The problem a side pocket solves

A debt fund holds dozens of bonds. One day a rating agency downgrades one of them below investment grade — the borrower may not pay. What’s that bond worth now? Nobody knows. It might recover most of its value in a restructuring, or almost none.

The fund still has to publish a NAV (net asset value) every day, so it marks the bond down to a guess. And that guess creates a race:

  • If the markdown is too small, investors who redeem now get paid out at a NAV that still counts the bad bond at too much, and the eventual loss falls on whoever stays.
  • If it’s too large and the borrower later pays more, new investors who bought at the depressed NAV collect a windfall that belonged to the people who were holding when the bond went bad.

Either way, the investors most alert to the news get the better deal, at the expense of the rest. The debt funds post covered credit risk; this is what happens after it bites.

Definition: what a segregated portfolio is

A segregated portfolio — informally a side pocket — splits the scheme in two on the day of the credit event. The bad paper goes into the segregated portfolio; everything else stays in the main portfolio. SEBI (the Securities and Exchange Board of India) introduced the option in circular SEBI/HO/IMD/DF2/CIR/P/2018/160, 28 December 2018, extended it to unrated paper on actual default in SEBI/HO/IMD/DF2/CIR/P/2019/127, 7 November 2019, and it now sits in paragraph 5.5 of the Master Circular for Mutual Funds (20 March 2026). The key rules:

Rule What it says
Trigger A downgrade to below investment grade (or further downgrades from there) by a SEBI-registered rating agency; for unrated paper, an actual default
Optional At the fund house’s discretion, only if the scheme’s documents allow it; trustees must approve, within 1 business day, with subscriptions and redemptions suspended until they do
Who gets units “All existing investors in the scheme as on the day of the credit event shall be allotted equal number of units in the segregated portfolio as held in the main portfolio”
New money New investors get units in the main portfolio only
Redemptions Redeeming investors are paid the main portfolio’s NAV and keep their segregated units
Exit from the side pocket No redemptions; units listed on a stock exchange within 10 business days so they can be sold
Recovery Any money recovered, even after a write-off, is “immediately distributed to the investors in proportion to their holding in the segregated portfolio”
Fees No investment management fee on the segregated portfolio; its costs can never be charged to the main portfolio
Manager incentives Trustees must be able to cut or claw back the fund managers’ performance pay over the segregated paper

The formula

On the credit event day:

  Main NAV        = (Total assets − bad bond) ÷ units
  Segregated NAV  = (Bad bond at its marked-down value) ÷ units      (same number of units)

  Your holding    = your units × Main NAV  +  your units × Segregated NAV

Later, on recovery:
  Payout per segregated unit = amount recovered ÷ units

The total value on the day is the same as without segregation. What changes is who owns the bad bond from here on: exactly the people who held the fund when it went bad, in proportion to their units.

Worked example: a hypothetical debt fund

A hypothetical debt scheme with ₹500 crore of assets and 40 crore units: NAV ₹12.5. One bond, ₹25 crore (5% of the fund), is downgraded to below investment grade. The valuation agencies mark it down 75%, to ₹6.25 crore. You hold 10,000 units.

  1. Before the event, your holding is worth ₹1,25,000.
  2. Without a side pocket, the NAV drops to ₹12.0312 and you hold ₹1,20,312.
  3. With a side pocket, the main NAV is ₹11.875 — the fund without the bond — and you get 10,000 segregated units at ₹0.1562. Your holding: ₹1,18,750 + ₹1,562 = ₹1,20,312 — the same total, split in two.
  4. Two years later the fund recovers 60% of the bond’s face value, ₹15 crore. That’s ₹0.375 per segregated unit, so ₹3,750 is paid to you — because you held the fund on the day it went bad.

Now see what the side pocket prevented. Without it, the recovery is ₹8.75 crore more than the ₹6.25 crore the bond was marked at, and it flows into the NAV of whoever holds the fund on the recovery day: about ₹0.2188 a unit, or 1.82% on the NAV of ₹12.0312. Someone who bought the day after the downgrade would share in it; you, if you’d redeemed in between, wouldn’t. With the side pocket, new money never touches the bad bond, redeeming investors keep their claim on it, and the race has no prize.

🧒 Explain it like I'm 10 (optional — skip if this is already clear)

Ten friends share a big box of mangoes. One mango looks rotten — maybe it’s fine inside, maybe not.

Without a side pocket, anyone can leave the group right now and take their share of mangoes, counting the maybe-rotten one as worth something. Anyone new can join and get a share of whatever it turns out to be.

