The Securities and Exchange Board of India (SEBI) has approved the proposal to create a ‘side pocket’ for mutual funds. This feature will be exclusive to debt mutual funds. The following are key details regarding how the “side-pocketing” mechanism works in mutual funds.
What is a Side Pocket?
A ‘side pocket’ allows managers of debt funds to segregate illiquid and distressed assets from other relatively liquid assets in a fund’s portfolio. Such illiquid assets may include investments in bonds that are scarcely traded, commercial papers of companies in default, etc.
In case of mutual funds, a side pocket creates a separate portfolio for illiquid, risky or stressed securities so that these do not affect other liquid assets of the scheme in case of a “credit event”. In simple terms, a ‘credit event’ is defined as a sudden, usually negative, change in a borrower’s capacity to pay their loan obligations. Example of a credit event include bankruptcy, debt restructuring and default on payments.
One Fund – Two Separate NAVs
Side-pocketing enables the mutual fund schemes to split the Net Asset Value (NAV) into two parts. One NAV is for the liquid assets of the scheme and the other is for the side-pocketed illiquid ones. This ensures that the side-pocket does not adversely impact the liquidity and the valuation of the good quality assets held in the portfolio. Doing so ensures that if a security is downgraded to ‘junk’ or ‘default’ status in the side-pocket, the change will be restricted and would not end up affecting the entire scheme.
For instance: ABC Liquid Fund has assets under management of Rs. 1 crore as of November 2018. On December 10, 2018, ICRA downgraded the rating for XYZ bonds to ‘junk’. The liquid fund has investments of Rs. 10 lakh in these XYZ bonds and decides to create a side-pocket. Doing so would result in the scheme having two NAVs: one with AUM of Rs. 90 lakh and the other with Rs. 10 lakh. Investors would not be allowed to invest in or redeem units from the Rs. 10 lakh corpus but can do so from the Rs. 90 lakh corpus. The two NAVs will be tracked separately. Investors can redeem from the Rs. 10 lakh corpus in XYZ bonds once the fund house is able to sell these bonds.
How do Side Pockets Work?
Any debt mutual fund with a corpus of Rs.1000 crore and at least 5% exposure to a company that is defaulted, is allowed to make use of the side-pocketing mechanism. This is because the default of one company may lead multiple investors to redeem their money from the scheme in order to avoid additional losses. The fund house will then be forced to sell its good quality papers in order to pay the investors redeeming their investments. This will further increase the quantity of bad assets in the portfolio leading to a further decline in the value of the fund. In such a scenario, it is better for the fund house to segregate its stressed investments and take a one-time loss on the fund’s investment so that more and more investors do not rush to redeem their investments as the value of the fund decreases.
Side pockets have been known to bring in a change in the fundamental attributes of a mutual fund scheme. In order to begin with side-pocketing, an AMC (Asset Management Company) must propose to create a side pocket by amending the existing SID (Scheme Information Document) of the fund and allow an exit window of 30 days to the investors without charging an exit load. After this, the AMC will be required to segregate the papers that are illiquid or in the default category from the liquid instruments in the portfolio. This process will eventually create two different schemes, one that will have only the illiquid papers and the other one with only the good quality liquid papers.
Importance of Side Pockets in Debt Mutual Funds
Even though side-pocketing for all bonds that turn into the non-investment grade has not been made compulsory by SEBI, it is considered to be a good practice to side pocket the non-investment grade papers rather than writing them off. This helps the AMC stabilise the fund’s Net Asset Value (NAV) by taking a one-time loss to help reduce the pressure of redemptions in the scheme.
Additionally, segregating the illiquid papers from the liquid ones also helps safeguard the good quality papers from the negative effects of the junk/default grade investments, to help maintain the reputation in the market. All the investors of the original fund also get allocated units of the side pocketed fund so that as and when the affected company gets liquidated or manages to pay its debts, the investors will get their money back.
Limitations on Side Pocket Subscriptions and Redemptions
Once a side pocket is created, it is split off of the rest of the scheme and closed for subscription as well as redemption. Investors can, however, continue to invest and/or redeem their investments in the non-side pocketed portion of the schemes. In case, the fund house receives any money from the side-pocketed funds in the future, it will pay the amount back to the unitholders of the side-pocket.
Side-pocketing also has a bright side to it for the fund house. When a borrower’s rating is downgraded, investors want to redeem their units and this puts the fund house under pressure to ensure availability of adequate funds. Segregating risky securities thus helps protect the fund house from such redemption pressure and helps in better management of the fund.
SEBI’s Approval for Side-Pocketing
SEBI has allowed debt mutual fund schemes in India to create side pockets for stressed assets. SEBI’s decision comes following the multiple payment defaults starting with the IL&FS default that triggered credit events and particularly impacted liquid fund schemes in a significant way in 2018.
This was not the first time that SEBI got a proposal for creation of a side pocket. In 2016, SEBI rejected the proposal, saying that it would encourage fund managers to take unnecessary risks.
JP Morgan Asset Management (India) – Amtek Auto: One of the first instances of side-pocketing India
In 2015, credit rating agencies in India downgraded Amtek Auto Limited bonds, which resulted in the bonds of the company becoming illiquid. Two schemes by JPMorgan Asset Management (India) had significant investments in Amtek bonds and their NAVs were severely impacted. Back in 2015, there was no provision for side-pocketing and the fund managers went ahead and created a side pocket after getting approvals from unitholders. The alternative to side pocketing available to the fund house would have been to limit scheme redemptions, which would have at the very least impacted the overall reputation of the AMC and may have even led to large scale redemption in unaffected schemes as a result of investor panic.