A Rs 1,500 crore credit fund holds 9% in bonds of one issuer, which is downgraded from AA to BB and falls 25%. What happens to NAV, why do early redeemers gain at the expense of those who stay, and how does side-pocketing work?

NAV falls 2.25%, from Rs 100 to Rs 97.75, and a side pocket stops the leavers taking value from the stayers. If the bond is marked too slowly, redeemers exit at too high a price; even at a fair price, they are paid from liquid assets, leaving the stayers holding more of the bad bond. Side-pocketing splits the bond into a separate portfolio in which every current investor keeps an equal share, so redemptions come only from the liquid main portfolio.

Mark the bond and divide. Rs 135 crore falls 25%, a loss of Rs 33.75 crore on a Rs 1,500 crore fund. The NAV falls by the weight times the fall, 9% times 25%, 2.25%, to Rs 97.75 a unit. The headline sounds small, but the problem is not the size of the fall, it is who ends up bearing it.

In two ways. First, if the valuation lags: suppose the bond is marked down only 10% for the first few days while the market works out a price. NAV reads Rs 99.10 instead of Rs 97.75, and the 30% of units that leave are paid about Rs 6.1 crore more than they are worth, money that comes out of the stayers' pockets. Second, even at a fair price, redemptions are paid from the liquid bonds, so the stayers own a bigger slice of the illiquid one: its weight rises from 6.9% to about 9.9%, and any further loss lands on them alone. It is the last people at a shared restaurant table being left with the bill for the most expensive dish.

On a credit event, such as a downgrade below investment grade, the fund can move the affected bond into a segregated portfolioA separate portfolio created to hold a distressed security, whose units go to every investor on the record date in proportion to their holding. Also called a side pocket.. Every investor on the record date gets one unit of the segregated portfolio for each unit held, so each unit of Rs 97.75 becomes Rs 91.00 in the main portfolio and Rs 6.75 in the side pocket. Redemptions are paid only from the main portfolio. Whatever Kesarigarh eventually pays goes to everyone who held units on the record date, leavers and stayers alike.

Say the limits. A side pocket does not recover any money; it only shares the loss fairly. It needs trustee approval and disclosure, the manager should not earn full fees on the segregated assets, and it can be misused to hide a bad credit call from the headline NAV, which is why regulators attach conditions. The deeper fix is concentration: 9% in one sub-AA issuer was the decision that made the side pocket necessary.