Credit event
Also written Credit events
An adverse credit development, such as a rating downgrade by a SEBI-registered CRA or an actual default, that permits a debt fund to create a segregated portfolio. In a CDS it triggers the protection payment.
In plain language
A credit event is the moment a borrower's ability to pay comes into real doubt: its rating is cut sharply, or it actually misses a payment.
For a debt mutual fund, that moment creates an unfairness. Investors who redeem first get paid at a NAV that may not yet fully reflect the damage, and those who stay behind absorb the loss. SEBI's answer is to let the fund wall off the troubled paper into a segregated portfolio from the day of the credit event.
In a credit default swap, the same phrase names the trigger for the protection seller to pay the protection buyer.
How it works
In mutual funds (Chapters 7 and 10):
- In December 2018, SEBI permitted a segregated portfolio of debt and money market instruments "to ensure fair treatment to all investors in case of a credit event and to deal with liquidity risk".
- The credit event at issuer level is a downgrade in credit rating by a SEBI-registered Credit Rating Agency. Creation of the segregated portfolio is optional, at the AMC's discretion.
- By a circular of November 7, 2019, for unrated instruments of an issuer with no outstanding rated debt, segregation is allowed only on actual default of interest or principal. The AMC informs AMFI, which informs all AMCs.
- New schemes launched after November 7, 2019 must have enabling provisions in the SID; AMCs need a written policy approved by trustees.
Once trustees approve: the segregated portfolio is effective from the day of the credit event; a press release is issued; NAVs of both portfolios are disclosed; all existing investors get an equal number of units in the segregated portfolio; no subscription or redemption in it, but its units are listed within 10 working days. No investment and advisory fee is charged on it; other TER is charged pro-rata only on recovery.
In a credit default swap (Chapter 19): the protection seller pays the buyer any loss in value on the reference obligation "if a credit event (e.g., default)" occurs during the contract.
A worked example
The workbook's Chapter 10 illustration. A debt scheme with 10,000 units holds, on 30 September 2019:
| Security | Market value (Rs) |
|---|---|
| 8.00% XYZ Ltd NCD (downgraded A− to C) | 12,38,800 |
| 7.80% AVC Ltd NCD (AAA) | 25,25,525 |
| 7.65% UYV Ltd NCD (AAA) | 21,00,462 |
| 8.10% MNO Ltd NCD (A−) | 29,86,440 |
| Cash and equivalents | 11,50,000 |
| Net assets | 1,00,01,227 |
NAV = 1,00,01,227 ÷ 10,000 = Rs 1,000.1227. XYZ was valued at Rs 99.105 before the downgrade and is marked down 50% to Rs 49.552.
The XYZ holding moves to a segregated portfolio from the day of the credit event:
Main portfolio NAV = 87,62,427 ÷ 10,000 = Rs 876.2427
Segregated portfolio NAV = 12,38,800 ÷ 10,000 = Rs 123.88
Total = Rs 1,000.1227
An investor with 500 units now holds 500 main-portfolio units worth Rs 4,38,121 and 500 segregated units worth Rs 61,940. If she redeems, she is paid on the main NAV only and keeps her segregated units, sharing in any later recovery from XYZ. A new investor buys only main-portfolio units.
Why NISM asks about it
Chapter 7 (Net Asset Value, Total Expense Ratio and Pricing of Units) gives the TER and NAV rules for a segregated portfolio; Chapter 10 (Risk, Return and Performance of Funds) sets out the credit event trigger, the 2018 and 2019 circulars, the operational steps and the XYZ Ltd illustration; Chapter 4 links it to the 2018 credit crisis; Chapter 19 uses the term for credit default swaps. Expect: what counts as a credit event, the actual-default condition for unrated paper, no fee on the segregated portfolio, and a NAV-split calculation.
Common exam traps
- Rated paper: downgrade by a SEBI-registered CRA. Unrated paper (issuer with no rated debt): actual default only.
- Segregation is optional, at the AMC's discretion, but needs trustee approval.
- No subscription or redemption in the segregated portfolio; exit is via listing within 10 working days.
- Every existing investor gets the same number of segregated units as main-portfolio units held.
