Franklin Templeton crisis: Short-term bond market is in deep trouble

The short-term debt market has frozen, with yields rising as corporate stress becomes apparent
Franklin Templeton’s decision to shut down six schemes oriented towards high yield investments will add to the stress in the short-term debt market, which is now well into a crisis. The six schemes collectively have assets under management of around Rs 25,000 crore, according to reports.

The decision has been prompted by lack of liquidity in the high-yield market, as well as heavy redemption pressures that are affecting all debt funds. The fund house will now try to manage an orderly liquidation of these assets so as to realise the maximum possible value for unit-holders. These schemes have a fair number of retail holders so it will affect sentiment, for sure.

This end of the short-term debt market is now stuck in what could be termed a vicious circle. Debt funds are one major source of funding for Commercial Papers (CP) and Certificates of Deposit (CD) issued by corporates. Debt funds have been hit by very high redemption pressures. So, they are in no position to meet corporate demand for loans.

Many schemes have been forced to borrow from banks to meet redemption demand. Securities and Exchange Board of India (SEBI) imposed a limit of 20 per cent of assets under management (AUM) for such loans and some funds are close to that limit. The short-term debt market has frozen, with yields rising as corporate stress becomes apparent. Hence, funds cannot easily sell assets to meet redemptions either, since they would have to book large capital losses. Or, they may find no buyers even at discounts.

If funds cannot meet redemption pressures except by booking massive losses, and corporates cannot borrow except by paying exorbitant rates of interest, the short-term bond market is in deep trouble. This is going to need regulatory intervention and that intervention will have to be coordinated at the highest levels between the market regulator, SEBI, and the central bank, the RBI.

It was in a similar sort of situation that the US Federal Reserve (US Fed) and the US Treasury Department mounted rescue operations in 2008-09 during the subprime crisis. The Treasury Department initiated the Troubled Asset Recovery Plan (TARP), buying troubled assets at discount from financial institutions. The US Fed started its Quantitative Easing (QE) policy, buying assets and pushing the liquidity out.  The European Central Bank (ECB) and the Bank of Japan (BoJ) have done extensive QE programmes as well.

The RBI has done similar bailouts in 2008 and 2013, when it averted a crisis in the debt market by creating a special window. The banks lent to debt funds and passed on assets as collateral; the Reserve Bank of India (RBI) accepted those assets as collateral from the banks and lent them money which they rolled back into the debt funds.

The scale of intervention will have to be larger in 2020. The RBI may have to intervene directly via creating some sort of TARP-like structure, or by a QE which buys bonds directly in the style of the European Central Bank. The SEBI will have to stretch its limit for loans taken by debt funds to allow for such a scheme. The RBI would have to expand its balance sheet and accept considerable risk since there is a high probability of corporate default.

A rescue act will require considerable care and ingenuity on the part of the RBI and SEBI. But if the debt market is to unfreeze, it needs liquidity and it also needs confidence that there is a lender, or buyer of last resort.
Devangshu Datta is an independent market analyst. Views are his own.

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