Market regulator Securities and Exchange Board of India (Sebi) has taken a significant step to enhance liquidity in the corporate bond market by allowing mutual funds to both buy and sell Credit Default Swaps (CDS).
Key Changes:
- Expanded Flexibility: Mutual funds can now actively participate in the CDS market, buying and selling these financial instruments.
- Investment Product: CDS offers mutual funds an additional investment option to manage credit risk.
- Previous Restrictions:
- 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.
How CDS work:
Credit Default Swaps (CDS) are financial instruments that act as insurance against the risk of a borrower defaulting on their debt obligations. Think of them as insurance policies for bonds.
- Contract: A buyer (protection buyer) enters into a contract with a seller (protection seller).
- Premium: The buyer pays a regular premium to the seller.
- Default Event: If the underlying debt issuer defaults, the seller is obligated to pay the buyer a specified amount. Example: imagine you own a corporate bond issued by Company XYZ. You're concerned about the risk of Company XYZ defaulting on its debt. To protect yourself, you can purchase a CDS on Company XYZ. If Company XYZ defaults, the seller of the CDS will pay you a specified amount, compensating for your losses.
Key points to note:
- Mutual funds can now both buy and sell CDS to manage credit risk.
- CDS can be used to protect against the credit risk of debt securities held by mutual funds.
- The value of CDS exposure cannot exceed the value of the underlying debt security.
- Mutual funds can only buy CDS from sellers with an investment-grade rating or higher. Mutual funds can sell CDS as part of synthetic debt investments backed by cash, government securities, or treasury bills.
- The total CDS exposure for a scheme cannot exceed 10% of its assets.
- Mutual funds must disclose details of their CDS transactions, including the seller's rating and any related-party transactions.
- The regulator said that CDS will be valued based on actual traded levels or credit spreads.
The Sebi order would come into effect immediately.