Market regulator Sebi on Wednesday allowed mutual funds to segregate distressed assets in the portfolio of their debt mutual funds, which will be useful to investors in the event of defaults of a debt paper that occurred in the case of the IL&FS crisis.

The decision was taken at the board meeting of the market regulator held here on Wednesday.

“The board noted the proposal to allow mutual funds to create segregated portfolios with respect to debt and money market instruments subject to various safeguards. This facility will be available to mutual funds based on credit events,” a Sebi release said.

A credit event is marked by any change that negatively impacts a borrower’s capacity to meet payment obligations in cases such as default or bankruptcy among others.

Called side-pocketing, it is a mechanism that separates distressed, illiquid and hard-to-value assets from other more liquid assets in a mutual fund’s portfolio.

It prevents the distressed assets from hurting the returns generated from more liquid and better-performing assets, which can lead to panic redemptions in a scheme.

Sebi’s latest move comes in the wake of the debt payment defaults at Infrastructure Leasing & Financial Services Ltd (IL&FS), which led to a liquidity squeeze in the sector.

There have been concerns that a credit event in even one issuer or a group could have systemic implications and lead to volatility in the market.

Therefore, a need was felt to put in place a mechanism to deal with a situation that arises in a mutual fund scheme if there is a credit event on a debt security in its portfolio. The mutual fund advisory committee of Sebi had recommended in favour of side-pocketing.

Speaking after the board meeting, Sebi chairman Ajay Tyagi said the board noted the proposal to allow fund houses to create segregated portfolios with respect to debt and money market instruments.

He, however, added that this will be subject to various safeguards. He pointed out the facility will be available to mutual funds based on credit events. Creation of a segregated portfolio has been made optional for mutual funds. However, approval of trustees is necessary for activating such a portfolio, the market regulator observed.

“It is in the interest of the retail investor that the toxic assets are segregated from assets which are doing well... so that the NAV (net asset value) of normal assets are maintained and there is less redemption pressure,” Tyagi said. “Because initially the information is with the institutional investors and they may redeem and then retail investors may be left with poor portfolio.”