📪What is segregated portfolio in mutual fund.

Debt funds can sometimes face significant challenges if the bonds they invest in default. When a bond in a debt fund defaults, it can lead to negative returns for the entire fund. To manage this risk and protect investors, mutual funds use segregated portfolios to separate the troubled bonds.

Franklin Templeton Case Study

A real-world example of segregated portfolios in action is the Franklin Templeton debt funds case in 2020. Franklin Templeton wound up six of its debt schemes due to severe liquidity issues and the credit risks associated with the underlying securities.

How Segregated Portfolios Worked in the Franklin Templeton Case

When the bonds in Franklin Templeton’s debt funds defaulted or faced downgrades, segregated portfolios were created to manage the fallout:

1. Segregation of Troubled Assets: The defaulted or downgraded bonds were moved into separate portfolios. This separation helped protect the main portfolio from the immediate impact of these troubled bonds.

2. Unit Allocation to Investors: Investors were allocated units in the segregated portfolio proportional to their holdings in the default bonds. This way, any recovery from the defaulted bonds would be directly passed on to the investors holding these units.

3. Main Portfolio Management: The main portfolio continued to operate (With reduced units) with its remaining healthy assets, minimizing the impact of the default on the overall fund performance. For eg out 100 units 5 units were alloted to segregated portfolio and remaining 95 are managed in main fund.

4. Recovery and Distribution: Over time, as the segregated portfolios managed the recovery of the troubled assets, any proceeds were distributed to the investors holding units in these segregated portfolios. Here there might be no intrest paid on the bonds as capital recovery itself is the major challenge.

Impact on Returns

While the creation of segregated portfolios helped manage risks, it also impacted the overall returns for investors. The main portfolios were safeguarded from the immediate adverse effects of defaults, but the segregated portfolios often recovered only a fraction of the bonds' original value, leading to lower overall returns.

Importance of Credit Ratings and Bond Selection

Choosing the right debt fund involves careful consideration of the credit ratings and the number of bonds within the fund. Higher-rated bonds are generally less likely to default, providing more stability for the fund. A well-diversified fund with a mix of bonds can also help spread the risk.

Conclusion

Investing in debt funds requires careful scrutiny of credit ratings and bond selection to minimize the risk of defaults. Segregated portfolios are a useful tool for managing the fallout from troubled bonds, but they can also reduce your overall returns. The Franklin Templeton case highlights the importance of understanding the risks associated with debt fund investments and the role segregated portfolios play in managing these risks.

In summary, while segregated portfolios protect the main fund from the negative effects of defaults, they can also limit your returns. It’s crucial to choose debt funds with strong credit ratings and a diversified mix of bonds to reduce the likelihood of encountering these issues.