On January 17, 2020, many debt mutual fund investors with Franklin AMC woke up to a nasty surprise. NAVs of many popular debt mutual fund schemes from Franklin had gone down by 4-7%.
Why did this happen?
Many of Franklin debt mutual fund schemes held debt issued by Vodafone-Idea.
What about Vodafone-Idea?
On January 16, 2020, The Supreme Court of India dismissed the review petition of telecom companies over AGR dues payable to the Government of India. Without going deep into the issue, the telecom companies would have to cough up tens of crores towards payments to the Government. Vodafone-Idea’s liabilities to the Government would have stood at around ~50,000 crores. And this amount had to be paid by January 23, 2020. Given Vodafone-Idea’s precarious financial position, it was unlikely the company would be able to meet make payments.
When a company does have money to make statutory payments to the Government, it is unlikely that other financial commitments will be honoured.
In the light of these developments, Franklin chose to write down the exposure to Vodafone-Idea debt in many of its schemes to zero. And this resulted in a sharp fall in NAV.
Why didn’t Franklin side-pocket the troubled asset?
Side-pocketing is possible if there is default or the company’s debt has been downgraded below investment grade. Nothing of this sort happened with Vodafone-Idea. Hence, side-pocketing was not possible.
Franklin took the next best option.
Franklin’s concern (as they stated) was that, as the implications of SC judgement became clear to smarter investors, they might have pulled out money from the fund. This would have affected the existing bondholders. Rs 900 crores is 4.5% of Rs 20,000 crore fund. If Rs 5,000 crores flow out, the fund size becomes Rs 15,000 crores. Rs 900 crores is 6% of a Rs 15,000 crore fund.
If Franklin didn’t write down the value on that day and the outflows happened the next day, the investors who stayed back would 1have suffered. Instead of losing 4.5%, they would have lost 6%.
So, a smart move in that sense. Here is the official communication from Franklin in this matter.
Do note that fall in NAV does not mean that the money is lost forever. If Vodafone-Idea makes the payment to various schemes, such amounts will be written back. Franklin, in its conference call, mentioned that they will keep revisiting the developments in this space on a daily basis. As I understand, they can write back some portion if prospects improve. However, in my opinion, it is prudent to write back the money only once it is received.
Another perspective that Franklin would not acknowledge can be: Writing down the Vodafone-Idea exposure helps them keep the AUM intact. Now, nobody would want to run away since their losses will become permanent. Therefore, this move helps Franklin keep the AUM intact and keep earning fees on it. Side-pocketing wouldn’t have prevented fund outflows. So, it was better to write down exposure even before side-pocketing could become possible.
A win-win for both.
By the way, Franklin has limited to Rs 2 lacs per investor per day. Therefore, any new investor coming in becomes a holder of Vodafone-Idea debt at no cost (at the cost of new investors). I hope this does not become a new selling point. In my opinion, Franklin should have restricted all investments in the scheme.
I am an investor in one of these funds. What should I do?
Had side-pocketing been done, there would have been a bad fund (that contained Vodafone exposure) and a good fund (that contained all the other assets). You could have sold your units in the good fund and still retain the holding in the bad fund. As and when the money was recovered from Vodafone, you would have got that money back too. Essentially, if Vodafone Idea paid back, your losses (due to fall in NAV) would have been recovered.
Since there is no side-pocketing, there is no bad fund that contains Vodafone-Idea exposure. Therefore, if you sell now, you are letting go of your claim on money recovered from Vodafone Idea. If you sell now, your loss becomes permanent. Therefore, if you are comfortable with the rest of the scheme portfolio (let’s say the portfolio of Franklin Ultra Short Bond Fund), you must stay put.
You also need to see when the exposure is maturing. For instance, in the case of Franklin Ultra Bond Fund, the exposure to Vodafone Idea will mature in July 2020. Personally, I would be comfortable if the exposure to a troubled asset is maturing sooner than later.
As an investor, you can wait until the maturity of the bond. If the company makes the payment on time, you are good. If it does not, NAV already accounts for the losses. However, in both cases, you must revisit your decision of investing in this fund and your comfort with the risk involved.
Update (January 27, 2020): The exposure to Vodafone-Idea has now been segregated by various Franklin funds i.e. side-pockets have been created now. The existing investors will get units in the segregated fund that will only contain exposure to Vodafone-Idea. Therefore, existing investors, who are uncomfortable with current portfolios of various Franklin funds and their investment strategy, can exit the main fund now. Despite exiting the main fund, they will retain the units in the Segregated scheme (Sideopocket). As and when money is received from Vodafone-Idea, it will be passed on to the investors.
Franklin wasn’t the only one
Franklin wasn’t the only AMC with Vodafone Idea debt in their schemes. There were other AMCs too. All such schemes took the hits, perhaps a day later.
By the way, not all the AMCs have written down their entire exposure to Vodafone-Idea.
What is the learning?
As investors, you need to appreciate the risks involved in debt mutual fund investments. Many of these funds were darlings of retail investors. Though the loss is nothing compared to an equity fund, the sudden fall has shocked many investors who thought of debt funds as a replacement for bank fixed deposits.
This is not the first time such a thing has happened. We witnessed such sharp falls (and perhaps even bigger falls) when issues with IL&FS and DHFL popped up.
Debt mutual funds can provide you better tax-efficient returns as compared to bank fixed deposits. However, this excess return comes with risk attached. Appreciate those risks. Select the right debt mutual fund for your portfolio. Get your allocation right.
If you can’t do that, seek professional assistance from a SEBI Registered Investment Adviser.
Disclosure: A few of my clients have invested in Franklin Ultra Short Bond Fund. Some of it was legacy money while a few invested based on my recommendation. Most of them were aware of Vodafone-Idea exposure too and the associated risk. This fund, despite being an ultra-short fund was chosen as a Credit Risk Fund in the portfolio. However, the exposures as a percentage of the overall portfolio were quite measured. Therefore, the net impact was small. I do not deny that the sudden fall in NAV took us by surprise.