Recently, you may have read announcements by mutual fund schemes, such as UTI Credit Risk Fund and Reliance Ultra Short Duration Fund, stating that they intended to “side-pocket” Altico Capital bonds held in their portfolios after this instrument was given a default grade rating.
If the term alarmed you, there’s no need to panic. ‘Side-pocketing’ is not a distant relative of ‘pick-pocketing’. Nowhere close.
It’s a mechanism introduced by SEBI to protect the value of debt mutual fund portfolios when some holdings turn out bad.
If we had to draw an analogy, we would say, it’s a way to ensure that one rotten apple doesn’t spoil the whole basket! In a sense.
“Side Pocketing” is a term mainly associated with debt mutual funds and is a new concept introduced by SEBI. The value of debt papers is significantly affected by a credit event such as a rating downgrade, default in payment by companies, etc.
Side pocketing involves the creation of two separate portfolios within the same scheme, namely the segregated portfolio and the main portfolio. The ‘segregated portfolio’ refers to the part of the portfolio comprising of debt or money market instruments that have been affected by a credit event. The ‘main portfolio’ contains the remaining portfolio,i.e., the entire portfolio excluding the segregated portfolio.
One of the main reasons for side pocketing is to preempt panic amongst unitholders when an instrument which forms part of their fund defaults or gets downgraded. It also makes sure that all is fair and square and unitholders get their due.
When there is a default/downgrade and security needs to be marked down, there is usually a steep fall in the NAV of the scheme. As a consequence, it creates panic amongst the existing investors who may then tend to exit the scheme. Thereafter, if there is a recovery in the security and the provision has to be written back, new investors (those who did not hold units during the default/downgrade) would be benefitted at the cost of the old investors, as explained later in this article.
In September 2018, SPVs of IL&FS defaulted on debt obligations; this was followed by volatility in the debt and money market instruments issued by Non-Banking Financial Companies (NBFCs) and Housing Finance Companies (HFCs).In September alone, redemptions spiked to Rs. 0.32 lac crores and Rs. 2.11 lacs crores in debt and liquid mutual fund schemes, respectively. An analysis of assets under Management (AUM) of debt and liquid schemes reveals that the AUM declined by around 9% and 25%, respectively, in a period of just 2 months from August 2018 to October 2018. This was despite the fact that the total exposure of mutual fund schemes to the IL&FS group was only approx. Rs.3,500 Cr. as on 31st August 2018, i.e., around 0.24% of the debt AUM of the mutual fund industry. (source: SEBI)
Thus, it was observed that a credit event in even one issuer/group could lead to significant liquidity risk in the entire industry, which in turn, could lead to further volatility in the market.
Accordingly, a need was felt for a mechanism that could deal with the situation that arises in a mutual fund scheme due to a credit event on debt security in its portfolio.
In order to ensure fair treatment to all investors in case of a credit event and to deal with liquidity risk, SEBI decided to permit the creation of a segregated portfolio of debt and money market instruments by mutual funds schemes.
A segregated portfolio may be created, in case of a credit event at the issuer level, i.e. a downgrade in credit rating by a SEBI registered Credit Rating Agency (CRA), as under:
1. Downgrade of a debt or money market instrument to ‘below investment grade’, or
2. Subsequent downgrades of the said instruments from ‘below investment grade’, or
3. Similar such downgrades of a loan rating.
Let us understand why side pocketing is important with the help of an example. Let’s say a fixed income fund with a corpus of ₹4,500 crores has an exposure of 4% or ₹180 crores to a company which has defaulted. The balance ₹4,320 crores are held in good quality paper of other companies. Default by one company may prompt many large investors to redeem their money from the scheme to avoid any further loss. To fulfil the redemption proceeds of investors, fund managers may be forced to sell good papers, while the distressed papers remain in the scheme. The distressed papers are illiquid and there are usually no buyers for these papers. In this scenario, the percentage holding of bad assets in the total portfolio rises. This often leads to a sharp drop in the NAV, which hits investors in the fund.
With the introduction of side pocketing, the fund may segregate the debt papers of the affected company, while the rest of the good papers remain in the original fund. All the investors of the original fund will also get units of the side pocketed funds. Upon recovery of money from the segregated securities, whether partial or full, it shall be immediately be distributed to the investors in proportion to their holding in the segregated portfolio.
The table below gives more information about the main & segregated portfolio:
1. Existing Investors: All existing investors in the scheme as on the day of the credit event will be allotted an equal number of units in the segregated portfolio as held in the main portfolio.
2. New Investors: Fresh investors subscribing to the scheme will be allotted units only in the main portfolio.
No redemption and subscription shall be allowed in the segregated portfolio while the units in the main/original scheme portfolio are redeemable as usual. Investors redeeming their units will get redemption proceeds based on the NAV of the main portfolio and will continue to hold the units of the segregated portfolio. However, in order to facilitate the exit of unitholders from the segregated portfolio, AMCs shall enable listing of the units of the segregated portfolio on recognized stock exchanges, within 10 working days of the creation of the segregated portfolio and also enable the transfer of such units on receipt of transfer requests.
Aditya Birla Mutual Fund, Reliance Mutual Fund, Sundaram Mutual Fund & Tata Mutual Fund are few of the AMCs that have added provisions to create a segregated portfolio. Tata AMC was the first AMC to create side pockets after the SEBI circular. As per the press release by Tata AMC, trustees of Tata Mutual Fund have approved the creation of a segregated portfolio of securities of DHFL in 3 of their debt schemes namely Tata Corporate Bond Fund, Tata Medium Term Fund and Tata Treasury Advantage Fund.
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Disclaimer:
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.
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