Debt mutual funds are not without risk. When a default or a rating downgrade of an underlying security, NAV of the fund takes a hit. Not just that, it poses an additional problem. In such cases, some of the more knowledgeable investors can benefit at the expense of less aware investors. SEBI has come out with a circular to address the issue.
What is the issue if there is a downgrade or default in a debt fund portfolio?
Let’s try to understand the issue with the help of an example.
There is a debt mutual fund. The number of issued units is 100 and the NAV is 100. Therefore, the total fund size is Rs 10,000 (100 units X NAV of Rs 100/unit).
Let’s assume there are 82 investors in the scheme. 80 retail investors like you and me. And 2 smart (high net worth/corporate/institutional) investors who have better access to information than the rest of us.
80 investors hold 1 unit each. The two smart investors hold 10 units each.
Total number of units = 80X1 + 2X10 = 100 units.
The fund has made an investment of Rs 2000 in a bond by single company K (there are restrictions but play along). Now, there is a default by the company K.
And the fund writes off a portion of the investment. Now, let’s consider two cases.
#1 The fund decides to write off 50% of the investment.
The fund size will shrink to Rs 9,000 because 50% of Rs 2,000 investment in company K has been written off.
NAV goes down from Rs 100 per unit to Rs 90 per unit (Rs 9,000/100 units).
Do note writing off 50% of the investment does not mean the remaining 50% is safe or that the 50% that has been written off can’t be recovered. Just that the fund house has used some valuation norms to write off this much amount from the portfolio i.e. they feel only 50% of the amount is recoverable.
Let’s assume now that the 2 smart investors realize that even that 50% that has not been written off won’t be recovered.
In this case, they will liquidate their position in the portfolio.
They will take out 20 units X NAV of 90 = Rs 1,800 from the fund.
To meet the redemption, the fund house has to sell bonds. It can’t sell bonds from company K (that defaulted) because it is difficult to find a buyer. Therefore, it has to sell units from good portion of the portfolio. It does and gives money to the smart investors.
Now, the fund size goes down by Rs 1,800. The new fund size is Rs 9,000 – Rs 1,800 = Rs 7,200. Of this Rs 7,200, Rs 1,000 is still exposed to defaulting company K.
There are 80 retail investors (like you and me) left with 1 unit each. NAV of each unit is Rs 90.
Now, suppose after 1month, the fund writes off the entire investment in company K. The fund size goes down to Rs 7,200 – Rs 1,000 (remaining exposure to company K) = Rs 6,200.
NAV will come down to Rs 6,200/80 units = Rs 77.5.
Had smarter investors not sold their investment, the NAV would have been Rs 8,000/100 units = Rs 80. However, as you can see, smarter investors (who sold at 90) benefited at the expense of retail investors (NAV at 77.5).
By the way, it is not just that smart investor who can benefit. Any investor who sells after the write-off ( in this case) gets the benefits at the expense of investors who did not redeem.
The investors who didn’t redeem are left with poor quality assets since good assets are being sold to meet redemption.
#2 The fund decides to write off 50% of the investment. The smart investors believe that the money would be recovered.
Let’s consider the very same example. The difference is that the smarter investors (with better access to information) decide to hold back their investments and buy more.
The fund still writes off 50% of the investment. The portfolio value goes down to Rs 9,000. The number of units is still 100. NAV goes down to Rs 90.
The smarter investors believe that the investment will be recovered. Hence, they buy 20 more units in the fund. The total number of units goes up to 120. The portfolio value goes up to Rs 9,000+20×90 = Rs 10,800. NAV is still 90.
Say, after a month, the amount is recovered i.e. Rs 1,000 added back to the portfolio.
The portfolio value goes to Rs 10,800 + Rs 1000 = Rs 11,800.
NAV goes up to 98.33.
Even though the complete investment is recovered, you lose Rs 100 -Rs 98.33 = Rs 1.67
On the other hand, the smarter investors had invested Rs 90 a month back and their investment has appreciated by almost 10% in a month.
Had the smarter investors not invested additional money, the NAV would have gone back to Rs 100 (and not Rs 98.33).
Again, smarter investors benefitting at the expense of retail investors.
For this reason, most fund houses stop fresh purchases in the affected funds. For more on this, go through this post on CapitalMind.
Why is this a problem?
Having better access to information is no crime. However, some of the information may be unfairly acquired. For instance, institutions or companies or influential investors through their banking relationships may get better information.
The banks always have a much accurate picture of the companies. It is another matter that they don’t use it as well as we would want them to. Smarter investors may be able to talk to the fund management to get the true picture and act accordingly. Retail investors may lack the skill or the influence to get such information or even act on such information.
As a regulator, you would not want retail investors to be unfairly taken advantage of.
