In recent months, there have been a few companies (like IL&FS, DHFL), which have delayed or defaulted in making timely repayments of interest/principal. Accordingly, their credit rating has been downgraded.
Consequently, the debt mutual funds, which had invested in the debt securities like NCDs issued by such companies, have been adversely impacted.
As per prudent guidelines, if and when any debt investment is downgraded, mutual fund schemes have to devalue that investment by a specified percentage. This reduces the value of the total corpus. And, since the no. of units don't change, the NAV goes down.
In short, the debt mutual fund investor suffers a loss.
However, this loss is only notional until
a. The investor actually redeems the investment
b. There is no hope of recovery and the default/delay becomes permanent.
Thankfully, so far the underlying companies are still a profitable concern. So the default is expected to be only a delay in meeting the obligations. Hence, full/partial recovery is still quite possible.
Therefore, later if the company repays the amount and there is no 'actual' default, the same will be added back to corpus and the NAV will jump up accordingly.
However, this puts the existing investor at a disadvantage, as compared to a new investor who enters after the downgrade.
Hence, SEBI has allowed the AMCs to adopt a new strategy — called side pocketing — of creating a segregated portfolio. In this, the portfolio is split into two funds, wherein
1. The downgraded company is put into a separate or segregated fund, and the same number of additional units are issued to the existing unitholders as on the date of segregation.
2. The balance 'good' portfolio continues as it is.
If and when the money is recovered from the troubled company, it is returned to the 'original' investors before segregation or side-pocketing. (Earlier, these windfall gains went to the new investors who invested after the default, while those who had sold their investment got nothing.)
Also, whenever there is a downgrade in any particular scheme, there is a mad rush among investors to redeem their investment. This puts unnecessary and uncalled for pressure on the AMCs to sell the good part of the portfolio to meet these additional redemption requests. This only aggravates the problem. The segregated portfolio helps to resolve this problem too.
Thus, side-pocketing ensures fair treatment to all investors and also deal with the liquidity risk.
Accordingly, all AMCs are adding this 'side-pocketing' clause to their Terms and Conditions. It is an enabling provision mainly for the future to protect the overall portfolio in case if a particular company in the portfolio is downgraded or defaults. (Of course, it applies to those funds also where the downgrade has already happened).
Since the Terms and Conditions are being revised, AMCs have to give a choice to the unitholders whether they want to exit the scheme or continue with the same.
Segregation or side-pocketing is a good strategy. So you need not do anything and continue to remain invested. Do not make the mistake of quitting debt funds just because of these few stray instances of default or addition of this new clause. Please do read my earlier blog post Should You Stop Investing In The Debt Mutual Funds? in this regards.
What if any of your funds is already affected?
Even then it makes sense to continue after the downgrade. As mentioned earlier, the loss is only notional until you sell or the default becomes permanent. Given that the chances of repayment by these companies are good, the probability of you eventually losing money is low.
Even if the default becomes permanent, 50-75% of the investment loss is already booked and reflected in the reduced NAV. So only the balance 25-50% would be your additional loss. If the holding % of the defaulted investment is not large vis-a-vis the total corpus, the impact will be minimal.
In short, (in most cases) the risk-reward ratio is quite favourable in remaining invested.
Consequently, the debt mutual funds, which had invested in the debt securities like NCDs issued by such companies, have been adversely impacted.
As per prudent guidelines, if and when any debt investment is downgraded, mutual fund schemes have to devalue that investment by a specified percentage. This reduces the value of the total corpus. And, since the no. of units don't change, the NAV goes down.
In short, the debt mutual fund investor suffers a loss.
However, this loss is only notional until
a. The investor actually redeems the investment
b. There is no hope of recovery and the default/delay becomes permanent.
Thankfully, so far the underlying companies are still a profitable concern. So the default is expected to be only a delay in meeting the obligations. Hence, full/partial recovery is still quite possible.
Therefore, later if the company repays the amount and there is no 'actual' default, the same will be added back to corpus and the NAV will jump up accordingly.
However, this puts the existing investor at a disadvantage, as compared to a new investor who enters after the downgrade.
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| Are you wondering what is Side-pocketing in Mutual Funds? |
Hence, SEBI has allowed the AMCs to adopt a new strategy — called side pocketing — of creating a segregated portfolio. In this, the portfolio is split into two funds, wherein
1. The downgraded company is put into a separate or segregated fund, and the same number of additional units are issued to the existing unitholders as on the date of segregation.
2. The balance 'good' portfolio continues as it is.
If and when the money is recovered from the troubled company, it is returned to the 'original' investors before segregation or side-pocketing. (Earlier, these windfall gains went to the new investors who invested after the default, while those who had sold their investment got nothing.)
Also, whenever there is a downgrade in any particular scheme, there is a mad rush among investors to redeem their investment. This puts unnecessary and uncalled for pressure on the AMCs to sell the good part of the portfolio to meet these additional redemption requests. This only aggravates the problem. The segregated portfolio helps to resolve this problem too.
Thus, side-pocketing ensures fair treatment to all investors and also deal with the liquidity risk.
Accordingly, all AMCs are adding this 'side-pocketing' clause to their Terms and Conditions. It is an enabling provision mainly for the future to protect the overall portfolio in case if a particular company in the portfolio is downgraded or defaults. (Of course, it applies to those funds also where the downgrade has already happened).
Since the Terms and Conditions are being revised, AMCs have to give a choice to the unitholders whether they want to exit the scheme or continue with the same.
Segregation or side-pocketing is a good strategy. So you need not do anything and continue to remain invested. Do not make the mistake of quitting debt funds just because of these few stray instances of default or addition of this new clause. Please do read my earlier blog post Should You Stop Investing In The Debt Mutual Funds? in this regards.
What if any of your funds is already affected?
Even then it makes sense to continue after the downgrade. As mentioned earlier, the loss is only notional until you sell or the default becomes permanent. Given that the chances of repayment by these companies are good, the probability of you eventually losing money is low.
Even if the default becomes permanent, 50-75% of the investment loss is already booked and reflected in the reduced NAV. So only the balance 25-50% would be your additional loss. If the holding % of the defaulted investment is not large vis-a-vis the total corpus, the impact will be minimal.
In short, (in most cases) the risk-reward ratio is quite favourable in remaining invested.
