Podcast #27: The run on debt mutual funds. Is your money safe?Podcast #27: The run on debt mutual funds. Is your money safe?

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"The whole money supply in India is about 150 lakh crores. Half of that is in Fixed Deposits with banks. Around 30-40 lakh crores is sitting with government bonds/funds issued by the government. The rest in retail deposits. Debt Mutual funds are nascent in comparison... we’ve calculated that you can pay 80% less tax if you hold a debt fund giving roughly the same interest as an FD if you hold it for 3+ years, even if you take out money from time to time. The tax advantage is huge for individuals who are in higher tax brackets."

On today's show, Shray and Deepak discuss debt mutual funds. How do they really work? What do they invest in? And how do you evaluate these funds before investing in them?

Transcript

Shray Chandra: Hi everyone and welcome to episode 27 of the Capitalmind Podcast. Today we are going to look at debt mutual funds. We’ve had a bit of a mini-run on debt mutual funds over the last couple of weeks. Perhaps an unexpected turn [of events] in this most recent market crisis. And it really came to a head this week with Franklin Templeton basically stopping new investments and redemptions from 6 of their funds. So today we wanted to get into debt mutual funds. And really ask the question - how do you know if your debt mutual funds are safe. How should you look at them. What’s really been going on.

So Deepak, welcome and let’s get started. Can you first lay [out] the landscape for us. How big are debt mutual funds? There’s been so much success with the MF Sahi Campaign, it seems SIP inflows are 6-8,000 crores per month. So how do debt mutual funds compare in size against Fixed Deposits (FDs) after all these years?

Deepak Shenoy: Hi Shray [and listeners]. Awesome to be on this show! Let’s look at debt mutual funds as a category. We’ve got a fairly large number of funds. Most people think of mutual funds as equity but obviously there’s debt as well. More than 50% of all mutual funds are debt. So roughly 25 lakh crores is in mutual funds as of [I think] Mar 31, 2020. 13 lakh crores of that - a bit more than 50% - is in debt mutual funds.

Liquid funds funds (more short term investments, people keep them for a few days to a week) that’s about 6 lakh crores. 7 lakh crores is in other debt mutual funds - the kind that have seen the carnage recently because Franklin shuttered about 6 of those funds in that category.

The rest [12 lakh crores] is equity, hybrid and a bunch of others.

If you look at the size of the FD market, people who have term deposits in banks, I’m saying term because this is different from a current account and savings account. That’s about 73 lakh crores roughly. The FD market is like 6 times the size of the debt mutual fund market. There’s a bit of overlap. Debt Mutual funds sometimes park their money in FDs with banks. So it’s a bit of a mixed affair over here.

Roughly speaking the FD market is 6 times the size of the debt mutual fund market.

The whole money supply in India is about 150 lakh crores. Half of that is in Fixed Deposits with banks. Around 30-40 lakh crores is sitting with government bonds/funds issued by the government. The rest in retail deposits. Debt Mutual funds are nascent in comparison.

S: Interesting numbers over there. It’s a bit surprising but perhaps intuitive that FDs are still 5-6 times bigger than all of debt mutual funds. Despite whatever little bit of double counting there may be.

Let’s now look at what purposes debt mutual funds serve. In general, why do people go to debt mutual funds? There were a lot of attempts to recast debt mutual funds as a more tax efficient FD or FD replacement for individuals. I don’t know if that succeeded. But can you answer - as an individual when should I be going to debt mutual funds. And as of today, who are the biggest clients for these debt mutual funds? Is it institutions like with everything else?

D: Yes. In fact I think a significant number like 84% of liquid funds are held by corporates or institutions. Only the remaining is held by individual investors. More than 50% of the remaining is again held by institutions.

You want to go to a debt mutual fund for a purpose. If you buy a FD you know the returns you are going to get and it’s going to take you (say) a year to get that return. In the intermediate time if you need any money then that money will lose a certain amount of interest. If you put 50 lakhs into a FD and you need 10 lakhs out of it in 6 months. You typically have to break the entire deposit or if you take out the 10 lakhs only using some kind of a linked scheme then that 10 lakhs would have earned you less interest even for the last 6 months that it was a FD because that’s the way FD operates.

Second - you don’t get very short term FDs, 7 days, 10 days, 15 days. That is the kind of liquidity that people want to park short term money in. Especially corporates and institutions.

Debt Mutual Funds also have this benefit that if you invest in it for 3 years you get compounding on a regular basis. They earn the debt funds themselves and go and buy other fixed income instruments. The fund is a vehicle and not the end use. When you give a bank and FD the bank gives you interest. In a debt mutual fund, they take your money, they invest it in other paper/debt instruments maybe of corporates or the government, state government or PSUs. They get the interest and they reinvest that interest back into buying more of these debt instruments. If you don’t take your money out for 3 years, this compounding works tremendously in a favorable way for you for taxability. That essentially means that you will pay substantially lower taxes. We’ve calculated that you can pay 80% less tax if you hold a debt fund giving roughly the same interest as an FD if you hold it for 3+ years, even if you take out money from time to time. The tax advantage is huge for individuals who are in higher tax brackets.

