The market regulator has cleared the way for mutual funds to sell credit default swaps (CDS), under specific conditions.
Until now, mutual funds in India were allowed to participate in CDS transactions only as users, that is, to buy credit protection to hedge risk on corporate bonds held by them and only in portfolios of fixed maturity plan (FMP schemes).
A circular issued on September 20 by the Securities and Exchange Board of India (Sebi) has eased norms.
The circular stated that the Reserve Bank of India, via a master direction issued in February 2022, revised its framework to help the CDS market develop by expanding the base of protection sellers by including major non-bank regulated entities including mutual funds.
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The circular added, in view of this and after after taking into consideration the recommendations of the Working Group set up to deliberate on the issue, recommendations of Advisory Committee on Mutual Funds (MFAC), inputs by AMFI and feedback received on the consultation paper on this issue, it has been decided to allow greater flexibility to Mutual Funds to both buy and sell CDS with adequate risk management.
The Sebi circular said, "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".
The following are some of the conditions under which the mutual fund may sell CDS, according to the circular:
1. MF Schemes may sell CDS only as part of investment in synthetic debt
securities, i.e., sell CDS on a reference obligation covered with Cash/GSec/T-bills. Overnight and Liquid schemes shall not sell CDS contracts.
2.The exposure of synthetic debt security (notional amount) shall be considered in respective single issuer, group issuer and sectoral limits. Such exposure to the issuer, group and sector of the issuer shall be equal to the notional amount.
3. Schemes shall sell CDS only against securities rated investment grade
and above.
4. Credit risk rating of the synthetic debt security shall be same as of reference obligation. For the purpose of Risk-o-meter, liquidity risk value of the synthetic debt security shall be Liquidity Risk Value of reference obligation + 2
5. For Potential Risk Class (PRC) matrix, Credit Risk Value shall be same
as reference obligation.
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