid the interest and repaid the principal.

The risk carried by Franklin debt fund customers is

• The customers do not know when they will be able to sell their units to get their money back
• The customers do not know how much money they will get back or whether they will get back anything at all
• The existing customers of the closed debt funds will now have to finance the loans taken by Franklin to past customers who were repaid, reducing their effective even further

RBI intervenes

In the meantime on 27 April 2020, there was a news item in Mint, that RBI is giving a Rs. 50,000 crore stimulus to mutual funds to repay the unit holders of such sticky debt funds. The way this will be operationalised is that RBI will give a line of credit to the commercial banks at a low rate of interest and in turn the banks are expected to finance the mutual funds.

Is it of any use?

The ground situation amongst banks today is that they are refusing to lend for normal business requirements. They are instead parking their liquid cash with RBI to be on the safer side. They are not sanctioning or disbursing normal loans to commercial enterprises. They are frightened of more non performing assets. So just because the RBI has offered a line of credit does not mean that commercial banks will use the same. In the past two years the commercial banks have not used any of the schemes or incentives of RBI for lending. Will the banks lend to the high risk debt fund portfolio of mutual funds? Let us wait and watch.

But who is going to pay for the loans in any case?

But suppose the banks do lend. Who is going to foot the interest bill on the loans the banks give mutual funds? Finally it is the unit holders who are going to pay this. In the process the actual value realized by the unit holders will be less than the published NAV. All in all the lending scheme is a loss to the mutual fund, it is a loss to the unit holder.

High rates normalize with low or negative rates over a period of time to give a normal long run rate to the investor

In the final analysis, the unit holder who was earning a higher rate in the earlier years, will now be earning a much lower rate (or even a negative rate) after the redemption of the units. For the period the unit holder held the investment the per annum rate of return wold be more or less to the rate earned in lower risk investments. This is how risk in investments kills the higher projected profits in the long run. And this is the reason why debt mutual funds are high risk.

There will soon be other mutual funds in the same situation

Franklin is not the only mutual fund that is so exposed. There are many debt mutual funds that will now surface as being either worthless or at a very low level of NAV. Close on the heels of Franklin, the BOI Axa Credit Risk Fund lost 50.22 % of its NAV value, and one can expect more to be on their way soon. Money Control.com has reported that Rs. 58,361 crores could be at stake on this problem, in the mutual fund industry.

Fortunately in life insurance, we,

Sell Risks, Not Returns
Returns are Uncertain, Risks are Certain