Institutions generally don’t pay commissions - they go direct. Direct ownership from institutions is 90-95%. But retail individuals are sold these products (debt mutual funds) saying you will get better yield and a more tax efficient yield. Go to these top mutual funds and buy their debt funds. Debt funds can charge as much as equity funds in terms of management fees. An equity fund will charge you 1 - 1.5% and you can find the top debt funds (say credit risk funds) may also charge about 1-1.5%. Which means if they are investing in paper that gives them 10% - you get 8.5%. For you 8.5% is great because there is no FD giving you 8.5% and the 1.5% is a huge management fee for a debt fund. That’s why for them having (since there’s so much money in debt funds, roughly as much as equity) the fact is that they earn quite a bit from the debt fund AUM as well.

These funds are sold aggressively - at least the riskier funds or they turned out to be risky now, they weren’t sold as risky funds. They are mostly sold as FD replacements - saying listen come here, it’s longer term, more tax efficient. As an individual you should go to a debt fund because you don’t need the money and an FD will tax you on intermediate income. There are very things that don’t do that. There’s an RBI 7.75% bond that gives you 7.75% per year but your money is locked in for 7 years. At the end the interest is entirely taxable. However, in a mutual fund if you’ve got even 7% and it was taxable at a much lower rate because of capital gains. You’re not locked in for 7 years - you can take out parts of it in the intermediate time frame. You will always have the liquidity, the tax advantage and if you understand the debt product well - you could manage risk also quite efficiently. You will take a little bit more risk but I think this is what the positives are of debt mutual funds in the longer term. A few accidents aside, the market is relatively small in India and we’re going through a bit of damage but I think this market is only going to grow.

S: That sounds very convincing and paying 80% lower tax for an equivalent interest rate AND having the benefit of greater liquidity, it’s a pretty compelling pitch. I can see why this does so well. But there’s a lot of variety in debt mutual funds right? I would like to think an FD is pretty much an FD but sticking with debt funds - what are the different kinds of debt funds out there? What’s the universe like? Surely they’re not all created equal?

D: Here’s where the advanced financial education of this country comes in handy because we have managed to muddle the water with so many complicated names that in the end you need a degree just to understand what all of this means. We’ll do a more detailed workshop in the sense of saying how do you select a debt fund, what kind of products are there, what kind of stuff do they invest in. But I’ll give you a brief here.

Base debt fund on the kind of risk you want to take. Something that’s shorter term in risk and something that’s longer term. Think of yourself as a bank and the MF is just investing your money in other things. If you want your money back within a week, you’re not going to invest in a product that buys something that is 5 years away to maturity. Let’s assume your mutual fund invests in a fixed deposit and that FD is 5 years away. You are investing for only a week then you’re not aligned properly with that fund. Your liquidity or duration you want to invest in, determine the kind of fund that you invest.

Most corporates may have 3 day paper. There’s something called liquid and overnight funds - they are very short term and they also tend to get their money in overnight nights.

Liquid is within 3 months. If you want money within 3 months then a liquid fund is a good investment.

As you get higher and higher in terms of time/term and duration - you can expand a bit to say I’m comfortable with something that’s between 3-6 months. I want to invest in something that invests in 3 and 6 months terms. Now there’s many reasons for this also. 3-6 months is called ultra short term.

6-12 months is called low duration. These are all duration based.

Then there’s the kind of market they invest in. There’s something called the money market, something called commercial paper (CP) and certificates of deposit (CD). Less than 1 year to maturity. I give a mutual fund some money, the Mutual Fund goes and gives Reliance some money but Reliance returns the money back within 1 year. That is the money market.

Then you can go into specific kinds - corporate bonds where they will go and lend to corporates who are rated AAA or AA. To the normal person - very highly rated companies. This doesn’t mean much because rating agencies don’t know - they rated IL&FS as AAA and DHFL AAA and those guys didn’t return their money. But the idea of rating is that there’s a very high chance of money coming back because those corporates are sound. These corporate bond funds tend to invest in something that matures in 3 months or even 5 years or a combination of the two. The fund manager is now deciding what to invest in. As long as it is AA or higher.

Then you get the credit risk funds which invest in stuff less than AA. So a little bit less chance your money will come back but say “we like this company, it just doesn't have the rating capability but they’re sure to return the money” - the fund manager takes that call. You give your money to such credit risk fund managers.

These classifications changed about 2 years ago. Earlier they were called different names. Then you have something called short term, medium term, long term. Short term is more than a year but less than 3 years. The idea over here is it’s not necessarily that you want to invest for that time. But that the fund will invest - each instrument is buys - should roughly align with this term.

In general if I feel interest rates will go up, I want to be in shorter term paper [liquids, ultra short term, low duration]. If I feel interest rates are going to fall I will be in longer term paper. I will actually want to position my debt funds in that way.

Interest rate cycles take 2-3 years. In 2 years it’s likely that interest rates keep going up. Another 2 years they’ll go down. When a cycle changes you might change your debt fund allocation. But these are the different kinds of funds out there.

