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Why Mutual Fund side-pocketing is not taking off in India?

Posted on 14-Jun-2019 Comments  0

Side Pocketing

Why Mutual Fund side-pocketing is not taking off in India?

In the aftermath of the crisis faced by debt funds holding bonds and CP of IL&FS and DHFL, the regulator decided to permit the side pocketing of debt funds. Here, the toxic assets in the fund will be hived off into a separate side pocket fund and only the good assets will remain in the principal fund.

How Side Pocketing works?

In terms of protecting the interest of investors, side pocketing offers the best option for mutual funds. In this case, when a debt fund portfolio is hit by toxic holdings in the bonds of IL&FS and DHFL, the fund has the option to separate the specific bonds into a side pocket portfolio. The side pocket will not permit any inflows or even redemptions so that distress traders do not make a short term profit at the cost of genuine long term investors. Under the side-pocket arrangement, your holdings in the fund remain the same. Instead, what the fund does is to transfer all toxic assets into a separate portfolio. The core portfolio without the toxic assets continues to permit free inflows and redemptions. Of course, the write off will still be taken but the side pocket ensures that short term traders do not make profits in distress at the expense of genuine investors who exited the fund. Funds normally write off 75% in case of distressed assets and any recovery from these toxic assets are directly credited into the side pocket account and paid back to the investor.

How is side pocketing working?

Unfortunately, a full 6 months after side pocketing was allowed, there is limited interest among funds. Tata AMC is the only MF to have side pocketed its toxic holdings. Most MFs prefer to either freeze fresh inflows or impose heavy exit loads on the fund to impose a cost on fund traders. Side pocket as a strategy is globally considered one of the best ways to protect the interests of the small investors in a mutual fund. Let us look at some reasons why the concept of side pocketing has not really taken off among Indian mutual funds? 

Why it is a slow starter?

There are several reasons why the side pocketing has been a slow starter among funds. Firstly, a side pocket is a tacit admission that the fund has parts of the portfolio that are extremely stressed. That could have an impact on the performance of other debt paper too. Secondly, there are regulatory issues pertaining to side pocketing. A side pocket will be treated as a change in fund strategy and hence it will have to go through the regular scrutiny as well as approval of board of trustees. One way would be allow this clause to be part of the offer document. Lastly, tax aspects are not too clear. Whether it will be transfer and will it attract capital gains and what is the buying price; are all still unclear. SEBI and CBDT must give clarity at the earliest!

Credit Rating

New SEBI norms could bring a big shift in credit ratings business

For a long time, the credit raters have been in the news for the wrong reasons; both in India and abroad. In India, the issue first came up back during Lehman crisis but Indian rating agencies really came under fire for downgrading Amtek Auto in a single stroke. Later, the same case was repeated with IL&FS as well as DHFL. The recent SEBI proposals for rating agencies need to be seen in this light. Here is why!

Where raters faltered?

Over the last few years, the rating agencies have been criticized for various reasons. There have been allegations that the same rating agency offering rating services and consultancy to the corporates created a conflict of interest. Secondly, rating agencies had been quite impulsive in their actions. For example, in the case of bonds of IL&FS and DHFL, the downgrade from “A” rating to “Default” rating happened in a matter of days. The need of the hour was to build a better early warning system. Lastly, there was a major issue of data availability. Most rating agencies get the default data from the banks and that tends to come out after a certain time lag. Hence, by the time the actual news is factored into ratings, it is just too late. In the case of debt instrument the impact on yields and prices due to a shift in ratings is huge and that is why the responsibility on the rating agencies is a lot higher. SEBI is trying three ways to address this ratings challenge.

Probability of default

Under the new norms, rating agencies will also have to assign probability of default to each instrument with separate such probabilities to short term and long term instruments. This will be subjective but such a numerical expression of probability of default will make the rating agencies more accountable and also enable finer pricing. In fact, the rating agencies may now be a lot more cautious about assigning AAA ratings to bonds. That could be the takeaway.

Sensitivity to triggers

Another key disclosure that the rating agencies will have to make is the extent to which the ratings are sensitive to triggers. Such triggers could be macro based, sector based, stock based or market risk based. This sensitivity disclosure gives investors an idea as to when they can expect upgrades in the bonds and when they can expect some downgrades as a response to stimuli.

Bond spread deviation

An important rule now will be that rating agencies will have to treat any sharp shift in bond spreads / yields as a material event. It becomes more of a cause than just an effect and rating agencies will have to factor this into their calculations. It is hoped that these 3 shifts will make the functioning of raters more meaningful!

Macro Cues

Inflation and IIP growth a positive; Trade deficit widens

It was a week of key macro data announcements. The week saw key data points being announced on inflation (both retail and wholesale), IIP growth and the trade data. There are some interesting signals coming from data.

What’s the inflation message?

CPI inflation has come under pressure in the month of May. The CPI inflation for May came in higher at 3.07%. Also, the inflation number for April was upgraded from 2.92% to 2.99%. If one were to look at the overall basket of inflation, then the real pressure came from the food items. In fact, food inflation went up from 1.15% to 1.83% which really added heft to the overall CPI inflation. This is important because this has happened at a time when core inflation has actually been on a consistent down trend. The big pressure for inflation came from food and oil, with oil having strong externalities for other sectors too. While the CPI inflation is still well within the RBI target of 4%, there is room for caution because food inflation is higher and IMD has predicted a weak monsoon this year. That could only add to the pressure on food items. What is ironic is that the CPI inflation has been at a 7 month high but WPI inflation actually came in lower. It implies that while inflation is going up, the benefits are not reaching producers and farmers. A higher inflation could also mean a possible rethink of the Monetary Policy Committee strategy to cut rates further.

IIP shows traction

The index of industrial production saw some positive traction for the month of April with YOY IIP growth coming in at 3.6%. This is a big improvement over the negative growth seen in the month of March. For the full year, the IIP growth was closer to 3.4%, which is relatively lower than the average growth in the last 10 years. But the good news on the IIP front is that the growth has been uniformly positive in all the three principal segments of IIP viz. Mining, Manufacturing and Electricity. What is also visible in the IIP numbers is that the there appear to be green shoots of recovery in the capital investment cycle and that is something that markets have been betting for long.

Trade deficit widens

On the macro front, there was not much respite on the trade account. Trade deficit for May widened to $15.36 billion even as the exports grew at a tepid rate of just 3.3%. While non-oil imports were up by just 2.9%, the oil imports saw a spurt of 8.4% on the back of higher import volumes and a higher average price. Trade deficit continues to hint at closer to $200 billion for the full year and that could put pressure on the value of the rupee. Also the message here is to balance our oil imports as any geo-political risk in the Middle East could create a short term challenge. That could be the key macro challenge!




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