Side-pocketing rules for debt mutual funds (India)

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Side-pocketing in the context of Indian mutual fund regulations refers to the practice of separating a distressed or defaulted debt security from the rest of a scheme’s portfolio into a distinct “segregated portfolio,” thereby ring-fencing the credit event’s impact on the main portfolio and preventing a run on the fund by existing investors who seek to redeem before the distress crystallises. SEBI formally permitted side-pocketing through circular SEBI/HO/IMD/DF2/CIR/P/2018/160 dated 28 December 2018, framed in response to the IL&FS group defaults of September–October 2018 which severely impacted several debt mutual fund schemes. The framework was incorporated into the SEBI (Mutual Funds) Regulations, 1996 and subsequently elaborated in the dedicated article on segregated portfolios.

Background: the IL&FS defaults and the policy gap

In September 2018, Infrastructure Leasing and Financial Services (IL&FS), a highly-rated infrastructure conglomerate, began defaulting on commercial paper and other short-term obligations. IL&FS securities were held across multiple debt mutual fund schemes managed by several AMCs, rated as high as AA+ before the defaults. As news of the defaults spread, investors rushed to redeem from affected schemes, forcing fund managers to sell liquid (performing) assets to meet redemptions, thereby concentrating the distressed IL&FS exposure further in the residual portfolio, a classic “adverse selection” dynamic.

Prior to December 2018, there was no regulatory mechanism permitting AMCs to segregate distressed securities. SEBI identified this gap and issued the December 2018 circular permitting (but not mandating) the creation of segregated portfolios, conditioned on trustee approval and compliance with prescribed mechanics.

Trigger events

Under the 2018 circular (and subsequent amendments), side-pocketing is permitted when a debt security held by a scheme is affected by:

  1. Credit event: A downgrade of the security to “below investment grade” (i.e., below BBB– or equivalent) by a Credit Rating Agency (CRA) registered with SEBI.
  2. Default: Non-payment of principal or interest on the due date.
  3. SEBI direction: SEBI may direct the creation of a segregated portfolio in specific situations.

The circular clarifies that a temporary “ratings watch” or “rating under surveillance” is not sufficient, an actual downgrade to sub-investment grade must occur.

Mechanics of side-pocketing

Step 1, Trustee approval

The AMC must seek the approval of the trustee before creating a segregated portfolio. The trustee must satisfy itself that the action is in the interest of existing investors and that the credit event has genuinely occurred.

Step 2, Timing requirement

The AMC must initiate the side-pocketing process on the day of the credit event (or on the business day immediately following if the credit event occurs after market hours). Delayed action, especially after investors with knowledge of the event have already redeemed, is treated as a regulatory violation.

Step 3, Portfolio split

On the day the segregated portfolio is created:

  • The total portfolio value of the scheme is calculated.
  • Units corresponding to the distressed security are carved out on a pro-rata basis among all unitholders as of that day’s cut-off. Each investor receives an equal proportional allocation of segregated portfolio units.
  • The main portfolio continues with the performing assets; NAV is published daily based on market values.
  • The segregated portfolio’s NAV is published separately. It will typically be at or near zero until recovery is realised.

Step 4, Redemptions and subscriptions

  • New subscriptions: Not permitted into the segregated portfolio.
  • Redemptions from the main portfolio: Continue uninterrupted.
  • Redemptions from the segregated portfolio: Not permitted until recovery is realised (debt collected, security restructured, or instrument sold in secondary market).
  • Transfers: Units of the segregated portfolio are listed on the stock exchange to provide a liquidity option for investors who wish to exit.

Step 5, Recovery and distribution

When the distressed issuer makes repayment or the security is realised:

  • The amount is credited to the segregated portfolio.
  • The recovered amount is distributed to segregated portfolio unitholders proportionally.
  • If recovery is partial, the remaining amount stays in the segregated portfolio.
  • The segregated portfolio is terminated once all assets are realised.

Investor protection provisions

The 2018 circular contains several investor protection provisions:

  • Pro-rata allocation: Ensures no investor receives preferential treatment; the segregated portfolio units are distributed in exact proportion to existing holdings.
  • Exchange listing: Segregated portfolio units must be listed within 10 business days of creation, enabling price discovery and secondary-market exit.
  • No new inflows: Prevents dilution of existing holders’ recovery claim by new investors.
  • Disclosure: The AMC must send a communication to all investors within one business day of creating the segregated portfolio, disclosing the credit event, the affected security, and the mechanics.
  • AMFI website disclosure: The segregated portfolio NAV and recovery status must be disclosed daily on the AMFI website.

Impact on total expense ratio and riskometer

  • TER: The AMC may not charge an additional TER for the segregated portfolio. The existing TER slab applies to the combined assets (main + segregated).
  • Riskometer: Upon creation of the segregated portfolio, the main portfolio’s riskometer must be recomputed excluding the distressed security. In most cases this reduces the credit risk score of the main portfolio.

Subsequent clarifications and amendments

SEBI issued further guidance through:

  • Circular SEBI/HO/IMD/IMD-PoD-1/P/CIR/2021/… (2021), clarified that the listing requirement for segregated portfolio units applies even to smaller AMCs and must be facilitated through the BSE/NSE.
  • Master Circular 2024, consolidated all side-pocketing provisions and confirmed that a second or third side-pocket is possible within the same scheme if additional defaults occur in different securities.

Market impact and usage

As of April 2026, side-pocketing has been deployed by several AMCs following events including:

  • IL&FS-related defaults (2018–2019): Scheme names include certain Tata Mutual Fund and other debt scheme side-pockets.
  • Vodafone Idea exposure by certain debt funds (2019–2020).
  • Yes Bank AT1 bond write-down (2020): AT1 bonds were written to zero by RBI; schemes with AT1 bond exposure created segregated portfolios.
  • Reliance Capital and DHFL defaults.

The availability of side-pocketing as a tool significantly reduced the severity of investor runs following credit events in 2019–2020 compared to pre-2018 episodes.

Regulatory criticism and limitations

  • Valuation opacity: Segregated portfolio NAVs may remain near zero for extended periods, creating uncertainty.
  • AMC discretion: The decision to create a segregated portfolio is at AMC/trustee discretion (subject to the trigger conditions), creating potential for delayed action.
  • Secondary market illiquidity: Exchange-listed segregated portfolio units frequently trade at steep discounts to recovery expectation due to thin liquidity.
  • Investor unfamiliarity: Retail investors frequently do not understand segregated portfolio mechanics, leading to uninformed secondary-market sales at very low prices.

See also

References

  1. SEBI Circular SEBI/HO/IMD/DF2/CIR/P/2018/160, 28 December 2018, Segregated portfolio/side-pocketing.
  2. SEBI (Mutual Funds) Regulations, 1996, as amended 2019.
  3. SEBI Master Circular SEBI/HO/IMD/IMD-PoD-1/P/CIR/2024/137, 27 May 2024.
  4. AMFI, “Guidance on creation and management of segregated portfolios”, amfiindia.com.
  5. SEBI Order in the matter of Yes Bank AT1 bonds and mutual fund schemes, 2020.

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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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