How to solve this problem? What is Side Pocketing?
SEBI has come out with a circular that attempts to avoid issues as mentioned above. Do note default or downgrades will still happen. Just that losses will be absorbed equally by all the investors.
In case of a credit event, the affected securities will be transferred to a separate fund. A credit event can be a rating downgrade to “Below Investment Grade” or an actual default.
Effectively,the fund portfolio will be segregated into two funds viz. the Main Portfolio and the Segregated Portfolio.
Main Portfolio (let’s call it the Good fund) will have good securities or those assets unaffected by the credit event. The Segregated Portfolio (the Bad fund) will have the affected assets. You can also call this process “Side pocketing” even though SEBI does not use any such nomenclature.
A few more points.
- No further redemption or purchases shall be allowed in the Bad Fund (segregated portfolio). This takes care of the problems posted above.
- Redemptions and purchases are allowed in the Good Fund (main portfolio).
- Any fresh investment in the scheme will go into the Good Fund only.
- To provide liquidity to investors of the Bad fund, the units of the segregated fund shall be listed on the stock exchange within 10 working days. However, don’t count much on it for liquidity.
- Division into two Funds (good and bad) will be effective from the date of the credit event. Very important otherwise the entire exercise may not really help if there are delays.
- On the date of the credit event (default or downgrade), the investors will get the same number of units in the Good Fund and the Bad Fund.
- Any recovery in the Bad Fund (partial or full) will be distributed to the investors in the proportion of their holding in the portfolio.
- The good part is that the impact of the creation of the Bad Fund will continue to reflect on the reported performance of the scheme. Therefore, fund management cannot hope to hide the impact of bad investment choices.
- The fund house cannot charge investment and advisory fee on the Bad fund (segregated portfolio).
- Creation of the bad fund (segregated portfolio) is optional and at the discretion of the fund house. There must be a provision for the same in the Scheme Information document. The fund house will likely take this route in case of default or downgrade in one of the bigger investments.
An example of Side Pocketing
Continuing with the above example, 80 retail investors and 2 smart investors hold 1 unit and 10 units each respectively. Total 100 units. Total Fund Size = Rs 10,000
The Fund has Rs 2,000 exposure to company K, which defaults. The fund management writes off 50% of the exposure.
If Side pocketing is done, the investor will get the same number of units in the Good and the Bad Funds (as they had held in the original portfolio).
80 retail investors get 1 unit of Good Fund (Main Portfolio) and 1 unit of Bad Fund (Segregated portfolio).
2 smart investors get 10 units of Good Fund (Main Portfolio) and 10 units of Bad Fund (Segregated portfolio).
The size of Good Fund is Rs 8,000 (since Rs 2,000 is the affected portfolio). NAV of good fund will be Rs 80 (Rs 8,000/100 units).
The size of Bad Fund is Rs 1,000 (Rs 1,000 written off from Rs 2,000). NAV of Bad fund will be Rs 10 (Rs 1,000/100 units).
So, if you held 1 unit with NAV of Rs 100 in the original fund, you will get 1 unit of Good Fund (NAV of Rs 80) and 1 unit of Bad Fund (NAV of Rs 10).
Do note NAV of Bad Fund is Rs 10 because only 50% has been written off (50% of Rs 20). If the entire investment were written off, the NAV of Bad Fund (segregated portfolio) would have been NIL. And yes, even though the NAV of Bad Fund may be zero or Rs 5, it does not mean you can sell it back to the fund house.
You can’t redeem units in the Bad Fund. As and when the fund house makes a recovery, it will distribute the recovery amount among various unitholders of Bad Fund
Any fresh purchases in the fund scheme will be in the Good fund (main portfolio).
How does Side pocketing help?
Clearly, with side pocketing, all the investors get fair treatment.
Since the affected asset moves into the bad fund (segregated portfolio) and you can’t buy or sell into the bad portfolio, no investor has an unfair advantage (at least after the credit event).
Redemption pressure will be low too because there will no rush to redeem investments. This will avoid unnecessary panic in the capital markets too.
What are the issues with Side Pocketing?
Now, with an option to transfer a bad asset to a different fund, there is a possibility that fund managers may take excessive risk. We will have to see if that happens. In the SEBI circular, it is mentioned that the scheme performance (Main portfolio) should reflect the fall in NAV due to segregation. In my opinion, this is a good enough disincentive.
There are a few subjective aspects in the circular. I expect the clarity to emerge over a period of time.
As an investor, side pocketing does not prevent losses for you. Losses can still happen in debt mutual funds. It is just that you would get fair treatment and losses in the fund will apply equally to all the investors. Therefore, you still need to exercise proper care while selecting debt mutual funds.