S: That was extremely helpful. I would like to second that point on how complicated this can become. Many years ago when you were ok with people buying the Franklin Templeton Ultra Short Term - which btw congratulations on getting out of earlier this year - I remember you had shared advice on the slack channel for people to go and buy a fund and even though you had given the exact name - it came with 4 different sub-options growth, dividend or whatever and between all of those they still couldn’t get to the right one. So you’re very right in that the waters are constantly muddied and not made very easy for you to do this yourself.

D: One thing I want to add is that every of these funds has a dividend and a growth option. Dividend means they pay out in the middle and Growth means that they don’t and they reinvest all the money they receive. This has been a very interesting thing because debt mutual funds in general have had a tax arbitrage earlier. This tax arbitrage is now gone. If you were a person receiving dividends from mutual funds and were in a lower tax bracket you had an advantage vs. being in a growth fund.

And every fund is a direct and a regular option. So there’s regular dividend and regular growth and direct dividend and direct growth. In regular - an intermediary gets a commission.

If you think of ICICI Direct (the brokerage platform) - they only sell regular funds. A direct fund can be bought from ICICI mutual fund from their own website. This is fairly complicated but direct is the best option for you if you’re listening to this and what to take action on your own. If your advisor is listening to this most likely they will tell you about the regular option because he will get a commission that way.

Franklin of course - thanks for that! We successfully managed to exit because we were looking at a certain set of dynamics which we’ll talk about in more detail later [we law large redemption in December and January].

S: Let’s get to the other side of this. You’ve talked about what kind of debt mutual funds there are. What do they go and buy, are all of these just like loans to companies or are they different kinds of/varieties to the instruments that they invest in?

D: You’ve raised a big point. What banks do is give loans. They go to a corporate and say here’s my money and give me my money back in x months. They don’t say if you don’t give me my money back, I won’t pay my depositors back. The depositors get their money regardless, the FD people get their money even if Nirav Modi comes and frauds the bank, no Punjab National Bank depositor lost any money.

The idea over here is that the bank takes the risk. A debt mutual fund does not take the risk. When it [a debt mutual fund] is exposed to a corporate default, the investors of that debt fund will lose their money. The higher returns of a debt mutual fund come from a higher risk.

A bank typically will give out loans but there is another way for a corporate to borrow money. A corporate or any other person can say I will issue you a security. Your FD receipt is a sort of security. If you think about an FD, once I buy it from a bank, I can only give it back to the bank and say redeem this for me [and give me my money].

But think of yourself as having an FD receipt that can trade. I take an FD from a bank at 8%. The bank now reduces its FD rates to 6%. So now my 8% FD should be valuable right? Because you might say, Deepak, you have an 8% FD and I want that.

So I’ll say, how much are you willing to pay for it? You’ll say since you paid Rs 100 I’ll also say Rs 100. I’ll say no because I’m getting 8% and if I take your Rs 100 and I try to put that Rs 100 back into the bank - I will get only 6% so I would rather hold on to the FD.

Then you offer Rs 110. Now you’ve set a price on this FD which was Rs 100 at the start but you’re now paying me Rs 110 because for you getting it at Rs 110 and then getting Rs 8 on that - you get 7.1% [7.3%] yield/return which is better than the 6% the bank is offering. Now we’re both happy. I sold my Rs 100 FD for Rs 110 and you’re getting 7+% return instead of 6%. And I could even ask for Rs 125 because that’s still better than 6%. This is what falling interest rates do.

This is the same way you find that securities change. Instead of thinking of tradable FDS - think of bonds. Once the issuer (bank, government or company) issues a bond, it says I will pay you an interest rate (coupon) of say 7% or 8%. Once it says 8% for the term of that bond, the interest rate will continue to be the same percentage for the whole term. The point is in the middle of this, after the bond is issued and someone has bought it, interest rates can go up and down and that will then determine if another party will pay more or less for it. This is tradable on exchanges. Sometimes the Rs 100 bond will trade at Rs 102, sometimes at Rs 98. What mutual funds do is buy these instruments.

Let’s look at different kinds of instruments. We’ll go into more detail about this in the workshop.

There are short term instruments like Commercial Paper (CP) and Certificates of Deposits (CDS) where banks and corporates issue what are money market instruments. They are sort of like bonds but they are issued for less than 1 year in duration.

The government issues a lot of bonds, it issues bonds every week in fact. You can buy these directly from the government but will have to pay tax on the interest but then you can buy MFs instead that will then buy these bonds. Government bonds can be bought for less than 1 year in duration - typically these are called T Bills. Government securities (G-Secs) are typically for 1 - 50 years in duration. That’s their term to maturity.

You’ve got non convertible debentures (NCD) - bonds of more than 1 year in duration at the time of issue.

You can have overnight instruments, give me money at 3pm and I’ll give it back at 9am at a 4% annualized rate (4%/365 per day). So if you give me 1 crore it will be Rs 1,095 [Deepak mistakenly says Rs 10k on the podcast] in interest.

