Market regulator SEBI has agreed to AMFI’s recommendation to allow asset management companies (AMCs) to join inter-creditor agreement (ICA).

Mutual funds have had exposures to stressed assets of companies like DHFL and IL&FS. Since mutual funds are not in the business of lending, they didn’t have a proper framework to recover their dues. This has been the primary motivation to join ICA.

Earlier, HDFC Mutual Fund and Kotak Mutual Fund had entered into a standstill pact with Essel Group to give it a chance to repay loans. SEBI was not in favour of this agreement and alleged that there had been a violation of mutual fund norms on investors’ protection of interests and due diligence.

This time, fund houses wanted to make sure that all the requisites are sought from the regulator. The new SEBI guidelines will allow mutual funds to participate in the resolution of stressed assets, but with certain conditions.

According to SEBI, the segregation (side pocketing) of portfolio pursuant to a credit event should be the pre-condition for signing ICA for the assets in the segregated portfolio. Side pocketing is a framework that allows mutual funds to segregate stressed assets of a scheme from the good ones in case of a credit event such as downgrade of a paper below investment grade or a repayment default. Segregation must be done on the day of credit event itself.

[Read: Should SEBI Allow Side-Pocketing In Mutual Fund]

Further, mutual funds must inform credit rating agencies of any such agreement. As per SEBI, if the revised credit rating of those securities is downgraded to below investment grade, the AMCs may segregate the portfolio. If not segregated already, pursuant to which then AMCs can at their option sign the ICA.

AMCs will be free to exit ICA if the resolution plan imposes conditions that are not in accordance with SEBI’s provisions on mutual funds or if the resolution plan is not implemented within 180 days from the end of review period. This period can be extended with approval from board and trustees if it is in the interest of the investors.

[Read: Are You Holding Debt Mutual Funds With Stressed Assets?]

Will it help investors?

The overall exposure of mutual funds to DHFL is estimated to be Rs 4,000 crore. Most mutual funds with exposure to DHFL have not segregated their portfolio– which means that they will not be able to join DHFL’s resolution process.

[Read: How Is DHFL’s Interest Delay Impacting Your Debt Mutual Funds]

Only Tata mutual fund has created side-pocket for three schemes affected by DHFL. The schemes are Tata Corporate Bond Fund, Tata Medium Term Fund and Tata Treasury Advantage Fund. However, it is unclear whether Tata MF will join ICA for DHFL.

The option will remain open for mutual funds to join future ICAs. But given the track record of low resolution rate, high creditor haircuts, and lack of time-bound resolution, joining the ICA may not be in the best interest of the unit holders.

If the fund house is confident of recovering the dues, it may join ICA, otherwise selling off the exposure to prevent further decline of NAVs could be the right choice. AMCs must evaluate the available options and decide the best recourse.

What should investors do?

Investors must remember that the option to join ICA will not make debt investment safe because all investments come with certain level of risk. Nonetheless, the move definitely gives fund houses one more course of recovery apart from the ones available.

SEBI has been continuously taking measures to safeguard interest of debt mutual fund investors and make fund houses accountable for their actions.

While the market regulator is doing its best to protect investor’s interest, as an investor, you must be careful before selecting any debt fund (including short duration funds) for investment. More importantly, evaluate your financial goals, risk profile, and investment horizon and follow a personalised asset allocation to pick the right scheme for your needs.

[Read: Approach Debt Funds With Your Eyes Wide Open…]

Pay attention to the portfolio characteristics and quality of the scheme to avoid schemes with high exposure to stressed assets. Choose debt schemes offered by mutual fund houses which follow robust investment processes and have adequate risk management systems in place.

This article first appeared on PersonalFN here.