Rs 25,215 Crore in “Safe” Debt Funds, Frozen Overnight

Tanmay Ghatpande retired from a power-plant maintenance job in Nagpur in early 2019 with a gratuity and provident fund payout of about ₹8,00,000. His bank relationship manager steered him firmly away from “risky” equity and into what she called a low-duration corporate bond fund — a debt mutual fund holding, among other things, commercial paper issued by Dewan Housing Finance Corporation (DHFL). He did not know the fund held DHFL paper. He did not know what a credit rating was. He knew “debt fund” sounded like “fixed deposit, but slightly better,” and that was the entire due diligence.

Then, in one week in June 2019, his statement did something a fixed deposit statement is not supposed to do: it split in two.

The DHFL default that started it

Dewan Housing Finance Corporation (DHFL) carried a AAA rating as recently as February 2019. By 5 June 2019, it had been downgraded straight to Default. As many as 165 mutual fund schemes across 24 AMCs had exposure to DHFL paper, totalling roughly ₹5,336 crore, as of April 2019. When Tata Mutual Fund became the first AMC to side-pocket its exposure, three of its debt schemes took immediate, visible NAV hits: Tata Corporate Bond Fund fell 30%, Tata Medium Term Fund fell 12%, and Tata Treasury Advantage Fund fell 4% — in a single day, in funds many retail investors held expecting bank-FD-like stability. Tanmay’s fund was one of the schemes that took the 30% hit. On paper, his ₹8,00,000 became ₹5,60,000 he could still touch and ₹2,40,000 that simply stopped existing as spendable money, overnight, with no phone call warning him first.

The circular that actually made this legal, and what it requires before it can happen

Here is the part almost nobody explains to someone like Tanmay: side-pocketing was not an emergency improvisation by his fund house. It is a specific mechanism SEBI created on purpose, through a circular dated 28 December 2018, months before the DHFL default, precisely so this kind of split could happen in an orderly way rather than through a fund-wide panic and a run on redemptions.

The circular does not let an AMC segregate a bond just because it is worried. It sets a specific trigger: a “credit event,” defined as an actual default, or a downgrade of the instrument to “below investment grade,” by a SEBI-registered credit rating agency. Below investment grade means a rating agency has already concluded, in its own published methodology, that the instrument’s credit quality has fallen out of the “safe” band — it is not the fund manager’s private judgment call. Once that downgrade or default happens, the AMC has the option, not the obligation, to segregate that specific asset into a separate portfolio, subject to trustee approval and a policy the scheme must have already disclosed in its offer document. Every unit holder in the fund on the day of the credit event gets units in both the surviving “main” portfolio and the new “segregated” one, in the same proportion they already held — nobody is singled out, and nobody who bought in after the credit event shares the segregated loss.

This is the detail that would have changed how Tanmay reacted, had anyone told him at the time: side-pocketing is not the fund “losing” his money in the way a bad trade loses money. It is an accounting and governance mechanism that ring-fences a specific, already-impaired asset so the healthy 70% of the fund is not held hostage to the recovery timeline of the impaired 30%. The 30% did not vanish the day it was segregated — it was simply relabelled as illiquid and handed a different, slower recovery path, separate from the units he could still redeem on demand.

Tanmay chose to wait, mostly because nobody at his branch offered to buy the segregated units off him at any price worth taking. Over the following two years, DHFL went through the National Company Law Tribunal’s insolvency process and was eventually acquired by another financial group under a resolution plan. Recoveries for creditors, including the mutual fund schemes holding DHFL paper, were widely reported at a little under half of the instrument’s face value, paid out in tranches as the resolution concluded — not the whole ₹2,40,000, and not for more than two years after it was frozen. He describes the two years mostly in terms of what he could not do with the money: no top-up to his daughter’s tuition fund the year he actually needed it, an FD he could not renew at the size he wanted, and a running, low-grade anxiety about a number on an app that would not move.

Then came the bigger one: Franklin Templeton

The DHFL episode was a preview. In April 2020, Franklin Templeton Mutual Fund abruptly wound up six of its debt schemes entirely — Franklin India Low Duration Fund, Ultra Short Bond Fund, Short Term Income Plan, Credit Risk Fund, Dynamic Accrual Fund, and Income Opportunities Fund — citing a total lack of liquidity in the bond market during the Covid lockdown. Combined AUM across the six schemes stood at roughly ₹25,215 crore. Investors could not redeem a single rupee from these funds for months while the matter went through the Supreme Court, which had to order Franklin Templeton to secure investor consent before proceeding with the wind-up. Notice that this is a different, more severe failure mode than side-pocketing: side-pocketing at least leaves the clean 70–95% of a portfolio redeemable while the bad piece is quarantined. Franklin Templeton’s schemes froze in their entirety, healthy assets included, because the wind-up mechanism used was different from a segregated portfolio.

