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Market regulator SEBI, will soon allow mutual funds to sell a new investment product on credit default swaps (CDS). The product will be allowed to buy, and sell CDS to benefit investors.
A CDS is a credit derivative contract, which acts as an insurance against credit default. For instance, if a mutual fund invests in a corporate bond, yielding 7 per cent per annum, it can sell CDS as an insurance, by paying a premium of about 0.50 bps. In case of default in the corporate bond, the buyer of CDS (insurance company), will pay a principal amount along with the interest.
However, SEBI will allow MFs to buy CDS, only for the purpose of hedge, and any naked exposure, may not be allowed, as it leads to speculative positions being held by mutual funds, clarified the regulator.
Hence, mutual funds have to buy a secured instrument, such as government securities or treasury bills, to protect investors’ interest.
In a consultation paper issued on Friday, SEBI said in order to provide additional investment products for the mutual funds, SEBI is considering to allow them to sell CDS for the purpose of taking exposure in synthetic corporate bonds, i.e., a position created by selling credit default swap, and buying G-Sec/ T-bills.
Stakeholders can send in their suggestions on the consultation paper, by July 1.
Risk management
In the recent revised guidelines, RBI has included Mutual Funds under CDS sellers, and based on consultation with the stakeholders, SEBI has proposed to allow greater flexibility, for MFs to both buy and sell.
CDS is under a standard framework to ensure adequate risk management. “The same will serve as an additional investment product for MFs and also aid in increasing liquidity in the corporate bond market,” it said.
Under the current regulatory framework, MFs are allowed to only buy credit protection, to hedge the credit risk on corporate bonds held by them. Moreover, the transaction can be undertaken by MFs only in the portfolio of Fixed Maturity Plans schemes having a tenure of more than one year.
SEBI has now proposed to allow participation of Mutual Funds in CDS buying (for all schemes), CDS selling (for all schemes except Overnight and Liquid). A detailed framework in this regard is expected soon.
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