Sebi for side-pocketing in debt mutual funds

Sebi is planning to allow mutual funds to undertake 'side pocketing' of debt and money market instruments in case of a credit event while ensuring fair treatment to all unit holders. 'Side pocketing' is a mechanism to separate distressed, illiquid and hard-to-value assets from other more liquid assets in a portfolio. It prevents the distressed assets from damaging the returns generated from more liquid and better-performing assets.

The proposal is likely to be discussed by Sebi's board at its meeting this week, officials said. The proposal comes in the wake of the liquidity squeeze triggered by the Infrastructure Leasing & Financial Services (IL&FS) default. IL&FS and its subsidiaries have defaulted on several debt repayments recently due to liquidity crisis. The company as of March 2018 owed over Rs 91,000 crore to banks and other creditors.

It has been noted that a credit event in even one issuer or group could lead to significant liquidity risk in the entire country, which in turn can lead to further volatility in the market. 

Accordingly, a need has been felt to put in place a mechanism to deal with a situation that arises in a mutual fund scheme due to a credit event on a debt security in its portfolio, officials said. Mutual Fund Advisory Committee (MFAC) has recommended in favour of side pocketing and the board of Sebi may discuss on the proposal to permit side pocketing by mutual funds, they added.

Under the proposal, side pocketing may be permitted for debt instruments in mutual fund schemes based on credit events at issuer level. It may be optional for mutual funds to exercise such mechanism. 

Further, activation of side pocketing would be subject to trustee approval and there should be monitoring by trustees to ensure timely recovery of side pocketed assets as per the proposal. Also, there should be adequate disclosure to existing and prospective investors to enable informed decisions, the proposal noted.

Currently, in the absence of side pocketing, in case of credit events, the existing investors potentially lose all the value. Any further recovery accrues to the investors in the scheme at the time of recovery. With side pockets, the investors who take the hit when the credit event happens, get the full upside of future recovery.