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SEBI has allowed mutual funds to buy and sell a new investment product - credit default swaps (CDS).
CDS is basically buying an insurance by paying a small premium against exposure in a corporate bond. For instance, if an MF holds a corporate bond of XYZ company yielding 7.75% per annum, they can sell CDS against this security by buying insurance by paying a premium of let’s say 0.50 bps. In case of default in this instrument, the insurance company will pay the principal amount along with the interest.
Currently, fund houses are allowed to buy CDS against corporate bonds held by FMPs having maturity of at least a year.
With this, SEBI has now allowed debt funds to buy CDS (all schemes) and sell CDS (except overnight and liquid funds).
This has come into effect with immediate effect.
Here are some key highlights of the new circular on CDS:
MFs as buyer of CDS
- MFs can buy CDS purely for hedging their debt securities. Such an exposure should not be added to the gross exposure of the scheme
- If the fund manager sells a particular debt which was hedged with CDS, the fund manager will have to close CDS position within 15 days of selling
- MFs can buy CDS only from sellers having instruments with lowest long term rating of investment grade and above
- MFs can buy CDS for both investment grade and below investment grade debt securities. This also indicates that MF will be allowed to invest in below investment grade securities only if hedging is available
MFs as seller of CDS
- If a fund house sells CDS, they will have to buy a secured instrument like government securities or treasury bills
- The exposure to such synthetic debt exposure will be added to single issuer, group issuer and sectoral limit
- They have to buy secured instruments to the extent of notional value + buffer for price fluctuation on government securities. Such a buffer has to be at least 3 times the daily haircut appliable for the g-sec instruments in case of repo transactions
- Debt index and ETFs can also take such a position
Other conditions
- MFs have to follow RBI norms if they buy or sell CDS
- MFs can participate in CDS only through standard contracts prescribed by Fixed Income Money Market and Derivatives Association of India (FIMMDA)
- CDS can be transacted through request for quote (RFQ) platform
- MFs have to make periodic disclosure of CDS
- Exposure to CDS should not exceed 10% of the total AUM of scheme
- CDS contract should mature on or before winding up date of schemes, wherever applicable
- Credit rating of CDS seller (lowest long term) should be disclosed
- AMFI will issue guidelines on valuation and accounting of CDS by MF schemes