Short term funds will invest in short term (less than 1 year) instruments. Again there are caveats here but there are also funds that invest only in government bonds and are called GILT funds. They will buy only government issued paper. What’s the difference? The government won’t default, it can print money and give it back to you whenever it wants if it were really in trouble. A corporate does not have the ability to do that. A bank is somewhere in the middle because there is an RBI sitting and saying we will rescue all the banks so the riskiness of the underlying paper [will the company return the money or not?] is also reflected in the price. A company may be considered reliable but because of the Covid slowdown you feel this company doesn’t have any money and may not get any more - then the bonds become less expensive because you want to sell it but no one else wants to buy it. This is credit risk.

There are other bonds where, we saw this in the YES Bank crisis, called Additional Tier Bonds bonds. Bonds are a financial engineer’s wet dream. It’s a phenomenal thing for them to keep adding layers and layers of complexity and people will largely ignore the complexity so one of these things called Additional Tier One (AT1) bonds. The concept is simple - please give me money and I’ll never have to give it back to you. But I will pay you 10% interest per year.

You say wow! This is fantastic but will I never get my money back? If I’m in trouble I will never give you anything, I’ll just say goodbye and you’ll never hear from me again. You say Oh my god that’s risky. Yeah but you’re getting 10%. Other people go 10% is great. After 10 years, if I really like you and the whole situation, I will pay your AT1 bond principal back.

These are the AT1 bonds. These are fairly large instruments. About 30,000 - 50,000 crores have been issued by banks. Recently when YES Bank went down, investors said won’t you buy this back? YES Bank said look we’re not giving your money back.

Everyone: How can you do this?

YES Bank: That was the contract. Exactly how it was written.

Now the issue is it was sold to retired people (10 lakhs per bond) who were not informed of the risks and they ended up saying we thought it was a fixed deposit but then it was not.

AT1 bonds are also held by mutual funds who also lost money in the YES Bank fiasco but they didn’t have a pretence that they didn’t know. They’re supposed to be sophisticated investors. Now the mutual fund in a sense did not take the risk. The investors in the mutual fund took the risk.

There are multiple such debt instruments that mutual funds buy. You can see this every month in a mutual fund’s portfolio and figure out exactly what they own. In order to figure that out you’ll need to know what all they can own and why they own what they own in the first place.

S: Interesting stuff there. As you said, let’s go into more detail about the securities in the workshop when we have it. I have two quick technical questions. I’ll club them together and you can take them in whatever order you prefer.

If I were to put Rs 1 lakh into a debt mutual fund tomorrow - how does that 1 lakh get deployed in the debt mutual fund. And why do I care? Should I be putting in money now?

How do debt mutual funds calculate their NAVs? It seems a little more complicated than equities where you have prices every day. And do I really care or is this technical stuff I can ignore?

D: It’s interesting because in a crisis this is the only stuff that matters. In normal times this stuff doesn’t matter. Let’s look at normal times.

I’m a debt fund, you’re an investor. You send me money, you think that what I’ll do with that money is take it and buy something in the debt markets. If I invest in something with a 7% interest, that 7% comes to you minus my management fee of 0.5% = 6.5%

But actually what happens is that you’re investing, someone else is redeeming. You give me 1 lakh rupees. That guy is redeeming 1 lakh. I won’t even invest your money, I’ll just take your inflow and give it to the person who is redeeming. My cash inflows and cash outflows net against each other.

Inflows = when you give me money and the interest on the bonds in my portfolio or the principal when they mature.

You might give me 1 lakh, I get 5 lakhs more from interest from the bonds that I’ve already invested in. At the same time, there may be 2 lakhs of redemptions. I’ll pay off the 2 lakhs of redemptions from the 6 (1+5) lakhs I’ve received. I have 4 lakhs remaining and I'll take this 4 lakhs and invest it. This is what happens in normal times.

In abnormal times, things change! You put in 1 lakh but I have redemption requests of 20 lakhs. I won’t invest your 1 lakh and invest it in the market even though the yields are looking juicy - reliance is at say 10%. You see this too and say this is a fantastic time to invest and I should give deepak shenoy (who runs the debt fund in this example) the money, he will put it in reliance and make the 10%.

Except when you give me the money, I am not prepared to invest in the market. I have 20 lakhs of redemptions waiting so I’m a seller and not a buyer. I am going and selling that same bond at 10% because I have to make 19 lakhs of liquidity beyond what you’ve put it to pay people.

When my outflows are substantially higher than my inflows, the mutual funds are not net buyers - they are net sellers in that market. Even if you give them cash and even if there weren’t 20 lakhs of redemptions that buy, but the fund manager sees redemptions happening everywhere else (for example there has been 35,000 crores of redemptions in the last 1 week in debt funds not counting liquid funds). So out of the 7 lakh crores sitting in non-liquid debt funds, 35,000 crores has been redeemed in the last 1 week after Franklin’s redemption pause.

That’s a lot of redemptions! If you’re a fund manager looking at this, you’ll say even if someone gives me money I’ll keep it as cash because I expect some redemptions tomorrow or soon after.

So if you’re thinking that markets are juicy and I’ll invest now to take advantage of that, please realize your money is not going into the markets, it’s probably being set aside or given to investors redeeming. You won’t get exposure to these best returns. Your money won’t calm down the markets. If you were a direct buyer of the bonds, you’d get this 10% bond and then keep it. You take this bond and as a direct buyer you’ve calmed down the market. You’re going in there and helping the market dynamic.

