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If debt mutual funds create side-pockets and offer investors an exit window without load, should you sell?

If you’re an investor in debt mutual funds, you’re probably puzzling over reports on ‘side-pocketing’ of bonds that figure in fund portfolios. Last week, UTI Credit Risk Fund and Reliance Ultra Short Duration Fund announced their intent to side-pocket bonds issued by Altico Capital after it as rated default grade by an agency. Previously, Sundaram Mutual Fund announced, and then backtracked on, its decision to side-pocket bonds from the troubled DHFL. If you’re confused by what all this means to you, here are a few answers:

When debt funds face a downgrade or default on a bond they own, they write down its value in the NAV. Why is side-pocketing needed?

When debt funds write down the value of a bond, they usually aren’t sure if the bond is a complete dud or will realise some value later. But in the interests of conservatism, SEBI rules require funds to write down the value of such bonds by 25, 50, 75 or even 100% in their portfolios, based on their credit ratings. When a fund takes such write-downs, the NAV takes an immediate blow. But if the issuer of the bond later pays up his dues, the fund will then have to increase its NAV to account for the repayment. In such cases, investors in the scheme who exit early taking NAV losses would fail to benefit from the recovery.

On the other hand, new investors who entered the scheme after the write-down would stand to pocket unfair gains on a bond they never owned. Segregating downgraded bonds in a fund’s portfolio into a ‘side-pocket’ avoids such unfair treatment. When a scheme side-pockets a doubtful bond, any recovery from the bond is distributed to all investors who were invested in the scheme when the downgrade happened. Investors who got into a scheme after the downgrade, get to buy only into the main portfolio excluding the doubtful bond.

When and what kind of bonds are debt funds supposed to segregate?

SEBI rules allow debt funds to side-pocket only those bonds that are downgraded below investment grade by rating agencies. When a bond rated BBB or above is pegged down, it turns from an investment grade bond to a non-investment grade one. Fund houses are required to decide on side-pocketing and secure the approval of their trustees for it, on the day the downgrade happens.

When a bond is downgraded, why do some fund houses announce side-pockets while others don’t?

SEBI has not made side-pocketing compulsory for all bonds that turn non-investment grade. This decision is left to the discretion of the AMC and its trustees. So, when a bond slips into non-investment grade, some AMCs may write down its value and hang on, while others may side-pocket it.

What happens when a side-pocket is created?

The scheme separates its portfolio into the good portion, consisting of investment grade bonds, and the bad portion comprising the downgraded bond. The NAV of the scheme will be carved out to the extent of the value (after write down) of the bad bond. All existing investors in the scheme will receive one new unit in the side-pocketed portfolio in addition to existing units in the scheme.

No transactions are allowed in these new units. So, if you redeem the fund after side-pocketing, you will only receive the NAV of the main portfolio. But if the scheme eventually recovers money from the bond, they will get automatically redeemed and you will receive a payout. The trustees of the AMC are supposed to monitor the recovery of proceeds in the side-pocketed bonds.

AMCs have put out newspaper ads about side-pocketing, offering a one-month exit window. Does this mean the scheme will take a hit from a bad bond? Do I need to exit it?

No, you shouldn’t. The ad is only an enabling provision that tells you that the scheme may, in future, use side-pocketing for some of its debt schemes if they take a hit on their bonds. When MFs make changes to their fundamental attributes, SEBI rules require them to give their investors a one-month exit window (without load). Given that SEBI’s side-pocketing rules are recent and most AMCs are introducing this feature into their debt funds for the first time, they have been advertising and offering investors a one-month exit window. Once all fund houses incorporate these enabling provisions into their scheme attributes, they can go ahead with side-pocketing in future without seeking the okay of their investors.

If I don’t check MF websites or newspaper ads, how will I know if a debt scheme is creating side-pockets?

On the day a scheme decides to side-pocket a bond, it is required to issue a press release and send an SMS as well as email to all its investors. It must also inform investors as soon as it secures trustee approval for this. On the day the announcement is made, all new purchases or sales of units in the scheme are frozen.

