Bond funds can transfer corporate bonds to a separate account if the bonds they own fail to pay interest on schedule or are downgraded in credit. This separate account is known as the ‘side pocket’. We must exercise caution when an AMC sends a communication to the unit holders of one of its funds stating that the fund was establishing a provision for a separated or segregated portfolio.
To better comprehend segregated portfolios, consider the risks that bond funds face. Investing in government bonds exposes a fund to interest rate and reinvestment risk. Interest-rate risk is the possibility that bond prices would fall while the bond market anticipates interest rates to rise. Furthermore, investing in corporate bonds involves credit risk. A notion that credit risk has increased may occur as a result of the bond issuing company’s failure to pay interest on time or a downgrade in their credit rating.
The notion of a segregated account in bond funds originated from hedge funds, which also participate in private equity. Private equity is stored in a separate account known as a ‘side pocket’ since it is an illiquid investment, whereas the hedge fund’s main account contains all of its liquid investments. However, it is crucial to note that investing in bond funds is not the same as investing in bonds. If you invest in a bond and keep it until maturity, you will get the par value independent of interest rate fluctuations. This means that direct bond investments are not subject to interest rate risk, whereas bond fund investments are.
However, while investing directly in government bonds reduces interest rate risk, it does expose investors to reinvestment risk. But parking your money in fixed deposits and recurring deposits with banks have no interest or reinvestment risk. They do carry a minimal amount of credit risk, but that risk is lower than what bond funds are exposed to, as the bank deposits are backed by the banks that are too big to fail, and even if they fail, further larger banks acquire those failing banks (as we have seen in the past), thus safeguarding the deposits.