Whereas if you go through a mutual fund, your buying may not calm down the market because the mutual fund itself may not go buy those bonds but it might just keep the money in cash. Because they are also scared that redemptions will come soon. Buying a MF does not mean your money is directly participating in the marketing. You have to be aware of this.

Now coming to the NAVs - debt mutual funds are different from equities which have traded prices. If a share trades at Rs 110 then that’s your price. The prices are reliable because if I wanted to sell at Rs 110 - I’ll get it out.

Bonds are by and large very very illiquid. Reliance itself may have 40 different kinds of bonds. One that matures 6 months from now, one that matures 1 year from now, one that matures 2 years from now but has an option to be repaid 1 year from now. Another one that perhaps matures every 7 days from now. There are different types of bonds. When you buy Reliance shares, your share is the same as mine.

However, if you have some type of Reliance bonds - these could be very different ones and I might not want the bond you have and vice versa. The liquidity situation is different. So how do I price something where no one has traded it today?

It’s a very complex equation. If I have traded it, I use the traded price. If I haven’t traded it then maybe some other bond of the same company has traded - that’s close enough. So I’m going to use that price as a proxy and use some calculations on top of that.

If none of the bonds of this company have traded, then maybe I can look at other companies that are like Reliance (in this example) and are also AAA rated and in oil and gas. If there’s something in the same range then I can use that price.

Then I can use another bond with the same rating and use that as a proxy and the basis for assigning a price to my bond. Now is it Rs 100 or Rs 105 - we’re trying to figure out what the price can be. We use this matrix on bonds of the same company, other companies with the same rating, just the same rating, if nothing then yesterday’s price and do an extrapolation for one more day.

CRISIL or someone puts out a matrix like this every day, the mutual funds price their bonds accordingly. What this means for you is that they take their prices and build their NAV by stitching this together. I get my total value, the total number of units and then calculate the NAV.

If there are lots of redemptions this may not be true and the NAV can be quite off. The price wasn’t real right, it was extrapolated or calculated based on the past - so the values may not be tradable or reliable prices. When people actually go to sell this bond the theoretical price of Rs 105 may be at odds with the traded price of Rs 101. So Rs 101 is the new price at which you can sell this. In a time of a crisis, bond market funds will fall in price when there are sales in the market.

You could see this in the last week of March and the last 1 week. In the last week of March liquid funds lost money! People were so scared of the corona virus and the lockdown etc. that they started to exit their liquid funds as well. Even paper that was 7 days later people were saying this should be valued at Rs 99.80 and you’ll get back Rs 100 in 7 days, customers said no I’ll give you Rs 99.50 for it. People were giving much lower values for something that was very short term in nature. There was fear and panic and that caused liquid funds to lose money on a week to week basis. Of course it came back after a week. If you had invested only for 3 days you would have seen negative returns. This wouldn’t have happened with FDs!

In the last 1 week we’re seeing this in long term bonds as well. Funds have been selling (35,000 crores of redemption requests in the past week!) and they don’t have this much cash so they’re going to sell what they have to generate that cash. Some of those sales will result in the NAV falling because when they go to the market to discover the real price then the price will fall.

So the NAV is a great thing in good times but in bad times it’s really lousy.

S: I have to say those were depressing technical answers. You’ve basically told us that as a small retail investor, even though there are people trying to raise money today at terms that will benefit you - you won’t be able to participate if mutual funds are net sellers since the 1 lakh you’re putting in will service other redemptions. And you’re not getting any access to the good stuff since they’re not buying.

The NAVs that you see are only as good the formulas that underlie them. In times of crisis those formulas become increasingly outdated and you’re looking at best case prices and not real prices.

Not the most encouraging stuff but thanks anyway.

Now, moving on to my next question, you’ve written this great article where you’ve described that there’s a big gap between the actual liquidity of the things that these debt mutual funds invest in and the liquidity that’s promised (implicitly or explicitly) to a customer. And there’s all sorts of weird stuff happening here. Can you talk about this? What’s this gap in the liquidity?

D: We’ve understood that we’ve got some unreliable parts that are only accurate in good times. Let’s also go to the fact that you can disguise/package a lot of things. One of the things you can do - let’s take Franklin Ultra Short Term Bond Fund as an example.

Now Ultra Short Term means between 3-6 months of duration. So you’re thinking, ok maybe they buy something that’s 2 months to maturity and something that’s 8 months to maturity and roughly the average is between 3-6 months so you’re ok. Worse case all the underlying stuff will take say 8 months to recover all the money in case Franklin says I can’t sell these instruments because the market is bad.

Let’s say there’s this bond by some housing company, you say I don’t know this housing company. Then we say no it’s a good company and they’ll pay you back. But you refuse, the market is bad and I’m also a seller.

If you can’t do anything and the bond is maturing in 8 months, I’ll wait for 8 months and then the housing company will pay me back my money. That’s what Franklin has said in a way.

