Sebi allows segregation of distressed assets by mutual funds

Markets regulator Sebi Wednesday decided to allow mutual funds to create segregated portfolios with respect to debt and money market instruments in case of credit events while ensuring fair treatment to all unit holders.

Creation of segregated portfolios 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.

With a segregated portfolio, investors who may take the hit when the credit event happens shall get the upside of future recovery, Sebi said in a statement after the conclusion of the board meeting.

The board has cleared a proposal "to allow mutual funds to create segregated portfolios with respect to debt and money market instruments subject to various safeguards", the statement said.

A credit event is marked by any change that negatively impacts a borrower's capacity to meet payment obligations in cases like default, bankruptcy etc.

As per the regulator, the new facility will be available to mutual funds based on credit events at issuer level. It may be optional for mutual funds to exercise such mechanism.

Further, activation of the new mechanism may be subject to trustee approval.

When asked that segregated portfolio of mutual funds might lead to such funds taking more credit risk in future, Sebi Chairman Ajay Tyagi said, "This was the issue that was discussed at adequate length and adequate safeguard will be built in the circular that would see issue so that it is not misused... We will see that this scheme is not misused." "The board also took note of the proposal to review the valuation norms applicable to mutual fund schemes investing in debt and money market instruments," the regulator noted.

He further said this decision on MFs is because of crisis in NBFCs and IL&FS.

"It is in the interest of the retail investor that the toxic acids are segregated from acids which are doing well. So that the NAV (net asset value) of normal assets are maintained and there is less redemption pressure.

"Because initially the information is with the institutional investors and they may redeem and then retail investors may be left with poor portfolio. So we think it is appropriate time to introduce it and it is optional," he added.

Infrastructure Leasing & Financial Services (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.

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 was 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.

The Mutual Fund Advisory Committee (MFAC) has recommended in favour of side-pocketing or creation of segregated portfolios.

Currently, in the absence of segregation of portfolios from distressed, illiquid assets from other more liquid assets in a portfolio, 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.

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