Money Manager Franklin Resources Is Getting Stung by the Commodity Crash

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Doubling down on the debt of drillers and miners is coming back to bite money manager Franklin Resources Inc. amid a prolonged commodities slump.

Losses are accelerating in bonds that the firm’s been buying up for the past two years as prices on everything from crude to iron ore resume declines. Debt of coal producer Peabody Energy Corp., in which Franklin was the biggest public holder as of March, plunged 51 percent in the past two months.

While Franklin’s not alone in feeling the pain of the steep drop in commodity prices from their peak last year, few mutual-fund managers have been as aggressive in staking their fortunes to the industry’s debt even as defaults begin to mount.

“This is a difficult time in the market, especially for anyone who’s had a meaningful energy exposure,” said Ed Perks, who manages the $90 billion Franklin Income Fund, which has had about 20 percent of its holdings in energy-related assets in 2015. “We’re always kind of evaluating our outlook for different companies and the best way forward.”

While Perks declined to comment on any of Franklin’s recent trades, he said energy-related assets have been the primary detractor from the performance of the fund.

Biggest Holder

The firm is the biggest public holder of Arch Coal Inc. notes, which have declined 46 percent; SandRidge Energy Inc., which are down 39 percent; and Linn Energy LLC, which have lost 19 percent, according to data compiled by Bloomberg based on regulatory filings.

The Franklin Income Fund, which invests in both debt and equities, has declined 2.9 percent since the end of May, and is down about 0.5 percent this year, trailing about 70 percent of its peers, Bloomberg data show. Its other positions have helped offset the declines from the energy and mining industries.

The market turmoil is highlighting the idiosyncratic nature of the San Mateo, California-based mutual-fund firm, which oversees $866.5 billion. The firm’s history of making bold, contrarian wagers has put it alongside the biggest hedge funds during company restructurings.

“They’re not afraid to make bets,” said Jeff Holt, an analyst at Morningstar Inc. who covers the Franklin Income Fund. “Investors need to be aware that it’s going to be relatively volatile. It can fall out of favor at times.”

Cash Pulled

Some investors have responded to the underperformance of that fund by withdrawing money. Investors pulled about $2 billion from the Franklin Income Fund this year through June, Bloomberg data show. Any recent outflows haven’t affected the fund’s day-to-day management, since it’s a diversified strategy that’s had a minimum cash holding of more than 1 percent of assets, Perks said.

This year has been a wake-up call for investors who’ve reaped an average annual 28.6 percent return from the riskiest corporate debt in the five years through 2013 as the Federal Reserve deployed unprecedented stimulus.

The easy gains are disappearing as the U.S. central bank lays the groundwork for its first increase-rate increase since 2006. Distressed corporate bonds -- or those that yield at least 10 percentage points more than benchmark rates -- have plunged 9.8 percent this year, the worst performance since 2008, according to Bank of America Merrill Lynch index data.

What’s more, price declines are being amplified when investors try to sell because biggest dealers have retreated from buffering such swings with their balance sheets in the face of new regulations.

Walter Loan

As the slide in commodities prices accelerated this year, Franklin has been dumping its holdings in some companies, while betting even bigger on others.

Franklin dumped its stake in Walter Energy Inc.’s $975 million term loan before the coal producer’s July 15 bankruptcy filing, according to people with knowledge of the trades.

As Walter negotiated a restructuring plan with its lenders, Franklin sold holdings and dropped off a committee that was hammering out the plan, people with knowledge of the matter said at the time. The firm held more than 29 percent of the loan in March.

With Australian iron miner Fortescue Metals Group Ltd., Franklin swapped its holdings for debt that would recover more in a restructuring. Franklin and Capital Group Cos. bought almost half of Fortescue’s $2.3 billion bond offering in April in a so-called reverse inquiry, a person with direct knowledge of the matter said at the time. The sale allowed the money managers to exchange lower-ranking unsecured notes for the new secured debt, which also paid more, a second person said.

While the price of the debt surged in the months after the sale, reaching as high as 107.1 cents on the dollar in June from their issuance price of 97.6 cents, it has since plunged to 91.25, Trace data show.

“We’re looking at different opportunities,” which may include buying more distressed bonds, Franklin’s Perks said. For other positions, the best strategy may just be to get out, he said.