What is Side Pocketing by Mutual Funds or AMC’s?

#CorporateDebt #RatingsDowngrade #VodafoneIdea #AGR #MutualFunds #SidePocket

Recently Franklin India Ultra Short Bond Fund had written off its entire exposure in Vodafone Idea debt security (~4.3%) on increasing concerns of a possible default (due to supreme court rejecting the plea to reconsider its judgement regarding Adjusted Gross Revenue (AGR) related payments for telecom companies). This led to a one day fall of 4.3% in its NAV!

What Triggered the Mark Down of Vodafone Idea Debt?

This development is largely in lieu of the financial strain that telecom companies such as Vodafone Idea Limited have been going through given their enhanced financial liability. As per the fund house ‘Pursuant to the Honorable Supreme Court (SC) decision on the interpretation of Adjusted Gross Revenue (AGR) for computation of license fee, the financial liabilities of several telecom operators including VIL stand increased significantly. A review petition was filed by VIL before the SC on account of the fast approaching deadline of January 23, 2020 to discharge the dues, and the SC dismissed the review petition on January 16, 2020.’ As per the news reports, with this decision, VIL has admitted its inability to retain financial solvency in the absence of relief measures, given the huge quantum of AGR dues which they are required to pay immediately. Because of the uncertainty arising in the light of the ongoing scenario in case of VIL, the fund house took the decision to proactively mark down its exposure in the debt securities of the company.

Why is Franklin Templeton Not Side Pocketing VIL exposure in it’s schemes?

This could raise a question as to why the fund house didn’t side pocket VIL exposure. And the answer to that is that there has not been any rating action yet on this security, which as of now carries an investment grade rating of either CRISIL BBB- or CARE BBB-. A security can be side pocketed in case of a downgrade to a rating below investment grade.

The Purpose of Proactively Marking Down the Security

As per the fund house, the idea is to protect existing unitholders interest. Infact, the valuation adjustment here only reflects the realisable price of the relevant securities on the date of valuation and does not indicate any reduction or write-off of the amount repayable by VIL.

Moreover, fresh inflows in the schemes having exposure to VIL have been limited to INR 2 lacs per day per fund per investor, till further notice. This limit is imposed only on the new applications received after the cut-off time on 16^th January 2020. This is to ensure that the interest of existing unitholders does not get diluted to a large extent in case of debt recovery form VIL.

What is Side-Pocketing?

“Side Pocketing” is a mechanism to separate distressed, illiquid and hard-to-value assets from other more liquid assets in a portfolio. This prevents distressed assets from adversely affecting the returns of the rest of the portfolio. It has been introduced by the regulator (SEBI) to safeguard the interests of small/ retail investors in debt mutual funds.

How does this work?

Side-pocketing involves separation of the mutual fund portfolio into main portfolio and segregated portfolio in case of a credit event (for example, a bond in the mutual fund portfolio is downgraded to below investment grade by any of the rating agencies like CRISIL, ICRA, etc. leading to a drop in the NAV)

To understand this with an example, consider a mutual fund where an investor holds 100 units at NAV of INR 20 (portfolio value INR 2,000).

• One bond in the mutual fund portfolio, which was earlier contributing INR 3 to the NAV, is downgraded and now contributes INR 2 to the NAV. Hence the investor’s portfolio value has dropped from INR 2,000 to INR 1,900
• The AMC now separates the downgraded bond into the segregated portfolio and the rest remains in the main portfolio
• Consequently, the investor will get 100 units each in both portfolios. Main portfolio will have NAV of INR 17 and segregated/ side pocketed portfolio has NAV of INR 2
• Hence investor portfolio value does not change: Main portfolio = INR 1,700 and segregated/ side pocketed portfolio = INR 200
• All buying and selling is allowed only in the main portfolio
• Investors cannot freely redeem the segregated portfolio with the AMC and will get back the money sitting here only when AMC is able to recover the money from the bond issuing company

Does it help you?

Remember that it is not just you, the retail investor, who is investing in debt mutual funds. Many debt mutual fund categories see a lot of investment from institutional investors (Investment of Crores of Rupees!!).

Over the past several months, credit events have led to some debt mutual funds witnessing a sharp single day fall in NAV. This leads to large redemption in these funds led by institutional investors. The fund manager is forced to sell good quality investments in the portfolio to meet the redemption. Retail investors in these funds are then left with a portfolio that has a higher concentration of the downgraded/ lower quality bond.

With side-pocketing in place, all investors on the day of the credit event will be treated the same as no investment/ redemption will be allowed until side-pocketing is completed.

Has any AMC implemented this?

At present, SEBI has not mandated AMCs to implement side-pocketing but has left it to the discretion of the AMCs.  TATA AMC has introduced side-pocketing in most of their debt and hybrid schemes with effect from 15th June 2019. DHFL Pramerica MF has introduced side-pocketing in two of their Fixed Maturity Plans (FMPs). It remains to be seen if more AMCs will follow suit.

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