HUDCO’s instruments come with high rating; returns are higher than bank FDs’

In a nutshell

HUDCO is a Miniratna focussing on housing needs of economically weaker sections

Government supports HUDCO by allowing access to low-cost funds and extending guarantees

HUDCO has issued 32 series of tax-free bonds in total

Over the past 12-15 months, a spate of corporate bond downgrades and defaults has made fixed-income investors jittery. Bonds issued by IL&FS, DHFL, Essel Group and Reliance ADA Group were all downgraded sharply. Such downgrades led to a sharp erosion in the value of the investment products that held these distressed assets in their portfolio. Mutual funds, insurance schemes, NPS and EPFO were among those that took a hit.

Capital safety has now become a prime concern for retail investors.

Investors looking for debt instruments that provide capital safety and decent returns can consider tax-free bonds available in the secondary market. Since these entities are backed by the government, investments in their tax-free bonds enjoy capital safety.

Further, the bonds issued by most of these companies are rated with the highest grade of AAA.

Tax-free bonds

Conservative investors, including retirees, looking for capital safety can consider buying the tax-free bonds issued by the Housing and Urban Development Corporation (HUDCO) that are available in the secondary market.

HUDCO issued 32 series of tax-free bonds totally, with varying maturities of 10, 15 and 20 years in FY12, FY13, FY14 and FY16.

Many series are actively traded on the BSE and the NSE with relatively higher yield-to-maturity (YTM) and liquidity.

According to data compiled by HDFC Securities’ retail research, five series of HUDCO tax-free bonds, with YTM (yield-to-maturity) of 5.4-5.9%, are actively traded on both the exchanges. For instance, the HUDCO N3 series (ISIN INE031A07832), with a coupon rate of 8.1% and residual maturity of 2.5 years, trades with a YTM of 5.6% on the NSE.

The daily average traded volume in the series over the past one month has been 1,120 units.

Since the interest paid by tax-free bonds are exempt from income tax, the current yield of 5.8% translates to 8% of pre-tax yield for investors in the 30% bracket. This rate is relatively higher than the rates offered by bank fixed deposits currently.

About the company

HUDCO is a wholly government-owned entity, providing loans for housing and urban infrastructure projects in India.

It has been conferred the status of Miniratna (category-I public sector enterprise) by the Centre. The company focusses on funding the housing needs of economically weaker sections (EWS) and low-income group category, along with funding non-commercial urban infrastructure projects.

Since its inception, HUDCO has funded 19.34 million dwelling units, about 86% of which belong to the economically weaker sections.

The Centre supports HUDCO by way of allowing access to low-cost funds, extending guarantees, easing various norms and guiding its broad policies and contours.

HUDCO’s gross non-performing loans stood at 4.5% in FY19. The company’s net NPA stood at 0.5% in FY19. In July 2019, India Ratings and Research affirmed HUDCO’s long-term issuer rating at ‘IND AAA’ with a stable outlook. AAA rated bonds offer a high degree of creditworthiness.

What is expense ratio?

Expense ratio, as the name suggests, is that part of a mutual fund scheme that takes care of expenses related to managing the fund. It is used to meet the administrative, management and other operating expenses of the scheme. Fund houses have to pay salaries to fund managers, commissions to distributors and other marketing costs. As per Securities and Exchange Board of India (SEBI) regulations, all the expenses incurred while managing a particular scheme have to be borne out of the scheme only.

How much is the expense ratio?

As part of its measures to ensure that fund houses do not charge exorbitant amount or percentage as expense ratio, the capital markets regulator has capped expense ratio limit.

Last year, the board of the regulator capped the maximum total expense ratio or TER at 2.25% for open-ended equity schemes, some of which were earlier charging 2.75%.

Though the cut looked marginal in terms of overall cap, the benefits are believed to be significant as the regulator has also laid down various slabs based on the assets of the scheme with the TER going down as the assets rise.