- No investment and advisory fee on the segregated portfolio; other TER only pro-rata on recovery, and never charged to the main portfolio.
- Listing does not guarantee liquidity; segregated units may trade well below NAV or realise nothing.
Check yourself
1.An AMC creates a segregated portfolio following a credit event. What is the position of unitholders?
- a)Only investors who consent are allotted segregated units, at the AMC's discretion
- b)All existing investors are allotted the same number of units in the segregated portfolio as they held in the main portfolio; no subscription or redemption is allowed in it; and it must be listed on a recognised exchange within 10 working days
- c)The segregated units may be redeemed at any time at their declared NAV
- d)Investors subscribing the next day receive units in both portfolios
Show the answer
Answer: (b) All existing investors are allotted the same number of units in the segregated portfolio as they held in the main portfolio; no subscription or redemption is allowed in it; and it must be listed on a recognised exchange within 10 working days
"ALL EXISTING INVESTORS SHALL BE ALLOTTED EQUAL NUMBER OF UNITS IN THE SEGREGATED PORTFOLIO AS HELD IN THE MAIN PORTFOLIO AS ON THE DAY OF THE CREDIT EVENT", and "NO REDEMPTION OR SUBSCRIPTION IS ALLOWED IN THE SEGREGATED PORTFOLIO. However, in order to facilitate exit to unitholders..., AMC shall ENABLE LISTING of units of segregated portfolio on the recognized stock exchange WITHIN 10 WORKING DAYS of creation." Option (d) is reversed by the text: "investors SUBSCRIBING to the scheme, will be allotted units ONLY IN THE MAIN PORTFOLIO based on its NAV", while "the investors REDEEMING proceeds based on the NAV of main portfolio WILL CONTINUE TO HOLD THE UNITS OF SEGREGATED PORTFOLIO." Other rules: it is "effective FROM THE DAY OF CREDIT EVENT", a press release issues immediately, and "NAV of BOTH segregated and main portfolio shall be disclosed from the day of the credit event" and daily thereafter. Listing is no guarantee of an exit — "there may NOT be active trading... trading price... may be SIGNIFICANTLY LOWER than the prevailing NAV."
Where this is taught
Free preparation for NISM Series V-ARelated terms
- Credit ratingAn opinion on how likely a borrower is to service an instrument on time, reduced to a symbol by a SEBI-registered rating agency — and reviewed continuously, not fixed for the life of the bond.
- Segregated portfolioA ring-fenced sub-portfolio holding the debt instrument hit by a credit event, split out of a scheme so that the good assets stay liquid and exiting investors cannot leave the damaged paper behind.
- Credit Default SwapA contract in which a protection buyer pays a regular premium to a protection seller, who agrees to pay any loss in value on a specified reference obligation if a credit event such as default occurs.
- Credit spreadThe extra yield a non-government borrower must pay over a government security of the same tenor — the market price of credit risk, quoted as an add-on over the risk-free rate.
- Deemed residual maturityThe maturity SEBI tells mutual funds to assume when valuing perpetual AT1 and AT2 bank bonds and computing their duration. For AT1 bonds it is 100 years from issuance from April 1, 2023.
- GatingA temporary restriction on mutual fund redemptions, allowed only in a market-wide crisis, for at most 10 working days in any 90 days — and never on the first Rs 2 lakh of any redemption request.
- Main portfolioSEBI's defined term for what is left of a mutual fund scheme once a segregated portfolio has been carved out of it — the scheme portfolio excluding the segregated portfolio.
- Closed-end discountThe gap by which units of a listed close-ended (or interval) scheme trade below their NAV on the stock exchange. The workbook says there is no limit to it; it tends to narrow as maturity approaches.
- Duration managementA debt fund manager's deliberate strategy of lengthening or shortening a portfolio's duration based on a view on interest rates, used only where the scheme's mandate allows it.
- Co-mingling riskThe risk, in securitised debt, that a servicer briefly mixes investor collections with its own funds before remitting them, so a servicer default in that gap causes investors a loss.
- Loan to Value (LTV) ratioIn securitised debt, the share of a financed asset's cost that came from a loan rather than the borrower's own money — the lower the LTV, the more the borrower loses by defaulting, and the safer the pool.