Recently, an asset management company (AMC) sent a notice to unit holders of one of its funds mentioning the fund was creating a provision for a segregated portfolio. Such a portfolio is referred to as a side pocket. In this article, we explain a side pocket. We also discuss other risks associated with bond funds and how bank deposits moderate these risks.

Credit risk

To understand segregated portfolio, consider the risks bond funds are exposed to. Investment in government bonds exposes a fund to interest-rate and reinvestment risks. We will ignore reinvestment risk for this discussion. Interest-rate risk is the risk that bond prices will decline when the bond market expects interest rates to rise. In addition, investments in corporate bonds carry credit risk.

This risk is not just about defaults. It includes a rise in investors’ perception of the bond-issuer’s credit risk, which could lead to a decline in corporate bond prices. A perception that credit risk has risen can arise because of a failure by the company to pay interest on time or a credit-rating downgrade.

In 2018, SEBI allowed bond funds to move corporate bonds to a separate account if the bond held by the funds failed to pay interest on time or suffered a credit downgrade. This separate account is called a segregated portfolio. The concept comes from hedge funds that also invest in private equity. Being an illiquid investment, private equity is kept in a separate account called a side pocket while the main account carried all the liquid investments of the hedge fund. A segregated portfolio is a side pocket.

That said, it is important to understand that investing in bond funds are different from investing in bonds. If you buy a bond and hold it till maturity, you will receive the bond’s par value regardless of the interest-rate changes. That means direct investment in bonds does not carry interest-rate risk. Investment in bond funds do.

Conclusion

Bond funds generate returns from interest income and capital appreciation but carry interest-rate risk and reinvestment risk. Bond funds that invest in corporate bonds also carry credit risk.

Investing directly in government bonds eliminates interest-rate risk but exposes you to reinvestment risk. Cumulative fixed deposits and recurring deposits with banks do not have interest risk and reinvestment risk. They carry credit risk, but that risk is lower than what bond funds are exposed to.

(The author offers training programmes for individuals to manage their personal investments)

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