Revisiting our ratings of FT debt funds

By Morningstar |  08-05-20 | 

On April 23, 2020, Franklin Templeton announced it was winding up six of its fixed income schemes— Franklin India Credit Risk, Franklin India Income Opportunities, Franklin India Short term Income, Franklin India Ultra Short Bond, Franklin India Low Duration & Franklin India Dynamic Accrual.

The announcement came without warning, shocking investors and observers us included. Indeed, we had covered five of the six funds, assigning Silver or Gold Analyst Ratings to them. In light of Franklin’s announcement, we’ve downgraded the ratings of these funds to Negative.

In this article, we describe the rationale for the original ratings we assigned to the funds, explain what went wrong at the funds and in our analysis of the strategies, and reflect on what we’ve learned from these events. We conclude with an explanation of why we’re downgrading the funds’ ratings to Negative.

In summary, while we have conviction in the Analyst Ratings we’ve assigned to the funds we cover, this episode has been humbling. Our mission is to put investors first, providing research and ratings that help them to make sound investment decisions and achieve better outcomes. In light of the events at these funds, and investors’ inability to withdraw their assets, we recognize we didn’t meet that mark in this case. We are taking this event very seriously, re-examining our process to identify any shortcomings and taking the necessary steps to address them.

Our Ratings on Franklin Schemes

Franklin Templeton mutual fund was one of the early entrants in the lower credit space of the Indian fixed income markets, a unique niche at the time. Cognizant of the risk that is inherent to such strategies, Franklin developed a research-intensive investment process and security selection framework around it. The investment team considered credit and liquidity risks as the two major risks inherent to such strategies. To mitigate credit risk, it relied on its research strength, which involved rigorous qualitative and quantitative analysis to gauge the credit worthiness of companies and building safeguards in terms of security/asset cover.

Our conviction in the funds stemmed from this research-intensive investment approach. While short-listing securities for making investments, the focus was on investing in companies where there is a good degree of comfort with the management—greater emphasis was laid on aspects such as management background, their track record and financial strength of the promoter group.  The team augmented this research using quantitative analysis to understand the company’s cash flows, future capex requirements, underlying security/asset, and leverage ratios, among others to gauge the credit worthiness of the entity. More often than not, this investment approach has helped the team to largely short-list companies which have efficiently serviced their debt obligations.

We did consider the funds’ inherent risks, which get magnified amid adverse market conditions, when downgrades and defaults are more common. This is why we have always tried to clearly convey the funds’ risks in our analysis. In short, our research led us to conclude the funds would deliver superior returns, but with markedly higher credit risk than their peers.

And, until relatively recently, that was more-or-less how the funds’ performed, delivering outsized returns in more-placid markets while weathering turbulence when it arose. For instance, while the 2013 “Taper Tantrum” didn’t significantly impact the funds, they did experience short-term pain in 2016 when they took a haircut on their exposure in JSPL, but quickly rebounded from that setback.  All told, this lower-credit strategy served them well with stellar performance for the funds over time.

What Went Wrong

That said, the strategy began to come under strain and show cracks in recent year. For instance, like many other credit-focused funds, the Franklin strategies were roughed-up by defaults post the Infrastructure Leasing & Finance Services (IL&FS) crisis in September 2018.

Consequently, the funds had to markdown some of their investments and create side pockets. We evaluated these instances on a case to case basis and discussed them with the manager at the time to understand the rationale for holding those securities as well as the road to recovery/resolution.

Yet, the paradox of investing in lower-rated securities is that while they can deliver attractive returns, they also can be difficult to exit. To manage that liquidity risk, the funds’ manager had instituted several measures, including laddering portfolio maturities, imposing steep exit loads to discourage large or frequent redemptions, establishing bank borrowing lines, and diversifying the investor base to reduce investor concentration.

Against this backdrop, we failed to fully appreciate two factors. First, how the funds would fare amid a prolonged deterioration of credit-market conditions. The funds had held up well on previous occasions when trouble had set in. But with the benefit of hindsight it’s clear that those were somewhat episodic issues that were confined to certain issuers or industries. This downturn, by contrast, has been much more widespread and persistent. Thus, the funds’ performance has suffered to a far greater extent than we would have expected.

Second, we under-rated the possibility that investors would rush for the exits amid a performance slump. When this occurred, the funds’ managers had to sell the relatively more liquid portfolio holdings to meet mounting redemption requests. Had this continued, the funds could have entered a liquidity spiral, in which the managers were forced to sell at ruinously low prices, begetting deeper losses and spurring further outflows. Under those conditions, Franklin made the right choice to halt redemptions. But it never should have come to that and we erred in not foreseeing this potential outcome, which is unfortunate for investors left in the funds.

What We Learned

One of the key learnings from this episode for us is that - if a fund is an outlier in its peer group especially from an aggressive credit risk perspective, it would be better suited to be more cautious in our rating outcomes. When the credit market cycle turns bad, the risks could get exacerbated and prolonged, which could further impact investor sentiment if there are any resulting downgrades/defaults and side pockets.

Greater focus on liquidity management. While we have typically looked to understand the liquidity management of portfolio and the measures taken to reduce this risk. The recent events have shown us that extreme scenarios need to be factored in. Hence, another key takeaway is to not limit the liquidity evaluation purely at a fund level but also from the category perspective. We will also look at it more holistically from the context of overall asset manager exposures as well as industry level exposures.

We have downgraded the funds to negative because the fund managers failed in their job of liquidity management in these portfolios. The fund managers should have focused with an even keener eye on liquidity management in the portfolio, with the worst-case liquidity scenarios also factored in, and modulated their credit exposures if the situation so demanded. The team misjudged the gravity of the scenario, which it should have ideally been able to gauge and deployed pre-emptive measures to safeguard the funds and investors interest more prudently. Though the redemptions may have seemed extreme and gating the fund at that point was probably the best possible alternative, it should have never come to that in the first place. Winding up a fund is the worst possible outcome for the fund’s investors.

We are committed to integrity, and never have we compromised on that front. Our learnings here will be cemented into our process going forward.

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ninan joseph
May 31 2020 05:06 PM
 Really appreciate your honest self assessment. None of the so called star rating agency in India had the guts to self assess and admit that something went wrong. Example - Value Research. Thank you and your honest feedback has made me become a member.
manoj singh rathore
May 14 2020 11:59 PM
 Rating agency has so many relationship to manage. They have to earn money. So failure will keep happening. Sab maaf hai.
Deepak Parab
May 14 2020 06:01 PM
 I am sure this will not be last time when rating agencies have failed. This will keep on happening. Some how the trust in rating agencies have disappeared after ILFS fiasco and this event has further strengthened it
s r
May 9 2020 04:28 PM
 Investors have also learnt their lessons. No one would have predicted this outcome though holding low tarted assets was a red flag. But with past great returns risk was not appreciated. Not all investors follow events at all times. So rating agencies need to also warn investors earlier on by either revising their ratings. Atleast this will warn investors to an extent.
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