The Securities and Exchange Board of India (Sebi) on June 7, 2024 proposed allowing greater flexibility to mutual funds to participate in credit default swaps (CDS).
At present, mutual funds are only allowed to participate in CDS transactions as users, i.e., to buy credit protection only on corporate bonds held by them on fixed maturity plan (FMP) schemes having tenures of more than one year.
Sebi has now sought comments from the public before July 1, 2024, if CDS buying for all schemes and CDS selling for all schemes (except overnight and liquid schemes) should be allowed.
Sebi said that mutual funds can buy CDS programmes rated by credit rating agencies (CRAs) for both investment grade and below-investment grade debt securities. The capital markets regulator said that exposure through CDS (notional amount of both CDS bought and sold) shall not exceed 10 per cent of the AUM of schemes and shall be within the overall limit of derivatives exposure prescribed in the scheme information document (SID).
In case the protected debt security is sold, schemes should ensure that the respective CDS position is closed within seven days of selling such protected debt security. Also, an MF may be permitted to sell CDS only as investors in synthetic debt securities, or in other ways, sell CDS as a reference obligation covered with cash or government securities or treasury bills. Therefore, overnight and liquid schemes will not be allowed to sell CDS contracts.
A CDS is facilitated by an insurance contract between two parties in which one party purchases coverage from another party against losses, if a company which sold a corporate bond defaults in its payment. A premium is paid in exchange for this coverage. In case any debt security on which a CDS is bought defaults, the seller (seller of CDS) pays the notional amount (amount of debt security) and takes over the debt security in default.
According to a report in Financial Express, the CDS market does not have much exposure in India, as risk coverage for debt papers, which is AAA-rated or backed by sovereign guarantee is not needed. Meanwhile, below AA-rated corporate bonds have low liquidity and come with a slight hint of uncertainty in terms of performance of the concerned companies. As such, CDS can play a huge role in deepening the corporate debt market.