Here’s how funds think, you can wait and get your money back. When Franklin has shuttered all these funds, the investors say they’ll wait for 6 months. But they have to wait more than 5 years in some cases. Why is that? It’s because the way this 3-6 month duration is calculated was based on a formula that you could work around it with some financial engineering.

If something is 5 year to maturity you think it will mature in 2025. But the company could have given you a floating rate bond. The floating rate bond is simple. I’m not telling you how much interest I am going to pay you. It will float. Right now I'll pay 8% and if interest rates at say SBI 1 year lending rate falls by 0.5% then instead of 8% I’ll pay you 7.5%. So the rate is pegged to SBI 1 year lending rate.

When do I change the floating rate since SBI could change every day? Let’s say once in 6 months, we’ll evaluate SBI’s lending rate and we will reprice or reset the interest rate for the next 6 months. After 6 more months we’ll do this again all the way up to 5 years and have 10 such points. A normal person would still say this is a 5 year bond but the calculations of duration which is what factors into the 3-6 month target for ultra short term criteria. They say the interest rate is resetting every 6 months so the maximum duration is 6 months for the purpose of calculation.

What happens therefore is an ultra short term bond fund can have a 5 year floating rate bond in its portfolio and still call itself a 6 month product. So you can have a lot of this across many funds - it’s not just Franklin. Almost every fund has floating rate bonds in it. They have a bunch of other such bonds in their portfolios where now when i t comes to the extreme crisis situation of shuttering funds and suspending entries and exits.

When Franklin has come into a situation where they are shuttering entries and exits and now have to wait till the fund receives money from who they invested in, you’re finding out you have to wait 5 years. A 6 month fund is actually a 5 year problem. You’re not just taking credit and interest rate risks. You’re also taking the fund manager or fund financial engineering risk. Even though the portfolios are public no one really looks at this while picking a fund.

But if you do the calculations it could turn out to be not right. They use the Macauly duration which is how long to replay but in the case of floating rate bonds the Macauly duration is used till the next interest rate reset date. I feel this is wrong. We talk about it in the blog entry. We say you should use the whole term for the sake of maturity calculations. You can do pricing based on Macaulay duration which is based on the interest rate reset. But time to maturity should not be this way.

There’s unlisted bonds, if the company doesn’t have a good standing therefore those unlisted bonds sit on portfolios for years and years. When funds received redemptions. They can’t sell the unlisted bonds so they sell the better/listed stuff.

If I have 10 eggs and 1 is rotten (let’s run with this analogy), if you ask me to give you 4 eggs I have to give you 4 of the good ones. You’re not going to accept the rotten one. So my rotten egg percentage was 1 of 10 = 10% but now it’s 1of 6 = 16%. So when I have redemptions the debt that can’t be sold increases as a percentage of my portfolio.

Redemption wise you get a lot of these bonds that can’t be sold because of regulation - they become increasing weights of your portfolio simply because of SEBI rules. According to me, SEBI should allow funds to take these unlisted bonds, put them in a sequestered portfolio where our returns will come only when the bonds mature. You have a concept of segregation/side pockets which can be kept by funds whenever certain things happen. SEBI should allow that here.

What this also means is that the actual liquidity that you’ve been promised is not the same as what the investment allows. Credit risk funds say you can redeem every day but they are investing in products that are illiquid or long term in nature and perhaps repackaged as short term thanks to this floating rate condition.

You can demand your money any time, if enough people demand it the underlying bonds are illiquid in that time frame. In liquid funds they’ve said, keep 15% of the money in government bonds which can be sold any time quite easily. So I can have 15% redemptions without any issues.

I’ve talked about 35,000 crores of redemptions in non-liquid credit/debt funds. 35,000 crores out of 7 lakh crores is only 5%. If all these funds have 1% in government securities, a 5% redemption event would not have caused this level of chaos where we’ve nearly destroyed and frozen markets. So you really have a crisis because the instruments they have are not liquid. So you can introduce liquidity criteria as well.

The last bit is where you’ve got debt which is not good debt in the first place. There are companies owned by promoters of public listed companies. Some of those promoters have borrowed in their own personal names. They won’t tell you why but they’ve said I will borrow Rs 50 and give you Rs 100 of my shares as collateral so you have 2x cover.

I won’t tell you what I’m doing with the money. I’m just going to give you the shares as collateral. I can’t do this to banks, banks say I need to know what you’re going to do with the money so the banks will not lend. You can go to an NBFC and they have limits on how much they can lend to such companies.

Or you can go to a MF and issue a bond which is secured by 2x of shares. In good times this happens and the promoter company says I won’t even pay you interest every year, I am going to take a loan for 3 years and pay you the entire thing as a lump sum interest after 3 years.

But after 3 years, when we meet and you ask for your money back, they say they don’t have any money but they reissue another bond, you buy it and they use that money to pay back the first bond from 3 years ago. These are promoter companies which use only shares as collateral. They keep rolling over the loans and never really paying any interest and are called zero coupon bonds or cumulative bonds. They’re just rolled over for ever and ever except when it comes to a time like this - when people are redeeming no one wants to buy that bond because they all know the underlying quality.

