- May 2014
- December 2013
Ruby Jacob, 16 Nov 2012
Securities market regulator SEBI has permitted mutual funds to deal in CDS for Corporate Bonds. Now mutual funds can buy Credit Default Swap (CDS) for Fixed Maturity Plans (FMPs) having tenor over one year.
Though RBI opened up corporate bond CDS market for Financial Institutions late in 2011 and allowed them to deal in CDS to hedge their risk, it has remained largely exotic. This time SEBI has taken the initiative to encourage mutual funds to start dealing in CDS.
For the uninitiated, bond credit default swap is like taking insurance on the bond. Mutual fund FMPs invest heavily in bonds. Bonds are long term debt securities and typical of debt instruments they have credit risk. Credit risk simply means that the borrower (or in other words issuer of the bond) may be unable to repay according to interest and other terms of the issue. Bonds CDS is an instrument that allows buyers of bonds (for eg mutual funds) to pass on this risk to another entity (usually banks) for a fee. If the bond issuer actually defaults it is the mutual fund's gain and if it does not it is the bank's gain.
Aren't the banks then taking on unnecessary risks? Well banks have traditionally been the big guys in corporate lending and they know their strong clients and weak ones, the ones who issue bonds. They can price CDS accordingly.
More and more players dealing in CDS would slowly bring life to the sleepy bond market in India and widen the role of non-bank financial institutions in lending, especially to capital heavy industries like real estate and heavy industries.
According to SEBI's recent guidelines mutual funds have to stick to cap of 10% of net assets of the scheme for CDS by a single counterparty. Every mutual fund company would need to have approval of AMC board and trustees before starting to deal in CDS. They have been asked to disclose all CDS transactions in the scheme monthly portfolio.
Another important SEBI move is set to allow mutual funds to participate in repo in corporate debt securities rated AA and above. In a repo transaction the seller of securities agrees to buy them back at a later date for a higher price than the sale price. Underlying securities can be Commercial Paper (CP), Certificate of Deposit (CD), and Non Convertible Debentures (NCDs). Earlier mutual funds were allowed to participate in repo of corporate debt securities rated AAA.
How is all this going to affect you as an investor? The impact would not be direct as of now since only financial institutions are permitted to deal in them. If FMPs have CDS their risk would be reduced and mutual fund Asset Management Companies (AMCs) would have one more complex investment avenue! Expansion of the base of eligible debt securities for repo again means AMCs have a lot more short term securities to deal in but lower rating means these would carry higher default risk. This additional risk cannot be hedged with CDS since CDS is allowed only in bonds at the moment.