With a side pocket, the doubtful mango goes into a little separate bag with the ten friends’ names on it. The good mangoes stay in the big box, where people can come and go. Whatever the doubtful mango turns out to be worth, it belongs to the ten friends who were there when it went bad — nobody else.

Case study: Franklin Templeton’s six debt schemes, 2020

A side pocket handles one bad bond. What happened in April 2020 was a different problem, and it’s the episode most Indian debt-fund investors remember. What follows is only what court orders, SEBI’s order and the fund house’s own disclosures record.

On 23 April 2020, the trustees of Franklin Templeton Mutual Fund decided to wind up six debt schemes: Franklin India Ultra Short Bond Fund, Franklin India Low Duration Fund, Franklin India Short Term Income Plan, Franklin India Income Opportunities Fund, Franklin India Dynamic Accrual Fund and Franklin India Credit Risk Fund. The reason given, as reproduced in the Supreme Court’s order of 12 February 2021: “it is no longer possible for certain schemes of Franklin Templeton to generate adequate liquidity to fund daily redemptions”, in light of “the severe market dislocation” and illiquidity caused by the Covid-19 pandemic. Winding up meant redemptions stopped, and the portfolios would be sold down and the proceeds paid out over time.

Date What happened Source
23 Apr 2020 Trustees decide to wind up the six schemes SEBI order
24 Oct 2020 Karnataka High Court holds that winding up needs unitholders’ consent As described in the Supreme Court’s order
26 to 29 December 2020 Unitholders vote by e-voting; in each scheme 96.78%–97.97% of those voting (by number) vote for winding up Supreme Court order
12 Feb 2021 Supreme Court appoints SBI Funds Management (State Bank of India’s fund house) to carry out the winding up, including selling the assets and paying unitholders Supreme Court order
7 Jun 2021 SEBI order against the fund house (below) SEBI order
June–July 2021 The Securities Appellate Tribunal (SAT) stays SEBI’s order, subject to a ₹250 crore escrow deposit Franklin Templeton disclosure
14 Jul 2021 Supreme Court rules that unitholder consent is to be sought after the wind-up notice, not before it Supreme Court judgment
30 Sep 2025 ₹27,548.21 crore distributed across the six schemes — 109.25% of their assets under management on 23 April 2020 Franklin Templeton
24 Oct 2025 Appeals at SAT still pending, per the fund house’s disclosure Franklin Templeton disclosure

SEBI’s order of 7 June 2021 (WTM/GM/IMD/08/2021-22) directed the asset management company not to launch any new debt scheme for 2 years, to refund the investment management and advisory fees it had collected on the six schemes from 4 June 2018 to 23 April 2020 with 12% simple interest — ₹512.51 crore in all — and to pay a penalty of ₹5 crore. The findings behind those directions are set out in the order itself; the fund house appealed, and we’ve found no final SAT ruling as of this post’s writing.

What the case teaches about mechanisms, which is all this post claims:

  1. Side pockets are for credit events, not liquidity. The segregation rules trigger on a downgrade or default of a specific instrument. The trustees’ stated problem was being unable to raise enough cash for redemptions across the portfolios — a different problem that a side pocket isn’t built to solve.
  2. Illiquid paper and daily redemptions are a mismatch. An open-ended fund promises daily exits. If what it holds can’t be sold quickly without a large price cut, that promise depends on markets staying calm.
  3. Winding up locks everyone in together. Like a side pocket, it stops early leavers from exiting at others’ expense — but for the whole fund, for as long as the sell-down takes. Unitholders in these schemes were paid in tranches over several years.

Common mistakes

  • Reading a side pocket as a loss. It’s a separation, not a writedown. The markdown happens either way; the side pocket decides who owns the outcome.
  • Selling the segregated units in a panic. They’re listed so you can exit, but a thin market for units of a defaulted bond can pay far less than the eventual recovery — or more. Know that you’re making a bet either way.
  • Ignoring the footnote. A scheme’s performance figures must show the fall in NAV from segregation and any recoveries, for at least 3 years after the paper is fully recovered or written off. A fund with a side pocket in its history is telling you something about the credit risk it took.
  • Assuming “debt fund” means your money is always a day away. The rules allow redemptions to be suspended in some circumstances, and 2020 showed a whole scheme can be wound up. Liquidity is a property of what the fund holds, not of its label.

Takeaway: A side pocket splits a defaulted bond away from the rest of a debt fund, so only the people who held the fund when it went bad bear the loss or share the recovery. It stops a run on one bad bond; it can’t create liquidity a whole portfolio doesn’t have, as the 2020 Franklin Templeton wind-up showed.