How Franklin Templeton investors should vote on the winding-up proposal

How did the position of Franklin Templeton’s debt funds deteriorate?

All funds that wound up – Franklin India Low Duration, Franklin India Dynamic Accrual, Franklin India Credit Risk, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond and Franklin India Income Opportunities – had high exposure to low-rated bonds, which were the worst impacted in the bond market turmoil in March and April.

Huge redemptions had been weighing on these funds for a while. While the fund house tried to manage the redemptions prior to April through borrowings and credit lines, the heightened market turbulence made matters worse. Increased redemption pressures, limited inflows and illiquidity in the low-rated bond market compounded the issue, forcing the fund house to close the six debt funds.

What happened after the funds were wound down?

Subsequent to the winding down, the decision to wind up the schemes was challenged in multiple High Courts. The Supreme Court ordered that all cases should be heard by the Karnataka High Court.

In October, the Karnataka High Court ruled that while FT had given investors the choice to choose an administering agency for the winding-up process, it failed to provide unit holders an option to reject winding up altogether.

The Court stated that the consent of a simple majority of unit holders is required for the winding up of mutual fund schemes and stayed the winding up till the vote was taken.

The Supreme Court has now ruled that the trustees should call a meeting of unit holders to seek their consent/approval for the winding up within a week from now. The redemption payment being made to unit-holders has been halted until then.

How should investors vote?

It would be best for investors to vote in favour of winding down the funds. Such a vote will lead to the distribution of the cash flow that the schemes have been receiving since April. It would be best if FT indicates the periodicity of the payouts, to help investors decide.

In all, the six schemes received ₹11,576 crore from maturities, pre-payments, and coupon payments since they were first suspended in April.

The four debt schemes – Franklin India Low Duration Fund, Ultra Short Bond, Dynamic Accrual and Credit Risk Fund – have ₹7,226 crore surplus cash after paying out for the loan availed to meet the redemption pressure before the schemes were suspended for trading.

The two debt funds – Franklin India Short term Income plan and Income Opportunity Fund – have loan outstanding of ₹943 crore and ₹497 crore, and could not repay the loan despite receiving ₹440 crore and ₹138 crore in the second half of November, due to the Karnataka High Court order.

Once the shareholders’ approval is obtained for winding up, it may be possible to realise a large portion of the funds currently locked up in the schemes.

With the conditions in bond markets easing up significantly, there is relatively lower risk of capital erosion in the bonds in the portfolio. However, the key risk for investors in these funds is the possibility of defaults from corporates issuing the underlying bonds. Given that the six debt funds have a high exposure to low-rated bonds, credit risk emanating in these portfolios can hurt investors.

What if investors vote against winding up?

If investors vote against winding up the scheme, the schemes will have to be opened for investments and redemption. There could be large-scale redemption, especially from larger institutional investors. This will result in the schemes having to resort to distress sale of assets. The NAV can fall further, thus reducing the value of fund holding.