SEBI’s new rule: Mutual funds can now buy and sell credit default swaps
Previously, mutual funds could only engage in CDS transactions as buyers, primarily to hedge credit risks on corporate bonds within Fixed Maturity Plans (FMPs) lasting more than one year.
The new guidelines, however, enable mutual funds to both buy and sell CDS.
Such flexibility to participate in CDS shall serve as an additional investment product for mutual funds and also aid in increasing liquidity in the
corporate bond market, SEBI said.
What are Credit Default Swaps (CDS)?
Credit Default Swaps are financial contracts that act as a form of insurance against the default of a borrower.
In the context of mutual funds, CDS allow funds to manage and mitigate credit risk associated with the bonds or debt securities they hold.
When a mutual fund buys a CDS, it pays a premium to the seller for protection against the default of a specific bond (the reference entity).
If the bond defaults, the seller compensates the fund for the loss.
Key changes in SEBI’s guidelines
The recent circular modifies existing regulations to allow mutual funds to buy and sell CDS, expanding their role beyond just hedging credit risks.
Here are the main points:
- Mutual funds can still buy CDS to protect themselves against credit risks on debt securities they hold. However, the CDS exposure cannot exceed the amount of the debt security being hedged.
- Mutual funds are now permitted to sell CDS as part of investments in synthetic debt securities. This means they can use the CDS to create a new type of investment that mimics the characteristics of traditional debt securities.
- When selling CDS, mutual funds must maintain adequate collateral, which can include cash, government securities, or treasury bills. This collateral must be valued daily to ensure it meets margin requirements.
- Mutual funds can only engage in CDS transactions with sellers that have investment-grade ratings. This helps to mitigate risks associated with lower-rated counterparties.
- The total exposure from both bought and sold CDS cannot exceed 10% of the mutual fund’s total Assets Under Management (AUM). This limit helps keep risk levels manageable.
Benefits of the new guidelines
This new framework will provide several advantages:
For mutual funds: The ability to sell CDS may allow funds to enhance their investment strategies and better manage risks.
For Investors: Increased flexibility in CDS participation means mutual funds can better protect their assets, which may lead to more stable returns.
For the corporate bond market: Enhanced liquidity in the CDS market can improve pricing efficiency and reduce volatility, benefiting the overall market.
First Published: Sept 20, 2024 5:14 PM IST
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