Side-pocketed scheme in debt mutual funds

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A side-pocketed scheme (formally called a segregated portfolio) in a debt mutual fund is a regulatory mechanism under which a stressed or defaulted debt security is separated from the main portfolio into a distinct sub-portfolio, allowing the fund to quarantine the troubled asset while continuing normal operations for the remaining healthy portfolio. SEBI introduced the segregated portfolio framework through Circular SEBI/HO/IMD/DF2/CIR/P/2018/160 (dated 28 December 2018), effective immediately, in response to the IL&FS crisis that year.

Before this mechanism existed, a credit event in a debt fund (such as a downgrade or default of a holding) would cause the scheme’s NAV to drop sharply, triggering panic redemptions. This distress selling forced the fund to liquidate other healthy assets at unfavourable prices to meet redemptions, creating a cascading liquidity crisis that harmed all remaining unitholders.

Trigger conditions for segregated portfolio

A mutual fund scheme may create a segregated portfolio when:

  1. A security in the portfolio is downgraded by a SEBI-registered credit rating agency to below investment grade (below BBB− for long-term instruments, below A2 for short-term instruments).
  2. The issuer defaults on payment of principal or interest.
  3. The security experiences a credit event as specifically defined by SEBI’s circular.

The AMC’s Board of Trustees (not the AMC alone) must approve the creation of the segregated portfolio. The decision must be made within one business day of the credit event.

Mechanics of segregation

Once the segregated portfolio is created:

  1. Portfolio bifurcation: The affected security is moved from the main portfolio to the segregated portfolio. All other assets remain in the main portfolio.
  2. NAV bifurcation: Two separate NAVs are computed and disclosed daily:
    • Main portfolio NAV: Based on the remaining healthy assets.
    • Segregated portfolio NAV: Initially marked to the current fair value of the stressed security (often near zero or at a steep discount). Updated as and when recovery information becomes available.
  3. Unit bifurcation: Existing unitholders at the time of the credit event receive units in both the main portfolio and the segregated portfolio in the same proportion as their existing holdings. Their total unit count increases (main portfolio units + segregated portfolio units), but their total economic value immediately after bifurcation is unchanged.
  4. Subscription restriction: New investors can only subscribe to the main portfolio. They do not receive units in the segregated portfolio.
  5. Redemption from main portfolio: Proceeds normally. Investors redeem at the main portfolio NAV.
  6. Segregated portfolio redemption: Suspended (investors cannot redeem segregated portfolio units through normal channels). Recovery proceeds are distributed to unit holders periodically as and when the issuer makes payments.

Investor implications

Fairness: The segregation mechanism protects existing investors from flight-to-exit scenarios where early redeemers exit at a better effective price (before the full NAV impact of the credit event is recognised) at the expense of remaining investors.

Transparency: Two separate NAVs are disclosed, clearly showing the value of healthy assets separately from the distressed holding.

Liquidity: Investors can continue to redeem from the main portfolio (healthy assets) without having to accept the side-pocket uncertainty. The segregated portfolio units are illiquid until recovery.

Exchange listing: SEBI allows segregated portfolio units to be listed on recognised stock exchanges, providing a mechanism for price discovery and potential secondary market exit. In practice, trading liquidity for segregated portfolio units on exchanges has been limited.

The segregated portfolio’s NAV reflects the latest fair value of the stressed security. This fair value is determined by the AMC’s valuation committee:

  • Immediately after default: Typically marked to the last available market price or to an estimated recovery value (often 20%–40% of face value or lower, depending on the security and collateral).
  • Subsequent updates: As partial payments are received from the issuer or resolution proceedings produce outcomes, the NAV is updated accordingly.

Full details of the mark-to-market methodology for debt holdings underlie the valuation.

Historical cases in India

The IL&FS defaults (2018) preceded the regulatory mechanism and caused significant mark-to-market losses in debt funds without the benefit of segregation. The SEBI circular was issued specifically to prevent a repeat.

Subsequent notable segregated portfolios include:

  • Vodafone Idea (Vi) papers in several credit risk and short-term debt funds (2019–2020) following covenant breaches and rating downgrades.
  • DHFL (Dewan Housing Finance Corporation) papers following default in 2019; multiple debt funds created segregated portfolios.
  • Essel Group papers in certain funds following concerns over promoter pledges (2019).

Recovery from these segregated portfolios has varied widely; some delivered near-zero recovery while others returned 40%–80% of the originally invested amount over multi-year resolution processes.

References

  1. SEBI Circular SEBI/HO/IMD/DF2/CIR/P/2018/160 (28 December 2018), Segregated portfolio framework.
  2. SEBI Master Circular for Mutual Funds (2024).
  3. AMFI operational guidelines on segregated portfolio creation and management.

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The WebNotes Editorial Team covers Indian capital markets, payments infrastructure and retail investor procedures. Every article is fact-checked against primary sources, principally SEBI circulars and master directions, NPCI specifications and the official support documentation published by the intermediary in question. Drafts go through a second-pair-of-eyes review and a separate compliance read before publication, and revisions are tracked against the SEBI and NPCI rule changes referenced in the methodology section.

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