Mutual Funds now allowed to create side-pockets due to debt restructuring of issuer firms affected by Covid-19

With markets preparing for a rise in corporate debt rejig due to Covid-19, regulator SEBI has permitted mutual funds to segregate securities of companies going for debt restructuring

Kumar Shankar Roy Sep 3, 2020

side pocketing in mutual fundsUntil now, debt mutual funds could create a side-pocket when at an issuer level there was a credit event. Now the mutual fund industry, which has corporate debt exposure of Rs 3.7 lakh crore, has been given the freedom to separate good and bad assets in their portfolio when a debt issuer portfolio company goes for debt restructuring.

The need for corporate debt restructuring is real, especially in the mid-sized sector. As per the RBI’s announcement dated August 6, a restructuring window will be open only for companies which are under stress due to the pandemic and which were classified as standard, but were not in default for more than 30 days with any lending institution as on March 1, 2020. Several corporates are likely to explore the opportunity to restructure their loans in order to conserve liquidity, especially given the continued weakness in demand amid an economic recession.

Given this scenario where a large number of debt issuing companies, many of whom are in debt MF portfolios, go for debt rejig, SEBI said that the date of the proposal for restructuring of debt received by Asset Management Companies (AMCs) shall be treated as the trigger date for the purpose of creation of segregated portfolio. “Such proposal of restructuring of debt received by AMCs shall be immediately reported to the Valuation Agencies, Credit Rating Agencies, Debenture Trustees and AMFI. AMFI, on receipt of such information, shall immediately disseminate it to its members,” SEBI said.

As per previous norms, an AMC could create a segregated portfolio in a mutual fund scheme in case of a credit event at issuer level including downgrade in credit rating by a SEBI registered Credit Rating Agency (CRA) to ‘below investment grade’, or subsequent downgrades of the said instruments from ‘below investment grade’ etc.

Just a few days ago, SEBI had stated that if the CRA is of the view that the restructuring by the lenders/ investors is solely due to Covid-19 related stress, or is under RBI’s prudential framework for resolution of stressed assets, CRAs may not consider the same as a default event and/or recognise default.

Given that the moratorium announced by the RBI has ended on August 31, and the cash flows of debt issuer companies are taking time to normalize, lenders will quickly thrash out differences and get ahead with debt restructuring plans.

Assume an AMC is informed about a restructuring application of a portfolio company before the due date of repayment. In this scenario, the debt issuer company has not technically defaulted by rejigging its debt. So, the rated entity’s credit profile is unlikely to face any sharp rating action. But, that the company has to go for debt restructuring can be taken trigger for MFs to protect investors.

RupeeIQ take

If debt restructuring is going to trigger side pocketing, does that mean there could be a growing number of side pockets as a large number of investment grade companies may opt for restructuring? It is not just default that is triggering the side pocket event now. This could be negative for investors as you could see a lot of side pockets being created in your debt funds, if the companies go in for restructuring. We will come back with a detailed impact analysis on this issue.

Read the latest SEBI circular here.

Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at [email protected].

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