Ask any Personal Finance guru, and they will tell you to use your age as a guide to decide the amount of risk you can take with your savings. So, if you are 40, 100 minus your age, or 60 percent of your savings should go into equities and the remaining 40 percent should go into debt. That's because equities - or stocks and shares - are more risky and volatile, while debt gives safer and steadier returns.
How does one invest in debt? The easiest method is to put your money in a fixed deposit in a bank. Your deposit is used by the bank to lend money to others, so in effect, you are lending your savings to your bank. You can also invest in bonds which are instruments through which governments and companies raise money directly from the public. Just as you earn interest from a fixed deposit, bonds come with a coupon rate, which is similar to an interest rate. While fixed deposits cannot be bought or sold, you can trade in bonds.
There is one more way to invest in debt and that is through debt mutual funds. These work just like regular equity mutual funds do. When you invest in an equity mutual fund, you simply buy units of a particular scheme - the fund manager of the mutual fund invests your money in an entire portfolio of stocks. The Net Asset Value (NAV) of each unit of the scheme changes with the change in the value of the underlying shares that the fund has invested in.
Debt funds are similar - you buy units, and your money is invested by a fund manager into various debt instruments. These funds are considered to be safer than equity MFs because most debt funds invest in government and PSU bonds, which have a high credit rating and always deliver in terms of returns. However, some debt funds invest in riskier assets, such as low-rated corporate bonds, to get better returns - effectively, a higher rate of interest. These are known as credit risk funds or credit funds. Since they invest in riskier debt securities, they command higher coupon rates. These bonds also have a shorter maturity period, which means your money gets locked up for a shorter time.
The six funds Franklin Templeton has closed were all short-maturity, high-risk-high-return credit funds. The names of these schemes themselves made it very clear - Franklin Dynamic Accrual, Franklin Credit Risk, Franklin Ultra Shot Bond, Franklin Low Duration, Franklin Income Opportunity, Franklin Short-term income. Informed investors would have known this when they put their money into it, but a large number of people, who depend on their investment advisors and wealth managers, wouldn't have had a clue. Industry insiders say that distributors earn higher commissions by selling such credit funds over regular debt funds. So they tend to push such risky debt funds onto unsuspecting clients.
When COVID-19 hit India and factories shut down and corporate projects stalled, investment-advisors got nervous and started telling their clients to get out of credit funds. In normal times, there is a robust market for bonds, and a fund-house like Franklin Templeton would have simply sold some of the bonds it holds and raised the cash to meet the redemption demand from investors including people like you and me who want to cash in. But COVID-19 has badly affected the corporate bond market as traders are uncertain as to how long it will take for factories and projects to come back on track. So Franklin found no takers for the bonds and other debt securities it was holding, and had to offload them at low prices. So the value of its assets - the debt instruments it held - began to erode and the fund began to lose money. On top of that, Franklin Templeton had to borrow money to meet the increased redemption pressure, adding to its costs. The only option left to stop the fund from losing all its value was to block all investors from exiting. Now, people will have to wait for the bond market to revive so that the fund can sell its assets and return money to its investors in dribs and drabs.
The Mutual Funds Industry lobby AMFI (Association of Mutual Funds in India) has moved quickly to say that less than 1.5 percent of the total assets of the mutual fund industry has been hit by Franklin Templeton's closure and other debt investments are in safe securities. But will investors listen? Given that COVID-19 has taken so many jobs and caused widespread pay cuts, middle class investors may already be thinking of redeeming some mutual fund investments to make unavoidable payments like home and car loan EMIs. A lot of corporate money is invested in mutual funds as well as CFOs try to make the most of cycles when they have extra cash. At a time when companies are having to pay salaries without any revenues, they are likely to take money out of their mutual fund investments.
Although, the funds closed by Franklin Templeton are risky credit funds, the scare is unlikely to spare other mutual funds. This could cause a bigger liquidity problem as funds are forced to borrow to meet the redemption demand. After all, panic is as infectious as any pandemic and it also spreads exponentially. If liquidity gets sucked up by nervous investors trying to rush for an early exit, it will quickly lead to a credit crisis. Corporates will find it difficult to get loans, NBFCs which depend on refinance from banks, will find it difficult to raise funds, farmers will have trouble getting loans from micro-finance institutions, small businesses will be left without working capital. In short, the entire credit-cycle could come to a standstill.
The Modi government and the RBI will have to work in tandem and act quickly to stop this from happening. One tool could be to direct liquidity towards mutual funds at cheaper rates so that they can meet growing redemption pressure. Along with that, the government has to announce an economic package for industry which will restore confidence that things will return to normal once the lockdown is over. If the uncertainty about India's economic future deepens, all investments will be affected.
There is a bigger learning from this experience. Since the 1990s, governments have encouraged people to put their savings in equity markets or derivative debt instruments. Policy has been oriented towards keeping interest rates low. Equities and mutual funds have been given tax breaks, while traditional fixed deposits have been taxed as income. Even senior citizens, who used to depend on interest income, have been forced to seek riskier investments to get adequate returns on their savings. It is time to rethink these policies to ensure that ordinary people don't get stuck when fund managers act like reckless cowboys.
(Aunindyo Chakravarty was Senior Managing Editor of NDTV's Hindi and Business news channels.)
Disclaimer: The opinions expressed within this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.