You want to be careful that your mutual fund or MFs in general are not the only lenders to a company. If the company has only borrowed from mutual funds, they have no operating business, they have no cash flows and they are not paying an interest - they are only paying at the end of the term - then I think you’ve got a product where you as a mutual fund investor are actually taking this risk and not anybody else.

So the actual liquidity of the underlying investments that are in a fund are very different from what you’re being offered. So you need to go a little deeper and find out what the MF is investing in.

S: That’s extremely sobering and a bit of an eye opener. I didn’t know there was so much going on in the debt MF space, do we also need to look closer at Fixed Deposits? For instance I doubt that loans to companies, which is what FD money goes into, surely those aren’t all that liquid either. So are FDs actually much safer or is this just untested and one day a similar problem can happen if there’s a 35,000 crore liquidity request from FDs in 1 week. Will the same crisis happen there?

D: A few things are different. FDs have a rule that says you have to put about 20% of the FD money into government bonds. So the liquidity position is much better in the event of a sudden run on the bank. This happened in YES bank’s case where a lot of people took their money out but the bank did have substantial amounts (70-80k crores) in government bonds which could have been sold easily.

Banks also get a credit line from the RBI. They can take their deposits and go to the RBI and the RBI will give them money no questions asked. They have a lender of last resort and they can borrow money from that lender. MFs don’t [really] have that access.

Third the RBI has said it won’t let a bank go down and help depositors. There’s a government guarantee of Rs 5 lakh per depositor. That also ensures that a significant proportion of the depositors will be paid back in the event of an extreme situation and the RBI has done this in the past.

GTB was bought by Oriental Bank of Commerce, it was merged forcibly when it was going down. Centurion Bank of Punjab, others were merged into larger stronger banks. Simply because the RBI wants to protect the banking system. There’s no one who is such a protector of the mutual fund system in a way. Remember the lender is not the mutual fund - it’s you - the investor. Don’t expect yourself to be rescued because you are not too big to fail.

The one other thing is that while we’ve seen runs, the country and the banking system works together to see that a run doesn’t get out of hand. If you took out all your money from the bank as cash, you would bring down the whole country’s banking+financial system overnight. That’s why people stop you from getting to that point.

That’s why the government and RBI create this confidence. In the US things are different because there they care about the markets as well (In India we care about the banks). Liquidity right now is much better in banks than in mutual funds because they have a lender of last report.

S: Why were you saying the RBI can’t support MFs? Wasn’t there a news release about the RBI doing a 50,000 crore intervention to help support debt funds?

D: I think I shouldn’t have said “can’t do that”, I should have said “don’t want to do that”. They’ve said there’s a problem with MFs and they’re not able to sell even good paper. There are multiple players in the market - the government which is selling bonds, there are companies that are selling bonds and also buying mutual funds or bonds directly. There are pension funds and insurance companies and certain other funds which are buyers. Mutual funds are also buyers and sellers.

If you take one player and make it only a seller because of redemption pressures on it, then who will take their place? Right now RBI is saying let me push banks to take that place. I’ll give 50,000 crores to banks and banks will then go buy this paper from mutual funds. Banks will say listen - if this is really junk paper I’m not going to buy it. I’m going to buy only some of the high quality paper like an NTPC bond because it’s quasi guaranteed by the Government. Or a bond from a company with every little debt because I want to be safe. They will be very selective and careful. RBI has promised 50,000 crores but only 12,000 has been used/taken.

Now the next question is - will RBI do more? The Fed is buying even junk paper - we’ll buy anything because we want to unfreeze (unclear) this market

S: Directly?

D: Yes, buying it directly from the market and also from companies directly. So the RBI has said listen you’ve [banks] got to buy bonds from companies but only the high rated bonds. And you can buy from the market as well - so half and half. But having said that, in the US and in Europe as well, the central bank is literally buying anything. Now the Fed buys junk paper and that’s considered bad but the Swiss National Bank buys equities, it prints swiss francs and buys equities

S: You had mentioned this (Swiss National Bank buying Apple) in the last podcast

D: And the Bank Of Japan owns 70% of their EFT market which is equities. These guys are way down the risk cycle, to expand the balance sheet, print money and buy anything. We’ve got a situation where the RBI hasn’t purchased directly, but the RBI Act allows it to buy anything and it doesn’t need to amend the Act. It can say I will buy junk bonds or good bonds and that will not be a legal problem. Except RBI has not wanted to do this so far. It will probably be forced to if the market situation continues for longer but given where it is right now, RBI is saying let me try everything else before I have to actually go and buy stuff. We’ve seen in the past in the west at least, this hasn’t worked because when you do piecemeal things no confidence is generated. Without confidence people take their money out.

S: That leads me to my next question. You’ve described that there are some entities out there to whom mutual funds are the only liquidity providers. Similarly mutual funds are playing a significant role in the CP/CD markets. Now that mutual funds are just sellers and are taking a backseat, what are the ramifications on the system? Is everything drying up? Are companies going to start going under? Is this going the be the next phase of the crisis.

D: India’s Lehman? It could be. What happened with Lehman was similar. They couldn’t roll over paper in the overnight markets. When they couldn’t they realized they had to file for bankruptcy then if Lehman was allowed to file then a lot of the counterparties they had would not receive their money.

