News Excerpt
Franklin Templeton Mutual Fund has decided to close its six credit risk funds. The fund house has not given any clear indication about the possible timeline within which it will liquidate all its investments and return investors' money.

Pre-Connect  
The crisis was long building up
•    As per a report from B&K Securities, the corpus of the six exposed FT funds stood at Rs 47,658 crore at the end of August 2018. It was also the time when the liquidity crisis in the shadow banking space began to surface after the first default by IL&FS.
•    Since then, these six closed funds from Franklin Templeton lost a total corpus of Rs 16,804 crore till March 2020. As a result, in a span of 19 months, the reduced corpus stood at Rs 30,854, including Rs 2,753 of borrowing to manage redemption pressure.
•    Worst was yet to come as in April, these funds lost a corpus of Rs 4,075 crore in first 20 days of the month and reduced corpus stood at Rs 26,779 crore on April 20, 2020.
•    This means these debt funds were yet to come out of the liquidity drought that started in the wake of the shadow banking crisis when COVID-19 blew the knockout punch.

Analytica
    Franklin Templeton said that the extreme drop in liquidity in the bond markets, coinciding with very large redemptions following the COVID-19 outbreak has compelled us to make difficult decisions in order to protect the interests of the funds' unit-holders.
    RBI has been making sure there is no big liquidity issue in the financial system. So, it was not entirely the liquidity issue but more of an overall redemption pressure in the financial system due to coronavirus and apprehension over its economic fallout. For Franklin Templeton, the issue appears peculiar, which has more to do with illiquid exposure the fund house took to generate higher returns.
    The maturity timeline of the debt securities held by these six funds spans above 5 years. So it looks impractical that the fund house will wait for these securities to mature. As per the communication, the intent is to wind up in less than a year but only 26% of the portfolio will mature in the next year. If the market does not resume normalcy, it will be difficult to sell illiquid papers.


Credit Risk Fund
    Credit-risk funds are a type of debt funds that invest approx 65% of the investment corpus in less than AA-rated paper. By taking greater credit risk and investing in lower-rated documents, they produce high returns.
    Such firms offer greater interest rates and offer a capital gain advantage as and when their ratings move up.
    The risk of interest in these funds is small because most of them are of a lower duration. Typically, these funds can return 2-3 percent greater than risk-free investments.

Return
    First, they receive interest income.
    Second, since they invest in lower-rated securities, they can create capital gains if the security rating is upgraded.
Shadow Banking System
A shadow banking system is the group of financial intermediaries facilitating the creation of credit across the financial system but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.


PEPPER IT WITH
IL&FS Crisis, Shadow Banking, Tier-1, Tier-2 Capital

Conclusion
Despite the categorisation by SEBI, a lot of debt schemes take on risks that are not reflected in their scheme riskometer or their category names. Fund managers with a view to generating higher returns tend to take higher risks in the portion of other investments permitted in even safe low-risk categories.