One ought never to turn one's back on a threatened danger and try to run away from it. If you do that, you will double the danger. But if you meet it promptly and without flinching, you will reduce the danger by half— Sir Winston Churchill

This piece of advice seems to be very apt for mutual fund houses given the present situation. Debt schemes offered by mutual fund houses are gripped with the problem of heightened credit risk. Instead of taking it head on, they want to quarantine the virus. The Securities and Exchange Board of India (SEBI) does not approve of this approach of quarantining the troubled part of the portfolio of debt mutual schemes.

If you remember, JP Morgan Mutual Fund had hived off its troubled assets from the rest of the portfolio under its two schemes that were down by the default of Amtek Auto. PersonaFN had covered this story extensively. Although there wasn’t a reported default after that, the mutual fund industry has been facing a risk of deteriorating credit quality. Jindal Steel and Power Limited (JSPL) gave sleepless nights to mutual fund houses. Hoping to curtail such cases to reoccur, mutual fund houses approached the SEBI with a request to permit the creation of ‘side pockets.' Side pocketing is nothing but separating troubled, illiquid, and unyielding debt securities from the rest of the portfolio.

How ‘side pocketing’ helps the fund manager?
This move primarily aims to lessen the impact of defaults and downgrades on the Net Asset Values (NAVs) of funds. When any security in a scheme’s portfolio is downgraded or proves unproductive, it spreads panic and fear, leading to pressure mounting for its redemption. This further hits the NAV of the scheme. JP Morgan was forced to halt the redemptions from its troubled schemes until it separated the illiquid assets. Mutual Fund houses want to ensure that such instances do not happen going forward.

And this is what SEBI has to say...
In an informal communication with fund houses, the SEBI expressed its dissatisfaction with the proposal, as reported by Mint dated April 11, 2016.The Association of Mutual Funds in India (AMFI) favoured the demand of the industry for ‘side pocketing’ as “a pragmatic and a practical way to minimize stress.” It seems the SEBI believes that this move may encourage fund managers to take unwarranted risks if ‘side pocketing’ deems it official.

SEBI’s firm stand will protect the investor...
Upgrades and downgrades might be the part and parcel of the business for a debt scheme, but when a fund house or a fund manager invests in bonds with a lower rating (with the intent of earning higher yields), it sows the seeds for future troubles. Fund managers may cry wolf and blame the harsh economic conditions, higher interest rates, and the difficulty corporates face when servicing the debt for deteriorating the quality of their portfolios. However, the numbers expose them ruthlessly.

  Sub-“AAA” rated papers are in favour with fund managers...

Data as on April 05, 2016
(Source: Financial Express dated February 26, 2016, PersonalFN Research)  

The sharp rise in the exposure of mutual funds to “A” rated bonds and gradual fall of “AAA” rated securities highlights the real problem. Securities with sound credit profile are on the decline, and the risk appetite of fund houses is on the rise. Though ‘Side pocketing’ is unlikely to solve the problem, the change in approach may do the trick. Ironically, Mutual Fund Houses have created problems for themselves, hence seeking solutions outside the fence would be a futile exercise. It’s high time mutual funds adopt high fiduciary standards – do what’s in the best interest of investors, and not indulge in doing things that are convenient for them, which potentially jeopardises the interest of investors.

PersonalFN encourages investors to invest in debt schemes that hold high-quality debt securities and generate stable returns commensurate with the broader debt market trends. PersonalFN gives its subscribers a detailed analysis of such funds, each one with PersonalFN’s specialized research service—debt select. If you invest in debt funds, you may want to explore this.
 

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