Are Debt funds, stimulant for next crises in India?

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With the spread of COVID19, the economy is
undergoing a crucial phase right now. The stock market is perpetually dropping
over the period of 2 months and government is trying it’s best to maintain the
momentum of the market. There wasn’t any news in the financial sector that
created a shocking wave in this period, until Franklin Templeton made a blaring

this lockdown phase, Franklin Templeton, country’s 9th largest
mutual fund house, voluntarily chose to lockdown six of its debt mutual fund
schemes. Lakewater Advisors believes, corona wave was a mere catalyst and not
the reason for Templeton’s meltdown. We have a wrong conception that debt funds offer
steady returns
, with tax benefitsand keeps the
principal intact; which is now crystal clear with the failure of Templeton.

Underlying Risk in Debt Fund

Why did Templeton breakdown? Because its
strategy was set up for same. They were running an open-ended debt schemes,
provided more liquidity than the assets they invested in. This failure of debt
fund is not an overnight story that some experts might focus on. Apart from
fulfilling the obligation, this episode highlights India’s illiquid debt markets.

Let’s understand the roots of debt structure. The money collected from the
investors can be invested in government securities and corporate debt. Since,
the former carries zero credit risk, it provides low interest rate. If entire
amount is invested in it, high chances are that they might not even beat fixed
deposits’ return. This pushes them to invest in corporate bonds which aren’t
risk-free. Since, there are no free lunches in debt market, they invest in high credit
risk funds to give high returns

In India, most of the debt-fund structures
around liquidity and highlight it. However, they contradict, because their
objective is to out beat their peers, which makes them invest in low grade and
illiquid investments. Unlike USA, India claims junk bonds as high-yielding
debts. We have seen events revolving around this in 2008, 2013 and yet again
now. In spite of this the fundamental flaw stays incorrected and the
prescription to disaster continues. 

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Everything seems good, till it doesn’t.
Open ended MF can set off their outflows from their day to day inflows. The
regulations also permit them to borrow 20% of their assets to fund their
outflows. This further enhances their illiquidity. Prevailing structure itself
is vulnerable which needs certain deep reforms and remove the conditional

Zero Debt in Balance Sheet

In 2019, majority of the stocks that were virtually
debt free saw a rise, to an extent of 122%. 54 out of 95 companies that are listed
in BSE500 index and have ~zero debt-equity ratio delivered positive returns.
Also, some of them rewarded their investors with 50% market return. Reliance
Nippon Life Asset Management, Whirlpool of India, SBI Life Insurance are few to
be named.

In the current environment, debt-free
companies are safer investment
option. Leverage helps the
company to execute growth as they have the required capital. However, a single
dip can bust the companies having high debt-equity ratio. Once the lockdown
ceases, such companies will be in better position, as they shall be free from
financial liabilities related to interest and inflation.

Most of the blue-chip companies are debt
free or having low debt-equity ratio and thereby, depicting their strong
financial positions.

RBI – The Saviour

In 2008, RBI pumped INR 20,000 Crore,
followed by INR 25,000 in 2013. RBI, true to its statue, yet again stepped and
infused INR 50,000 crore credit line for the mutual fund industry, twice the
combined infusion made in 2008 and 2013. Even, global central banks are
offering help to create liquidity.
This huge amount of credit line depicts the issues ongoing in the debt
instruments of mutual fund industry.

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Where to invest for Fixed Return

Debt Funds and Fixed Deposits are the two
financial instruments available for risk-averse people. Debt Funds are
showcased as superior as they are tax efficient and provide better returns. Is
it so? Are they safe? After, II&FS default, the vulnerability of debt funds
is exposed. So, if you seek guaranteed return on the principal, Debt Funds are
strict NO. Interestingly, the difference between returns of debt fund and fixed
deposits isn’t much (~1% to 2% , as shown in graph), but the risk is. So, why
would Debt Fund be a choice for risk-averse -people. Fixed Deposits
and Government Taxable Bonds
are appropriate choices, as it
carries minimum risk.

Credit Rating

Are credit ratings trustworthy? We have
seen that credit rating agencies are highly criticized, especially in financial
crises. Be it the Asian financial crises of 97-98 or 2008 recession, the
agencies have given high ratings to the defaulters. In our home country, Fitch
Ratings, ICRA, CARE and Brickwork have been called for forensic audit by Grant
Thornton in 2018 in context to IL&FS debacle.

Credit downgrades take place, but it once
in blue. In recent times, debt failures have been mounting and were off guarded by
credit agencies
. Be it IL&FS default, DHFL trouble or
Franklin meltdown, none were caught by raters on time. And this is a worrisome
factor. The IL&FS fiasco was a message that MFs should analyse companies
and sectors more wisely than just relying on credit ratings. However, this
reminder was dusted as it was assumed the market has stabilised. The focus was
solely on interest rate risk and credit risk was ignored. It’s dangerous that
the rating changes sour from triple A in overnight.

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It’s irony that the credit rating agencies
are paid by bond issuer. Along with this, the non-disclosure agreements
restrict the agencies to disclose complete information, hence, acts as
hindrance for transparency. Globally there are 3 rating companies, but in India
there are 6, which makes the market competitive. High time, SEBI should wake up
and smell the aroma of coffee, and align the regulations.


With over 138 Crore population, India is projected to be World’s most populous country by 2025. This expansion of population is coupled with intense stress on infrastructure. Hence, in an economy like ours, debt market plays a crucial role and there is dire need of a comprehensive and diversified one. It acts as an alternate source of funding for bank finance, strengthens financial markets and encourage savings.

But is Debt Market sound in India? Is the magnitude
of safety, high? Lakewater has negative opinion. It may be premature, but the
market isn’t comfortable. Over the years, India has tried to capitalize debt
market and provided incentives to increase the participation but the same is


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Lakewater Advisors

Lakewater Advisors

The founder, Pankaj Singhania, is a Chartered Accountant and Cost Accountant. He has a distinctive knack for analyzing company fundamentals in tandem with management credentials.
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