Mutual Fund Mastery puzzles, solved step by step

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  1. 051A Rs 800 crore debt fund writes a Rs 40 crore bond down to zero and segregates it into a separate portfolio. An investor holds 10,000 units bought at a NAV of Rs 25. What does she hold after segregation, at what NAVs, and what does she receive if 60% of the bond is later recovered?NAV, units and fund mechanicsHardFund operationsFixed income desks

    Try it first

    Right after segregation, what does her holding look like?

    Show the worked solution

    She holds 10,000 main units at Rs 23.75, worth Rs 2,37,500, plus 10,000 segregated units valued at zero. The fund has 32 crore units; Rs 760 crore of healthy bonds over those units gives Rs 23.75. If 60% of the bond comes back, Rs 24 crore is spread over 32 crore segregated units, Rs 0.75 each, so she receives Rs 7,500. Her total is Rs 2,45,000 against Rs 2,50,000 before.

    Why split the fund instead of simply marking the bond to zero?

    Picture a housing society that lends money to a builder who then stops paying. If the society writes the loan off and lets members leave with their share of what is left, the members who leave first give up their slice of any money later recovered, and the ones who stay collect it all. A plain write-down hands the value of a future recovery to whoever is still in the fund when the cash arrives, not to whoever owned the fund when the loss happened. A segregated portfolioA separate pool, created on a credit event, that holds only the troubled bond. Everyone who held the fund that day gets matching units in it. fixes that by giving every holder on the day a separate, frozen claim on the bad bond.

    Here the fund has Rs 800 crore at a NAV of Rs 25, so it has 32 crore units. The bond of Rs 40 crore moves out; Rs 760 crore of healthy bonds stays behind. Divide by the same 32 crore units and the main NAV is Rs 23.75. Her 10,000 units there are worth Rs 2,37,500, and she also receives 10,000 segregated units, valued at nothing today.

    One fund becomes two: every holder keeps a claim on the bad bondBefore the defaultFund Rs 800 crore32 crore unitsNAV Rs 25.00Her 10,000 unitsRs 2,50,000Main portfolio: open for tradingRs 760 crore of healthy bondsNAV 760 / 32 = Rs 23.75Her 10,000 units: Rs 2,37,500Segregated portfolio: frozenThe Rs 40 crore bond, marked at 010,000 matching units, NAV Rs 0.00No redemptions; paid out as cash arrivesIf 60% recoveredRs 24 crore / 32 crore= Rs 0.75 a unitHer share Rs 7,500What she ends withRs 2,37,500 + Rs 7,500 = Rs 2,45,000, against Rs 2,50,000 before the default
    On the credit event the fund splits: the main portfolio keeps Rs 760 crore at a NAV of Rs 23.75, the defaulted bond moves into a segregated portfolio at zero with matching units, and a 60% recovery later pays Rs 0.75 a unit, taking her total to Rs 2,45,000 against Rs 2,50,000 before.

    What does the recovery pay, and who would have got it without segregation?

    A 60% recovery brings back Rs 24 crore. Spread across 32 crore segregated units it is Rs 0.75 a unit, so she receives Rs 7,500 whether or not she has since redeemed her main units. Without segregation, the same Rs 24 crore would land on whoever held the single fund on recovery day. Suppose half the units redeem at Rs 23.75 after the write-down: the recovery then lands on only 16 crore units, Rs 1.50 each. The holders who stayed collect Rs 15,000 per 10,000 units, double their fair share, and the holders who left get nothing.

    The relationship
    NAVmain=800−4032=23.75recovery per unit=0.6×4032=0.75\text{NAV}_{\text{main}} = \frac{800 - 40}{32} = 23.75 \qquad \text{recovery per unit} = \frac{0.6 \times 40}{32} = 0.75
    800fund assets before the default, Rs crore
    40the defaulted bond, Rs crore
    32units outstanding, crore, fixed on the day of segregation
    0.6the share of the bond later recovered
    What it says in wordsBoth portfolios divide by the same unit count, because every holder on the day gets one segregated unit per main unit.

    Say the limit too. Segregation does not reduce the loss; she is still Rs 5,000 down on Rs 2,50,000. It only makes sure the loss and any recovery fall on the same people. Indian rules allow it only after a defined credit event such as a rating downgrade, with conditions set in SEBI circulars that should be checked before quoting them.

    Where candidates lose it

    Most candidates stop at the main NAV of Rs 23.75 and forget the second set of units. The interviewer is testing whether you know the investor keeps a claim on the bad bond, which is the whole reason segregation exists.

    The second loss is dividing the recovery by the wrong number. The segregated units match the units outstanding on the day of the event, 32 crore, not the units left in the main portfolio after later redemptions or new purchases.

    What the interviewer asks next

    • A new investor buys the main portfolio the day after segregation. Does she get any segregated units?
    • Why might a fund manager prefer to hold a defaulted bond at a small positive value instead of zero?
    • The recovery arrives in three instalments over two years. How is it paid out?