As Franklin Templeton pays investors in six closed schemes, lessons investors must not forget 

The closure of six fixed income schemes of Franklin Templeton in April 2020 will remain a blot in the history of Indian mutual fund industry. The fund house had closed the schemes last year on huge redemption pressures and liquidity issues in the bond market.

However, in the week starting February 15, 2021, Franklin Templeton announced that as per Supreme Court orders it would be distributing Rs 9,121.59 crore to the unitholders in proportion to their holding in the schemes, with SBI Funds Management Pvt. Ltd. (SBI) overseeing the distribution to the investors.

While investors in these schemes who receive the payments would get some relief after 11 months, the Franklin Templeton issue holds a few important lessons for future investors.

Credit risk exists in debt funds

The schemes that were closed adopted the strategy of allocating more money to relatively low-rated bonds compared to its peers in order to generate higher returns. The additional returns came through low-rated bonds which have higher risk and consequently higher returns. The fund house never hid it. But the investors turned too cozy with it. When the macro-economic situation worsened, the fund house found it difficult to liquidate the portfolio to honour redemption requests of the investors. The situation, which was akin to a bank run, was precipitated by the additional credit risk on the books. Here is an important lesson. While it is perfectly acceptable to take credit risk with some part of the portfolio, investors should not overdo it.

Diversification is a must

Just because a particular scheme offers higher returns than the peers, do not put all your money in it. There are reports of individuals who had kept large amounts of their investments in one of these schemes that got closed for redemptions. It is always advisable to use a mix of fixed deposits, bond funds to park your money, especially when you are creating an emergency fund.

Take measured approach

An important takeaway for investors is not to be greedy for that extra return. To earn the higher return some investors took the systematic transfer plan (STP) route to equity funds through money parked in Franklin Ultra Short Term Bond Fund. This scheme was attractive as it had given higher returns compared to liquid and overnight funds. Always be careful that extra returns come with extra risk.

Long and short of it

The FT fiasco showed that in the long term, the financials of a corporation may change drastically. In view of this, though long duration funds offer higher accrual or yield to maturity, they also come with high risk. Credit risk is difficult to estimate for long term compared to short term. Long duration bonds are also more susceptible to interest rate risk. While investing in long duration products avoid credit risk altogether.

Do not over-react

After the Franklin Templeton scheme closure, investors started dumping credit risk funds as a knee-jerk reaction. The bearish sentiment at that moment made investors act without thinking. Many of them opted to sell and park their money into bank fixed deposits. Most of the selling happened at a time when the net asset values were depressed. Also the selling was not planned. This leads to unwanted costs such as exit loads and short-term capital gains, which eat into the returns.

Those who knew the risk involved with other well diversified credit risk funds and sat through the turmoil, managed to see healthy returns over the CY2020. Well managed credit risk funds gave 8 to 11% returns in that year.

(Views expressed are personal)