Markets regulator Sebi on Friday allowed mutual funds to both buy and sell Credit Default Swaps (CDS), a move aimed at increasing liquidity in the corporate bond market. This flexibility to participate in CDS would serve as an additional investment product for mutual funds, Sebi said in a circular.
Earlier, mutual funds were only permitted to use CDS transactions to buy protection against the credit risk of corporate bonds they held. These transactions were limited to Fixed Maturity Plan (FMP) schemes with a duration of more than one year.
Now, “It has been decided to allow greater flexibility to mutual funds to both buy and sell CDS with adequate risk management,” Sebi said.
In market parlance, Credit Default Swaps are like insurance contracts that protect against default by a borrower.
For mutual funds, CDS helps manage the risk of debt securities they hold. When a mutual fund purchases a CDS, it pays a premium to the seller in exchange for protection if a specific bond (the reference entity) defaults.
Under the new framework, Sebi said mutual funds can buy CDS to hedge the credit risk of debt securities they hold.
However, the CDS exposure can’t exceed the value of the debt security being protected.
The regulator said that mutual funds can only buy CDS from sellers with an investment-grade rating or higher.
On CDS sellers, Sebi said that mutual funds can sell CDS as part of synthetic debt investments backed by cash, government securities, or treasury bills. However, Overnight and liquid mutual fund schemes cannot sell CDS.
The total CDS exposure for a scheme –both buying and selling– cannot exceed 10 per cent of the scheme’s assets, Sebi said.
The regulator said that CDS will be valued based on actual traded levels or credit spreads.
Mutual funds have been directed to disclose details of their CDS transactions, including the rating of the CDS seller and any deals with sponsor group companies. The circular would come into effect immediately.
