Personal Finance

How side-pocketing affects you

Aarati Krishnan | Updated on September 21, 2019 Published on September 21, 2019

Side-pockets in debt funds allow bad bonds to be separated from good ones

If you’re an investor in debt mutual funds, you’re probably puzzling over the reports on ‘side-pocketing’ of bonds that figure in fund portfolios.

If you’re confused by what all this means to you, here are your questions answered.

When debt funds face a downgrade or default on a bond they own, they write down its value in the net asset value (NAV). So why is there a need for side-pocketing?

When debt funds write down the value of a bond, they usually aren’t sure if the bond is a complete dud or will realise some value later. But in the interests of conservatism, SEBI rules require funds to write down the value of such bonds by 25, 50, 75 or even 100 per cent in their portfolios, based on their credit ratings. When a fund takes such write-downs, it takes an immediate blow to its NAV. But if the issuer of the bond later pays up his/her dues, the fund will then have to increase its NAV to account for the repayment. In such cases, for investors in the scheme who exit early, taking NAV losses would fail to benefit from the recovery.

On the other hand, new investors who entered the scheme after the write-down would stand to pocket unfair gains on a bond they never owned. Segregating downgraded bonds in a fund’s portfolio into a ‘side-pocket’ avoids such unfair treatment. When a scheme side-pockets a doubtful bond, any recovery from the bond is distributed to all the investors who were invested in the scheme when the downgrade happened. Investors who got into a scheme after the downgrade get to buy only into the main portfolio excluding the doubtful bond.

When and what kind of bonds are debt funds supposed to segregate?

SEBI rules allow debt funds to side-pocket only those bonds that are downgraded below investment grade by rating agencies. When a bond rated BBB or above is pegged down, it turns from an investment grade bond to a non-investment grade one. Fund houses are required to decide on side-pocketing and secure the approval of their trustees for it on the day the downgrade happens.

When a bond gets downgraded, some fund houses announce side-pockets while others don’t. Why?

SEBI has not made side-pocketing compulsory for all bonds that turn non-investment grade. This decision is left to the discretion of the asset management company (AMC) and its trustees. So, when a bond slips into non-investment grade, some AMCs may write down its value and hang on to it, while others may side-pocket it. Where there’s no side-pocketing, if you exit the scheme after the downgrade, you won’t receive any benefits if there’s a recovery.

What happens when a side-pocket is created?

The scheme separates its portfolio into a good portion consisting of investment grade bonds, and a bad portion consisting of the downgraded bond.

The NAV of the scheme will be carved out to the extent of the value (after the write down) of the bad bond. All existing investors in the scheme will receive one new unit in the side-pocketed portfolio, in addition to their existing units in the scheme.

No transactions are allowed in these new units. So, if you redeem the fund after side-pocketing, you will only receive the NAV of the main portfolio. But if the scheme eventually recovers money from the bond, it will get automatically redeemed and you will receive a payout. The trustees of the AMC are supposed to monitor the recovery of proceeds in the side-pocketed bonds.

AMCs have published newspaper ads about side-pocketing offering a one-month exit window without charging any exit load. Does this mean the scheme is going to take a hit from a bad bond and I need to exit it?

No, you shouldn’t. The newspaper ad is only an enabling provision that tells you that the scheme may, in future, use side-pocketing for some of its debt schemes if they take a hit on their bonds. When mutual funds make any changes to their fundamental attributes, SEBI rules require them to give their investors a one-month exit window (without load) to exit the scheme.

Given that SEBI’s side-pocketing rules are recent and most AMCs are introducing this feature into their debt funds for the first time, they have been advertising this change in their fundamental attributes and offering investors a one-month exit window. Once all fund houses incorporate these enabling provisions into their scheme attributes, they can go ahead with side-pocketing in the future, without seeking the okay of their investors.

If I don’t check MF websites or newspaper ads, how will I know if a debt scheme is creating side-pockets?

On the day a scheme decides to side-pocket a bond, it is required to immediately issue a press release and send an SMS as well as an email to all its investors. It is also supposed to inform investors as soon as it secures trustee approval for this. On the day the announcement is made, all new purchases or sales of units in the scheme are frozen.

Published on September 21, 2019
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