The fund house had exposure to a large number of debt instruments that were considered risky. This means that they are borrowers with whom capital is less safe. They, therefore, offer a higher interest rate on borrowings.
This had helped Franklin outperform many peers in good times. It was unable to sell these instruments in bad times as people rushed to withdraw money from its schemes amid the economic crisis caused by the Covid-19 pandemic, prompting it to wind up schemes.
Inter-scheme transfers involve a scheme buying or selling a debt instrument from another scheme of the same fund house. The practice, while allowed, can be problematic since both the buyer and seller are essentially the same entity. This can create conflicts related to valuation, a matter that the Securities and Exchange Board of India (Sebi), has flagged earlier. This has since been looked into to address valuation conflicts related to how such transactions are handled, according one fund manager. “Sebi got stricter on that,” said the person.
Valuation is now done through an independent agency, which conducts a poll of those holding such instruments, said two other fixed income fund managers.
Another conflict might still remain.
A senior official with a fund house said transfers of illiquid paper can also happen to hybrid schemes that typically have more liquidity and face lesser scrutiny.
However, the person added, hybrid funds already have some exposure to risk through equity investments. Allocating additional risky debt securities to them through an inter-scheme transfer might not be ideal. It would result in the debt exposure also becoming risky, only to help out another scheme that might be facing redemption, said the person.
An analysis of regulatory data shows that inter-scheme transfers typically tend to rise towards the end of the year. They fall significantly in April. For example, the value of such transactions fell from 2.8 per cent of debt assets in March 2019 to 0.7 per cent in April 2019. A similar trend was seen in previous years as well. However, this April saw elevated numbers.
The spike in April might have something to do with the fact that so many investors looked to take their money back from funds to meet their own needs, or to avoid losing it to Franklin-like issues, according to a debt fund manager.
“There were a lot of redemptions,” said the person.
Such transactions accounted for 1.9 per cent of debt fund assets in March. In April it was 1.8 per cent. This is higher than the equivalent numbers for the first month of the financial year in previous instances. It has averaged around 1 per cent for the past five years.