All you wanted to know about 'side pocket'

History repeats itself they say. After Amtek Auto’s problems in 2015, the JSPL episode in 2016 and the recent case of the IL&FS group defaulting on debt obligations, mutual funds have been grappling with how to handle the situation, when a bond they hold defaults. One idea that has been making the rounds is allowing them to create a ‘side pocket’ for the doubtful asset, after such episodes.

A ‘side pocket’ is a way to segregate quality debt instruments in a debt portfolio, from those that have defaulted on interest or repayments, or are faced with a rating downgrade because of deteriorating financials. So, a fund house carves out the bad bonds from its main portfolio into a ‘side pocket’. The fund’s NAV will then reflect the value of the good assets, with a separate NAV assigned to the side-pocket assets based on the estimated realisable value for investors. If the doubtful asset is finally sold, the value is credited to unit holders who own the side pocket. There are rules governing the valuation write-down that a fund must take when in the case of downgrades or default, and this is typically done in phases, depending on the date of default and NPA recognition norms.

The concept of a side pocket was first tried out in the JP Morgan-Amtex Auto case. Amtek Auto was downgraded sharply in August 2015. As a result, a couple of JP Morgan debt funds took big NAV hits and experienced pull-outs, prompting the fund house to temporarily suspend redemptions. The fund created a side pocket with the securities of Amtek Auto alone. By December 2015, JP Morgan was able to sell the entire holding in Amtek Auto and realise 85 per cent of the invested value. The proceeds from the side pocket unit sales were credited to the investors in the fund when the ratings downgrade happened.

Creating a side pocket insulates the rest of the debt funds’ portfolio from such rotten apples. Typically, when there is news of a default or a ratings downgrade, investors in open end funds may panic and pull out money. As sentiment worsens, there can be a rush from all categories of investors to redeem units. When faced with redemption requests, a fund house that holds an illiquid downgraded security can be forced to sell its quality holdings in order to meet the redemption pressure. Also, investors who do not wish to cash out or are ignorant of the developments would be left back in the fund, facing severe erosion in their NAV. In the IL&FS case, over two dozen schemes had exposure to bonds from IL&FS or its group entities. After the downgrade, some schemes decided to treat their entire holding as doubtful, and write it down fully, resulting in a cut of 6-8 per cent in their NAV, which can shake investor confidence.

The side pocket also ensures that only investors who were in the fund at the time of the write off, will get the benefit of any future recovery from the bond. New investors who buy units after the write-down do not get to make windfall gains.

If you are invested in a debt fund, you need to watch out for default events that lead to a side pocket, as that can pose challenges in realising your financial target. Also, if the scheme that you hold decides to create a side pocket, you need to track two NAVs — one for your regular holdings and another for the illiquid assets. The NAV assigned to defaulted assets can be tricky to validate. But if you are lucky, the bad asset may eventually realise part of what was written off.

A side-pocket ensures that you don’t lose your shirt to bad bonds.

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