Side-pocketing — segregated portfolios for defaulted assets

Side-pocketing (also called creation of a segregated portfolio) is a mechanism by which an AMC can isolate a defaulted bond from the main scheme. The main scheme continues operations normally; the segregated portfolio holds the defaulted asset, with investors retaining a separate claim. SEBI formalised the framework in 2018 to prevent the contagion effect of single defaults destroying entire schemes.

The problem side-pocketing solves

Before the framework:

• A bond defaults in a debt scheme.
• The bond's market value drops dramatically.
• Healthy investors withdraw to avoid further loss.
• Forced selling of healthy bonds at low prices.
• Remaining investors bear larger losses.

This was the IL&FS / DHFL / Franklin scenario in 2018-2020.

How side-pocketing works

1. A bond in the scheme defaults (interest or principal).
2. AMC requests SEBI permission to side-pocket.
3. Defaulted bond moved to segregated portfolio.
4. Main scheme continues operations with healthy assets.
5. Investors retain proportional claim on both portfolios.
6. Recovery of defaulted bond happens over time; distributions to investors as recovered.

The structural protection

• Healthy investors can continue or redeem from main scheme normally.
• Forced selling of healthy assets avoided.
• Recovery from defaulted bond benefits original holders.
• New investors after side-pocketing don't share in the recovery (only the main scheme).

SEBI's framework

The 2018 framework specifies:

• Triggers for side-pocketing (rating downgrade to default).
• Approval process.
• Disclosure requirements.
• Investor communication.
• Valuation of segregated portfolio.

Investor impact

Existing investors at side-pocket time

• Receive units in both main and segregated portfolios.
• Can redeem from main scheme freely.
• Segregated portfolio units are illiquid until recovery distributions.
• Tax implications on recovery distributions when received.

New investors post side-pocket

• Only purchase units in main scheme.
• No claim on segregated portfolio.
• Cleaner exposure to healthy assets.

Recovery distributions

As the segregated portfolio recovers:

• Distributions made to original investors.
• Tax treated as capital gain on each distribution.
• Cost basis is the value at side-pocketing (often near zero).

Communicating to investors

AMC must communicate:

• Side-pocketing decision and rationale.
• Allocation of units between main and segregated.
• NAV implications.
• Subsequent updates on recovery progress.

Comparison to fund wind-up

Side-pocketing

• Isolates problem; main scheme continues.
• Investor flexibility preserved.
• Recovery distributed over time.

Full wind-up

• Entire scheme liquidated.
• All assets sold to distribute proceeds.
• Major operational impact.

Side-pocketing is the less drastic option.

What can be side-pocketed

• Defaulted bonds (interest or principal not paid).
• Bonds rated below investment grade (in some cases).
• Specific securities facing severe credit issues.

What cannot be side-pocketed

• Equity stocks (different mechanism for distressed equity).
• Currency-related instruments.
• Healthy bonds (even if their issuers have other defaults).

The Franklin Templeton context

The 2020 Franklin Templeton case was a partial side-pocketing scenario:

• Liquidity stress affected multiple schemes.
• Some defaulted bonds were side-pocketed.
• But overall liquidity stress forced full wind-up of six schemes.

Industry-wide impact

Side-pocketing has reduced systemic credit risk impact:

• Major defaults isolated rather than spreading.
• Investor flexibility preserved during stress.
• Healthy funds protected from contagion.

For investors evaluating funds

Side-pocket events worth investigating:

• Which AMCs have had side-pocket events?
• What were the recovery outcomes?
• What did the side-pocket reveal about credit research quality?

A fund with multiple side-pocket events signals systematic credit assessment issues.

Side-pocket valuation

At side-pocketing, the defaulted bond is typically valued at:

• Net realizable value.
• Often 30-70% below face value.
• Reflects expected recovery percentage.

If recovery exceeds initial valuation, the gain accrues to original holders.

Operational mechanics

Once side-pocketed:

• The segregated portfolio has its own NAV.
• Updates published periodically.
• Recovery distributions credited to investor bank accounts.
• Each distribution may have tax implications.

Where side-pocketing is most relevant

• Credit Risk funds (highest exposure to lower-rated bonds).
• Medium Duration funds with credit exposure.
• Corporate Bond funds (despite generally AAA-heavy).
• Specialty debt funds.

Reading side-pocket history

When evaluating a debt fund, look for:

• Number of side-pocket events.
• Frequency and timing.
• Recovery rates achieved.
• AMC's transparency in communication.

Patterns reveal systematic credit-assessment quality.

For new investors

Side-pocketing structures protect against catastrophic losses but don't prevent them entirely. Risk-averse investors should:

• Avoid heavy credit-risk allocation.
• Diversify across multiple debt funds.
• Consider AMC credit research quality as a major factor.

The framework's broader value

Side-pocketing represents thoughtful regulatory design:

• Acknowledges credit risk exists.
• Provides tools to manage it without catastrophic outcomes.
• Preserves investor choice.
• Protects healthy funds.

The framework has reduced systemic credit risk impact significantly in the Indian mutual fund industry.