Why debt mutual funds' liquidity may be an illusion

After the Franklin Templeton debacle, debt fund investors are waking up to the reality that returns are secondary to liquidity and safety. When large-scale redemptions from stressed debt schemes left Franklin Templeton short of cash, it decided to wind up the schemes. The lesson for investors was that actual liquidity may not be commensurate to the fund category profile and their own time horizon.A fund’s liquidity indicates its ability to quickly convert existing investments into cash. Why is liquidity so important? Debt fund investors are advised to marry the choice of fund with their own investing time horizon. Funds are now classified under various duration buckets—each carrying separate limits for bond maturities. Someone looking to park surplus funds for 3-6 months is advised to put it in an ultra-short duration fund. Those looking at a time horizon of 1-3 years may be advised short or low duration funds. The rationale is that the respective funds invest in bonds with a similar maturity profile. Since these are meant to provide for short term needs, they will not take undue liquidity risk. But what if the reality is different?Consider Franklin India Ultra Short Bond and Franklin India Low Duration, two of the six now closed schemes. These had an average maturity of 0.44 years (roughly 5 months) and 1 year and 5 months respectively as of 23 April 2020. Investors were under the impression that the funds would return money roughly around the same time. But actual cash flow projection by the fund house suggested a waiting period of over two years. It turns out that the maturity of a large number of papers was far beyond the portfolio’s average maturity date. “It is definitely not telling the whole story,” says Kalpesh Ashar, Founder, Full Circle Financial Planners and Advisors. The maturity profile of a fund may not accurately reflect the true liquidity of the entire portfolio.Here is why your fund’s liquidity may be an illusion: Both maturity and duration are deceptive indicators of cash flow. Despite what the fund category and the average maturity suggests, several underlying instruments held by the fund may actually be of much longer maturity. This is because the category defines the average maturity—it doesn’t mean every bond in the portfolio will mature at the same time. Rules say only the portfolio average should fall within the definition. So there may be a big gap between actual maturity and what is allowed by the category. “There is a lot of ambiguity in the way higher maturity papers are allowed to be be held by shorter duration funds,” says Ashar.Funds may hold bonds that will mature long after the stated average maturity 75915353Some bonds have call or put option dates closer to category maturity limits, allowing them to fit within rules. Data compiled by ETIG Database. Source: Ace MFThe duration of a fund is the weighted average time until all the cash flows from underlying bonds are received. A debt fund at any time may hold instruments like floating rate notes and perpetual bonds, apart from regular coupon bearing fixed tenure bonds. While a floating rate note may have any maturity, it typically comes with a reset clause, where the rate payable is adjusted at fixed intervals.“The duration measure considers only the nearest reset date for computation of bond duration,” points out Kirtan Shah, Chief Financial Planner, SRE. So a floating rate bond maturing in five years but with next reset falling in six months will sport duration of six months. Similarly, in case of perpetual bonds—where there is no defined maturity date—the nearest call date is taken as current maturity date. Bonds with put options will project the nearest put date as prevailing maturity. Call options gives the issuer the right to repay lender on a pre-defined date before maturity. Put option extends the lender right to demand repayment from issuer at a predefined date before maturity. It is not necessary either call or put will be exercised.These facets completely distort the liquidity profile of debt funds, say analysts. Vidya Bala, Head of Research and Product, Primeinvestor.in, says, “The fund maturity profile may give an impression of liquidity that may not actually transpire owing to complexity in underlying instruments.” In the case of Franklin’s debt funds, the liquidity mismatch was also compounded by heavy borrowings to provide for ongoing redemptions. Since the funds’ borrowings have to be repaid first from any maturity or sale proceeds, it will lead to delay in cash flow to investors.Finally, the liquidity profile of a fund is directly linked to its credit profile. If the quality of underlying bonds is strong, the fund will always be in a position to sell bonds if the need arises. But if the fund holds too many low rated instruments, the liquidity will suffer in a crisis. So, if an ultra-short duration fund has put 20% of its portfolio in bonds rated lower than AA, its liquidity or cash flow will be far poorer than what its duration suggests. On the other hand, if the fund has substantial allocation in government securities or AAA rated corporate bonds, its liquidity will be comfortable even in the worst of times.For investors, it may be time to look beyond category definitions and fund maturity profile. Actual liquidity is often far different due to the fund’s choice of bonds. Bonds with the longest maturity in the portfolio would give the actual timeframe within which the fund can return your money when facing stress.Click here to download ET Online’s guide to everything personal finance in the times of Covid-19

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