Case 055Investment and portfolio riskWarm up
A credit fund has 9% of its Rs 2,000 crore portfolio in one issuer that has just defaulted, with expected recovery of 30%. What is the NAV hit, how would a segregated portfolio ring-fence the bad bond, and what does it mean for investors who redeem next week?
1The situation
Corazal Credit Fund is an open-ended debt fund with Rs 2,000 crore of assets and 20 crore units, so its NAV is Rs 100.00. It holds Rs 180 crore, 9% of the fund, in bonds of a single issuer that has just missed a coupon. The fund's valuation team expects to recover about 30% of face value over the next two years.
Investors have already asked to redeem about 20% of the units next week. The fund's rules allow it to create a segregated portfolio after a credit event of this kind, subject to the regulator's conditions.
2Your task
Compute the NAV hit, explain how segregation works, and show what it changes for investors who redeem next week and those who stay.
Quick check
How much does the NAV fall when the bonds are marked to a 30% recovery?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
NAV falls 6.3%, from Rs 100.00 to Rs 93.70, when the Rs 180 crore position is marked to a 30% recovery. Segregation splits the fund: performing bonds stay in a main portfolio worth Rs 91.00 a unit that can be redeemed, and the defaulted bond goes into a segregated portfolio worth Rs 2.70 a unit that cannot. Next week's redeemers take the main portfolio and keep their share of the recovery, so the uncertainty is shared by everyone who held on the day.
Step 1How big is the NAV hit?
The position is 9% of the fund, Rs 180 crore. Only the part not expected back is lost: 70% of Rs 180 crore is Rs 126 crore, a 6.3% fall in NAV. The fund must mark the bond down now, on the day of the credit event, not when the recovery arrives. A stale price would let anyone redeeming this week leave at Rs 100.00 and leave the whole loss to those who stay.
Step 2Why is a single marked-down NAV still unfair to someone?
Think of four flatmates who lend a friend money together; the friend says he may repay about a third. If one flatmate moves out tomorrow and takes his share of the rent deposit plus a third of his loan share in cash, the other three are left holding the whole uncertainty. The 30% recovery is only an estimate, and whoever redeems first is paid for it in cash while those who stay carry the risk that it comes in lower. Suppose 20% of units redeem at Rs 93.70 and the recovery turns out to be 10%, not 30%. The Rs 36 crore shortfall falls on the remaining 16 crore units alone, taking their value to Rs 91.45.
Step 3How does segregation change who carries the recovery risk?
On the credit event the fund splits. Every unitholder on that day gets one unit of the main portfolio, Rs 91.00, and one unit of the segregated portfolio, Rs 2.70, so the bad bond is shared in proportion and nobody can cash out of it early. Redeemers next week receive Rs 91.00 in cash and keep their segregated units. If the recovery comes in at 10%, each segregated unit pays Rs 0.90, and every original holder ends at Rs 91.90, redeemer or not.
| Rs a unit, if recovery ends at 10% | Without segregation | With segregation |
|---|---|---|
| Investor who redeems next week | 93.70 | 91.00 + 0.90 = 91.90 |
| Investor who stays | 91.45 | 91.90 |
| Gap between them | 2.25 | 0.00 |
Step 4What would a risk manager check before and after?
Before: a 9% position in one issuer is the real finding. A sensible single-issuer limit keeps any one default from costing investors more than about a year of the fund's yield, and 6.3% is well beyond that. After: the fund's liquidity. Paying 20% redemptions from the main portfolio means selling the best bonds first unless the fund keeps a cash buffer, which quietly concentrates what is left. The segregation rules, including which credit events qualify and how the segregated units are listed and valued, are set by SEBI and should be confirmed in the current circular. Segregation shares a loss fairly; it does not reduce it.
Where candidates lose it
Candidates often answer 9%, the whole position, forgetting the expected recovery, or say the NAV should not move until the recovery is known, which is exactly the stale price that rewards whoever redeems first.
The second miss is thinking segregation protects investors from the loss. It does not. It stops early redeemers leaving the uncertain part of the loss to those who stay.
What the interviewer asks next
- What if the recovery comes in at 50% instead? Who gains under each approach?
- Why would a fund manager be reluctant to segregate, and why might that reluctance be wrong?
- How should the fund's concentration limit be set, given what this default cost?
Company names and figures are illustrative.