Context: Recently, Franklin Templeton Mutual Fund has recently decided to close its six credit risk funds. It is one of the largest fund houses in India.

About Credit-Risk Funds

• The funds which have at least 65% of their investments in less than AA-rated (i.e. in lower-rated) papers is called as Credit-risk funds.
• The Debt funds aim to generate returns for investors by investing their money in avenues like bonds and other fixed-income securities.
• A fund house is a company that invests the pooled money of investors to buy financial securities like Stocks, Mutual Funds, Equities, Etc.
• The Investment grade refers to the quality of a company’s credit. Anything below ‘BBB’ rating is Considered a Non-Investment grade.
• They have the potential to offer 2-3% higher returns compared to risk-free higher rated papers.
• It make returns in two ways such as,  they earn interest income on the securities they hold and  since they invest in lower-rated securities, if the rating of a security is upgraded, they have the potential to make capital gains.

About Risk

• Credit-risk funds have a higher liquidity risk. If a bond with a lower rating in the portfolio defaults or faces a further downgrade, it may be difficult for the fund manager to exit the holding.
• If the portfolio is concentrated or has high holdings in any single business group, then even a single default by business group will affect the Entire Portfolio.This is known as Concentration risk.

Impact of the Franklin Templeton issue
It is unprecedented indicating the impact of COVID-19 lockdown on financial system

• On Fund managers: They may now prefer the safety of more liquid higher rated paper, leading to further stress in the bond markets
• On Investors: It breaks investor confidence in mutual funds.
• On Saving Habits: It will push people to adopt informal means of saving Ex: Gold purchases, which is not in the long-term interest of circular economy
• On Credit availability: Debt funds are a key source of funding of corporates which might get further squeezed due to such types of stress in system
• On Society: It can create a panic among public leading to distrust on such financial instruments