What this means in India is that liquidity providers - which are mutual funds - are refusing to buy anymore paper. We’re not going to buy anymore. We’re just going to be sellers. When it’s time for you as a company to repay I want my money back, I won’t roll over your loan/debt.

So companies who have salaries to pay whom or who may need a loan for working capital for a few months, they might be rolling that loan over each time taking a loan for 6 weeks then pay it back and need more money for the next 6 weeks. These are companies that have depended on these markets for years and years. They have calibrated their requirements to that.

You’ve gone to a situation where they can’t go to the markets and say give me a loan now. A lot of these don’t go to bank loans since bank loans are pegged to something called the MCLR. A certain market based lending rate. Now that’s a lending rate below which a bank cannot lend.

If you have an MCLR of 8% for a year - that means you cannot give a 1 year loan for less than 8%. If you have a 3 month MCLR for 7.5% - you can’t give a 3 month loan for less than 7.5%. However, they can buy bonds where the return is say 5.5% or 6.5%. A bank can do that.

So if I have a working capital loan as a bond, 6 month paper or CP, after 6 months I might say listen let’s roll this over, the mutual fund says I’m not going to buy it. There are very large players in the CP market. So now what do I do? I go to a bank and the bank says the MF may have been giving it to you at 6.5% but I can only give it at 8%.

Now at 8%, this working capital might ruin me because my margins collapse and I might make losses. To that point where a company which is a very highly leveraged company tries to borrow at higher yields, it will end up

I’ll give an NBFC example - an NBFC that lends to the housing market. It was borrowing at 6% and lending at 10% - how a housing loan works. Expect now if they go to banks, banks will say I’ll give it to you at 8.5%. At 8.5% you have only 1.5% spread and that’s not enough to meet your own expenses and the fact that some homeowners may default and not pay you back.

You’ve started making losses. Now I can’t not borrow money but I can’t borrow at this rate either. You could have companies that might go under just because interest rate differential is too high.

Another reason why banks don’t cut their rates is because if they cut their rates from 8.5% to 7.5% - every single loan in their book are linked to the MCLR which means all those loans will start paying 0.5% lower interest rate. They are afraid of that, they don’t cut it down. They raise it as soon as they can but they don’t want people to pay less.

Banks therefore having a backstop of these markets being bank lending - this is not entirely feasible. And system drying up will result in companies going under if it lasts for a significant amount of time.

Now we’ve only had a week of craziness and a month of the Covid related lockdowns. If this were to last longer, I’m sure many companies would go belly up simply because of liquidity and interest rates.

In general you would expect that no country or central bank would want the system to dry up. Therefore we assume that RBI will come in at some point, calm the markets down and rescue it in some meaningful way.

S: It looks inevitable that there is going to be a more active RBI for the rest of the year. Some working weekends coming up! After hearing all the stuff you’ve said, I’m quite interested in figuring out which debt mutual funds I have, whether I should be exit-ing and whether i should hold them going forward. Can you give us a bit of a teaser - what are you planning on covering in the upcoming debt workshop?

D: We’ve done a summary level in this podcast. We’ll get into more detail, what debt funds do, how do you look practically at a debt fund and analyze what they have invested in, how you can look at the individual components of its portfolio and identify parts of it that are weak e.g, AT1 Bonds in certain portfolios. Sometimes they won’t even tell you it’s an AT1 bond - how do you figure that out.

How do you figure out if a certain company is good or bad when you’ve not even heard of it’s name? How do you look at the underlying basics of companies? How do you find out if your mutual fund is likely to be the only one lending to that company in the first place. Do you have a mismatch between what you’re expecting and the way the debt fund is actually investing? Are there floating rate bonds in there, are there lots of unlisted bonds? A lot of bonds that aren’t necessarily the ones you would have liked to invest in.

Remember you are investing, the MF is just the vehicle, therefore a little bit of your money goes to each of these securities - how do you practically analyze how funds are. Perhaps how often this activity has to be done in order for you to be confident you are in the right place. Looking at debt markets as a whole because the NAVs that you see are determined by prices of other bonds, of other markets, you have to analyze the market as a whole. I think if you were to do that more meaningfully you would actually appreciate or be understanding of the risks. I think we deny ourselves - we say that we’re astonished that these things happen - however, if we were to know more perhaps we could take more meaningful risk based assessments.

The idea of the workshop is basically how do these debt mutual funds - how can we evaluate them? Why should we select certain ones and not the others. And how to evaluate your debt portfolio overall in the context of things. More detailed, very hands on. Taking you to website and through analysis.

S: That sounds very actionable. Looking forward to it. Thanks a lot Deepak. I’ll hand it back to you and thanks everyone for listening.

D: Thanks everyone for listening, we’re @capitalmind_in on twitter, I’m @deepakshenoy. Visit us capitalmind.in for our research and content and visit us at capitalmindwealth.com where we manage portfolios including debt fund portfolios so a lot of this is actually practical stuff we do on a regular basis. And stay safe, wash your hands, enjoy and I hope you like the podcast and please let us know your thoughts. Thanks for listening!