SEBI likely to make liquid MFs safer for investors by allowing ‘ring-fencing’ of bad securities | Tomorrowmakers

SEBI may allow mutual funds to segregate distressed debt securities. Here's how it can influence your investment decisions.

SEBI likely to make liquid MFs safer for investors by allowing ‘ring-fencing’ of bad securities

Market regulator Securities Exchange Board of India (SEBI) is likely to allow mutual fund houses to safeguard the interest of investors arising out of credit risk in the debt fund category.

The proposed rule, known as ‘side-pocketing’, will offer fund houses the flexibility to segregate distressed debt securities from their portfolios.

The proposal, which was recently approved by the mutual fund committee appointed by the SEBI and for which a formal announcement is likely soon, will allow fund houses to safeguard a particular scheme’s net asset value (NAV) by excluding the defaulting assets from the portfolio.

The recent defaults from some troubled companies such as Jindal Steel and Power, Amtek Auto, and IL&FS and its subsidiaries, have resulted in a sharp decline in the NAV of funds that had these companies in their debt portfolio.

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The defaults from IL&FS alone resulted in a 3% to 6% erosion in the NAV of some debt schemes, which accounts for anywhere between 50% and 75% of the annual yield.

With side-pocketing, a mutual fund will be able to divide a debt scheme into two separate portfolios with distinct NAVs. One would be the regular portfolio with accurate yields and absolutely liquid to trade, while the other portfolio will have the defaulting securities which would be repaid as and when the monies are recovered.

With the relatively prompt insolvency process, investors could expect some convalescence in the yield over a year or two. While the affected investors on the date of default are paid, new investors will not be able to make windfall gains.

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In the past two years, defaults from corporate papers have led to unnecessary redemption pressure on fund houses. The decision to introduce side-pocketing is aimed at reducing the redemption pressure from such defaults.

The SEBI will ensure there are sufficient checks in place to prevent fund houses from misusing the facility. The segregation of the portfolio will only be permitted with the approval of the trustees and it is meant exclusively for corporate papers with a ‘default’ rating. 

Some members of the mutual fund advisory board are apprehensive about the introduction of side-pocketing as it could elevate a sense of greed and entice people to take unwanted risks, as the system ensures the core portfolio is not affected due to the segregation.

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Irrespective of the segregation, investors need to be wary of fund schemes that have suspect papers in the portfolio or are not investing as per the mandate and risk profile of the fund.

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