Mumbai: The Securities and Exchange Board of India (Sebi) on Friday allowed mutual funds to segregate stressed debt paper via the so-called ‘side pocket’ only if it falls below investment grade.

Debt fund managers would be able to segregate risky assets from other cash and investment holdings only if the rating of the paper falls below ‘BBB’, the market regulator clarified in a circular. Sebi and rating agency valuation term anything below ‘BBB’ as below investment grade.

A side pocket ensures money invested in a mutual fund liquid scheme that is linked to stressed assets gets locked until the fund recovers the cash from the company. Investors can redeem the rest of their money.

However, Sebi has left it to the discretion of the fund manager whether to use the facility or not. “The Sebi circular is a clarification to about what is a credit event on which a fund manager can use a side pocket," said Kaustubh Belapurkar, director of fund research at Morningstar Investment Adviser India Pvt. Ltd.

“I do not envisage a scenario where segregating of these assets will become common. Even today fund managers can take riskier bets but they have largely subscribed to high rated papers. This will be used only in scenarios where there is an actual credit event and investors and fund manager are saddled with bad assets," said Belaprukar.

The regulator has proposed a disincentivising mechanism to further prevent misuse such as taking riskier bets.

“Trustees shall ensure to have a mechanism in place to negatively impact the performance incentives of fund managers, chief investment officers (CIOs) involved in the investment process of securities under the segregated portfolio," said Sebi.

This disincentivisation would mirror the existing mechanism for performance incentives of the fund house.

The segregation of assets will need to be approved by the trustee board. All further subscription and redemption will be barred in the scheme, to also ensure that no one set of investor ends taking advantage till the approval.

All existing investors in the scheme as on the day of the credit event will be allotted an equal number of units in the segregated portfolio as held in the main portfolio.

No subscription and redemption will be allowed in the segregated portfolio, but unit holders will be given an exit opportunity.

“In order to facilitate exit to unit holders in segregated portfolio, AMC (asset management companies) shall enable listing of units of segregated portfolio on the recognized stock exchange within 10 working days of creation of segregated portfolio," said Sebi.

AMCs will also not be allowed to charge investment and advisory fee on the segregated portfolio.