For instance, if the assets under management (AUM) of a particular scheme is in excess of ₹50,000 crore then the TER has been capped at 1.05%. Earlier, any scheme with an AUM of more than ₹300 crore could charge 1.75%. So, for large schemes, the expense ratio was brought down by almost 70 basis points.

According to SEBI's own estimates, the reduction in TER would lead to investors saving around ₹1,300-1,500 crore in commissions.

Is the expense ratio standardised?

No. As a fund house has to put in more efforts and money to increase the overall penetration level of mutual funds to the far corners of the country, the regulator has allowed a higher TER for garnering flows from beyond the top cities of the country.

While lowering the cap for maximum TER, the SEBI allowed for an extra 30 basis points for retail flows from beyond the top 30 cities.

More importantly, it has been mandated that the additional expense will not be allowed for flows from corporates and institutions and will be limited only to retail flows.

Incidentally, all mutual fund houses, industry body Association of Mutual Funds in India (AMFI), along with SEBI have been putting in a lot of effort to channelise more household savings from far-flung towns into the stock markets through the mutual funds’ route.

Q. My wife is a senior citizen (under 80 years) and I am a super senior citizen (80 plus). We have limited income and that too, only from interest. So, we would like to plan for getting the maximum amount by investing in very safe avenues. The limit of investment in Senior Citizens Saving Scheme is ₹15 lakh. Can you please let me know whether both of us can individually invest in this, having the other as nominee? Is this legally permissible? Is there any other safe scheme which would give a return of more than 8%?

Subramanian V

A. Yes, you can individually invest ₹15 lakh each in Post Office Senior Citizens’ Scheme. So, you can effectively invest up to ₹30 lakh. Since the entire amount invested is attributed to the first account holder, you can also hold it jointly with each of you being the first holder in two different accounts and the other a joint holder.

One other good scheme for senior citizens is LIC’s Pradhan Mantri Vaya Vandana Yojana for citizens aged 60 years, introduced by the Government of India. It has an 8% p.a interest payable monthly (effectively 8.3% p.a). It is also available as quarterly, half yearly and annual payouts. The policy term is 10 years and the maximum amount that can be invested is ₹15 lakh. The purchase price will be refunded to the nominee/legal heir on the passing away of the policy holder. On survival of the pensioner over the policy term too, the purchase price shall be paid back with the final pension instalment.

Q. I am shortly due for a VRS in view of some health issues. I hope to invest most of the funds into totally secure and guaranteed returns but I am aware that unless I invest a little bit in mutual funds, NCDs or other market-linked schemes, my family and I may not be able to cope with the increasing cost of inflation in the future. Kindly advise. In one of your recent replies you talked about SEBI advisers. How do I choose a suitable one?

Sukumar P

A.You are right in recognising that you will need market-linked products like mutual funds to ensure that your corpus lasts longer. It is a good idea to seek a registered investment adviser’s help to aid in drawing up a plan as follows: your monthly cash flow plan, your requirement for medical expenses and any amount for emergencies and any financial goals for your family.

You must then identify how much you need to invest in low-risk fixed income products, to meet your monthly expenses for the next 3-5 years. The remaining corpus is what should be used to grow, until such time you need to tap it for your monthly requirements. You can visit https://www.sebi.gov.in/sebiweb/other/OtherAction.do?doRecognisedFpi=yes&intmId=13 to find a RIA near your place, in the city you live in. Look for a person who has understanding across personal finance products and not just mutual funds and insurance. Understand if the fee the adviser charges includes not just a planning fee but to also regularly monitor your investments.

Q. I am 24 and I earn ₹35,000 per month. My expenditure is ₹5,000 per month. How can I invest the remaining ₹30,000 to get maximum returns in 5 to 6 years?

Bhawna Khatri

A.You are starting with a good sum. Given your age, you should invest in market-linked investments such as mutual funds and stocks. To start with, consider consistently performing multi-cap equity funds with some low-risk debt fund, using the systematic investment plan (SIP). Do not stop SIPs if you see the market going down.

(The author is co-founder, Redwood Research)

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