The uncomfortable truth in the eventual “happy ending”

Franklin Templeton’s liquidators eventually distributed more than 100% of the reported AUM value back to investors — an outcome that, in hindsight, worked out. But “it worked out eventually” is not the same as “it was safe.” Investors who needed that money for an emergency, a medical bill, or a child’s school fee during the 12–18 months it was frozen had no recourse regardless of how the story ultimately ended. A debt fund’s marketing rarely mentions that your redemption can simply stop working for reasons entirely outside your control or the fund manager’s day-to-day skill. Tanmay’s segregated units eventually paid out a partial recovery too, and by the numbers alone his story also “worked out” — roughly ₹1,10,000 back against ₹2,40,000 frozen, arriving in three tranches across nearly two and a half years. Nobody who calculates a retirement corpus at 7% assumed a two-year detour with a haircut in the middle of it.

What actually changed since

SEBI tightened debt fund risk disclosure and introduced Potential Risk Class (PRC) matrices specifically so investors can see a fund’s credit-risk and interest-rate-risk exposure at a glance, rather than relying on the word “debt” to imply safety. Side-pocketing itself is now a formal, SEBI-sanctioned mechanism with a defined trigger, rather than an improvised response, meaning a future credit event would be handled through the same disclosed process instead of an ad hoc scramble. That does not mean it cannot happen to your fund. It means that if it does, there is now a rulebook governing how, not whether the process is fair to you personally.

What to actually do before you invest, and if it happens to you

Before you put money into anything labelled “debt fund,” open the Scheme Information Document or factsheet and find two things: the Potential Risk Class matrix, and the portfolio’s actual holdings by issuer and rating. A fund holding 90% sovereign and top-rated paper is not the same risk as one chasing yield through lower-rated corporate bonds, even if both are called “low duration.” If a credit event does hit a fund you hold, resist the urge to redeem your remaining, unaffected units in a panic — that just crystallises a loss on the healthy part of the portfolio while doing nothing for the segregated part, which you now hold regardless of what you do with the rest. Read the AMC’s specific disclosure on the segregated portfolio’s expected resolution path before deciding whether to sell it at a distressed exchange price or hold for a potential, slower recovery.

The calculator settles the one question that actually matters when you are deciding between a debt fund and a plain deposit ladder: not “which one returns more on paper” but “which one can I live without touching for however long a resolution actually takes.” Tanmay’s real answer, discovered the hard way, was that he could not.

What this does not mean

This does not mean debt mutual funds are secretly equity-risk products in disguise, or that side-pocketing is a sign the entire mutual fund industry is unsafe. Most debt funds, most years, never trigger a credit event at all, and the majority of debt fund AUM in India sits in liquid and overnight funds holding government securities and top-rated paper, where a DHFL-style default is structurally unlikely. It also does not mean Tanmay’s bank relationship manager broke any rule — recommending a corporate bond fund to a retiree is not, by itself, mis-selling. It means “debt fund” is a category label, not a risk rating, and the label alone told Tanmay nothing about what he actually owned.

Frequently asked questions

Can side-pocketing happen to equity mutual funds too?

No — side-pocketing is specific to debt instruments that default or face a severe credit downgrade; it has no direct equivalent in equity funds, where price discovery happens continuously on the exchange rather than through a periodic issuer rating.

Are all debt funds this risky?

No — overnight funds, liquid funds, and funds sticking to high-quality government and top-rated paper carry far less credit risk than credit-risk or lower-rated corporate bond funds. The category name alone doesn’t tell you which one you’re holding; the Potential Risk Class matrix and portfolio disclosure do.

Does the AMC have to segregate the portfolio once a credit event happens?

No — the December 2018 circular makes segregation optional at the AMC’s discretion, once the trustees approve it against a policy the scheme has already disclosed. An AMC can choose not to segregate and instead mark down the whole portfolio’s NAV, which spreads the loss differently across unit holders depending on when they entered or exit.

Can I sell my segregated units whenever I want, like normal fund units?

Not on demand. Segregated portfolio units are listed on a stock exchange to provide an exit route, but a listing is not the same as a liquid market — buyers can be scarce, and any sale may happen at a steep discount to the unit’s stated value, which is exactly what Tanmay found when he checked.

Regulatory source: SEBI‘s circular of 28 December 2018 sets out the credit-event trigger, trustee-approval requirement, and pro-rata segregation mechanism described above; verify the current version and any subsequent amendments directly on sebi.gov.in before relying on the specific mechanics. The DHFL and Franklin Templeton figures are drawn from widely reported AMC and court disclosures at the time. The reconstruction of Tanmay Ghatpande’s holding, timeline and arithmetic is this article’s own.

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Disclaimer: This article is for general information only and is not financial or investment advice. “Tanmay Ghatpande” is a composite character built for illustration and not a real individual. Credit events and their resolution vary case by case — check a debt fund’s current Potential Risk Class and portfolio disclosure before investing.