Status check of side-pocketing: Scope & scale

Indian debt markets have been turbulent for the last two-three years. The first shock came with the default of IL&FS in 2018 and the latest tremor was the Franklin fiasco. But there has been little talk about the value erosion suffered by investors in side-pocketed bonds. Securities of around Rs 6,000 crore have been segregated so far based on their market value before segregation. And roughly half of the amount is unlikely to be recovered.

What's also disappointing is that fund houses are not making optimal disclosure of segregated portfolios. So, here's a status check on them, put together by our team after much effort. But before we delve into the details, we shed light on the side-pocketing norms.

Side pocketing and its impact
In India, murmurs around side pocketing reportedly started when Amtek Auto defaulted on its bond payments worth Rs 800 crore in 2015, which led JP Morgan Mutual Fund to restrict redemptions in two of its debt schemes. The IL&FS debacle in 2018 acted like a clarion call that made SEBI scratch its head. On December 28, 2018, it issued guidelines for AMCs, allowing them to segregate debt and money-market instruments from the rest of the portfolio (create a side pocket) in the case of a 'credit event'. Creditworthiness is the ability of an issuer to meet its repayment obligations, which is reflected by the credit rating assigned to it by a rating agency. Generally, the AAA rating is considered the highest and D as the lowest. So, 'credit event' here means the downgrade of a security to 'below-investment grade,' i.e., credit rating below BBB-, any subsequent downgrade or a default. Thus, such a scheme would have two portfolios - main and segregated, both of which would have separate NAVs and AUMs. However, the onus is on fund companies to decide if they want to segregate the securities from the fund.

Regulators permitted the segregation of portfolios to protect the interest of all investors. As a result, investors planning to redeem from the main scheme will be entitled to any recovery in the future. Continuing investors will also have a liquid and well-managed portfolio because the segregation will save the fund from disruptive redemptions, which take a toll on the quality and liquidity of the portfolio. In addition, a new investor will not be unfairly entitled to the money received from a defaulting security in the past.

While the intent of this regulation is in the interest of investors, the ground reality is a bit different. When a segregated portfolio is created, it is forgotten after a hullabaloo of two-three days, as the main portfolio becomes clean of these bad papers. We assess these segregated portfolios, the amount that has been side pocketed and the present recovery level.

The overall size of segregation
Since the introduction of the side-pocketing norms, 45 portfolios across 27 schemes have been segregated, totaling securities of about Rs 6,000 crore. Out of the seven AMCs involved, Franklin and Nippon alone account for around 74 per cent of the total segregated value.

In terms of the fund category, as one would expect, credit-risk funds have contributed the highest (27 per cent) to the segregated value because of their rating downgrades, followed by medium-duration funds (16 per cent). Short-duration and ultra-short-duration funds have a combined share of 26 per cent in these portfolios, mostly because of Franklin funds' exposure to YES Bank's AT-1 bonds and the papers of Vodafone Idea. Here is how AMCs stack up with their share in the segregated portfolios:

In the next part of this four-part series, we would talk about the recoveries that have been made from these side-pocketed securities, with details at an individual scheme level.

You can read the next part here