Markets regulator Sebi on Friday allowed mutual funds to buy and sell Credit Default Swaps (CDS), a move aimed at boosting liquidity in the corporate bond market.
This flexibility to participate in CDS will serve as an additional investment product for mutual funds, Sebi said in a circular.Earlier, mutual funds were only allowed to use CDS sales to buy protection against the credit risk of corporate bonds they hold.
These activities were limited to Firm Growth Program (FMP) programs for more than one year.
Now, “It has been decided to allow greater flexibility in mutual funds for both buying and selling of CDS with adequate risk management,” said Sebi. In market parlance, Credit Default Swaps are like insurance contracts that protect the borrower from default.
With mutual funds, CDS helps manage the risk of the debt securities they hold.
When a mutual fund buys a CDS, it pays a premium to the seller to get protection if the specific bond (the reference entity) defaults. Under this new framework, Sebi said mutual funds can buy CDS to hedge against the credit risk they hold.
However, the CDS exposure cannot exceed the value of the collateral.
The regulator said mutual funds can only buy CDS from dealers at or above investment grade. On CDS sellers, Sebi said mutual funds can sell CDS as part of an investment in synthetic debt backed by cash, government securities, or treasury bills.
However, Overnight and liquid mutual fund schemes cannot sell CDS. The total CDS exposure of the scheme — both buying and selling — cannot exceed 10 per cent of the scheme’s assets, Sebi said.
The regulator said the CDS would be priced based on actual sales rates or credit spreads.
Mutual funds have been ordered to disclose details of their CDS transactions, including the CDS dealer rating and any deals with sponsoring group companies. The circular would go into effect immediately.
