SEBI’s new rule: Mutual funds can now buy and sell credit default swaps

Previously, mutual funds could only participate in CDS transactions as buyers, mainly to hedge credit risks on corporate bonds within fixed maturity plans (FMPs) with a duration of more than one year.

The new guidelines, however, allow mutual funds both to buy and sell CDS.

This flexibility to participate in CDS transactions will serve as an additional investment product for mutual funds and will also help increase liquidity in the market.
corporate bond market, SEBI saying.

What are credit default swaps?

Credit default swaps are financial contracts that act as a form of insurance against a borrower’s default.

In the context of mutual funds, CDSs allow funds to manage and mitigate the credit risk associated with the bonds or debt securities they own.

When a mutual fund purchases a CDS, it pays a premium to the seller to protect 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 guidelines

The recent circular amends existing regulations to allow mutual funds to buy and sell CDS, expanding their role beyond merely hedging credit risks.

Here are the main points:

• Mutual funds may continue to purchase CDS to protect against the credit risks of the debt securities they hold. However, the CDS exposure cannot exceed the amount of the debt security being hedged.
• Mutual funds can now sell CDS as part of investments in synthetic debt securities. This means that they can use 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 may include cash, government securities, or Treasury bills. This collateral must be valued daily to ensure it meets margin requirements.
• Mutual funds can only enter into CDS transactions with sellers that have investment grade ratings. This helps mitigate the risks associated with lower-rated counterparties.
• The total exposure of CDS bought and sold cannot exceed 10% of the total assets under management of the mutual fund. This limit helps to keep risk levels under control.

Benefits of the new guidelines

This new framework will bring several advantages:

For mutual funds: The ability to sell CDS can enable funds to improve their investment strategies and better manage risks.

For investors: Greater flexibility in CDS participation means that mutual funds can better protect their assets, which can lead to more stable returns.

For the corporate bond market: Increased liquidity in the CDS market can improve pricing efficiency and reduce volatility, benefiting the overall market.