Sebi mulls norms to help funds navigate default

Looks at creating rules on how and when funds can restrict withdrawals

The market regulator is looking at creating "gating" norms to determine how and when mutual funds can restrict investors from withdrawing money from debt schemes. The authority also wants to specify circumstances under which mutual funds can separate bad assets from good assets and hold the former in a segregated scheme, known as a "side pocket".

The aim is to help investors and funds navigate Amtek Auto-like episodes better, where a ratings downgrade of assets can spark off a massive exit by investors.  The issue assumes significance as ratings downgrades become common in a challenging economic environment.

WHAT IS GATING?

Gating involves temporary restrictions on redemption or withdrawal of investments. It helps prevent large-scale redemption from the entire scheme and gives fund managers time to exit the illiquid parts of the portfolio. Schemes are typically gated for seven to 10 days

AND WHAT IS  A SIDE-POCKET?
Creating a ‘side pocket’ involves separating the illiquid assets from other more-liquid investments. The side-pocket, thus,  becomes a segregated scheme with a different net asset value and with illiquid assets.
"At present, stopping or limiting of redemptions is at the judgment of the trustees, but Sebi (Securities and Exchange Board of India) wants norms to clearly define this process," said Manoj Nagpal, chief executive, Outlook Asia Capital. A trustee is a person or firm that holds or administers assets for the benefit of a third party.

On Wednesday, rating agency CRISIL downgraded the bank facilities and debt programmes of Jindal Steel and Power Ltd (JSPL) to D from BB+/A4+. Instruments rated D are in default or are expected to be in default soon. Earlier this year, CRISIL had downgraded JSPL to below investment-grade.

Currently, fund houses have the option of gating, or restricting, redemptions from schemes under circumstances such as war, natural calamity, or excess market volatility —when too many investors may head for the exit at the same time. This can be done only after getting approval from the mutual fund trustees. Gating involves temporary restrictions on redemption or withdrawal of investments. It helps prevent large-scale redemption from the entire scheme and gives fund managers time to exit the illiquid parts of the portfolio. Schemes are typically gated for seven to 10 days.

Creating a 'side pocket' involves separating the illiquid assets from other more-liquid investments. The side-pocket, thus,  becomes a segregated scheme with a different net asset value and with illiquid assets.

"We have recommended that side-pocketing be allowed in situations when companies default and the papers becomes illiquid and is difficult to sell. If side-pocketing is not allowed, fund houses should be allowed to resort to gating," said CVR Rajendran, chief of the Association of Mutual Funds in India. He added that the exact conditions when these practices could be resorted to need discussion with the regulator.

An email to Sebi did not get a response.

According to experts, the most important thing for open-end debt investors is transparency and liquidity. "In extreme situations, when a large part of the portfolio can become illiquid, investors need clarity on how the liquidity issue will be addressed. To that extent, any guidelines on gating and side-pocketing will be a welcome step," said R Sivakumar, head, fixed income, Axis Mutual Fund.

Assume the debt scheme has assets worth Rs 100 crore, of which Rs 15 crore is invested in papers below investment grade. Let's say after a panic redemption, the fund size comes down to Rs 50 crore. Now the Rs 15 crore bad papers will make up 30 per cent of the overall scheme. This means sophisticated investors who exited early will be far better off than smaller investors who stayed invested - the latter ending up owing a much more illiquid and riskier portfolio.

Interestingly, side-pocketing is not followed in most developed countries as the bonds markets there are liquid (unlike in India), and there are enough takers for bonds below investment grade. The suggestion to introduce the practice of side-pocket was rejected by Sebi a few years ago.

JPMorgan had gated redemptions in two of its debt schemes to not more than one per cent of the total number of units outstanding on any business day. It did this in the wake of a large-scale redemption because of the Amtek Auto episode. It also created a side-pocket, a first in India, where it segregated and put assets exposed to Amtek Auto debt papers.

JPMorgan AMC, through two of its schemes, had bought bonds worth Rs 200 crore issued by the New Delhi-based automobile component maker.

The Amtek issue first re-surfaced in August, after a ratings agency suspended coverage on the manufacturer's debt papers.

In September, Amtek Auto defaulted on the re-payment on its debt papers.