Sebi Enhances Flexibility for Mutual Funds in CDS Market

Sebi now allows mutual funds to both buy and sell Credit Default Swaps (CDS), enhancing liquidity in the corporate bond market. Previously, they could only buy CDS for protection in Fixed Maturity Plans. New guidelines focus on risk management, seller ratings, and exposure limits.

The Securities and Exchange Board of India (Sebi) announced on Friday that mutual funds will now be able to both purchase and sell Credit Default Swaps (CDS). This regulatory move is aimed at bolstering liquidity in the corporate bond market.

Earlier, mutual funds were restricted to using CDS transactions solely for buying protection against the credit risk of corporate bonds they held, particularly within Fixed Maturity Plan (FMP) schemes with durations exceeding one year.

"It has been decided to allow greater flexibility to mutual funds to both buy and sell CDS with adequate risk management," Sebi said in a circular.

In financial terms, Credit Default Swaps function similarly to insurance contracts, providing protection against borrower default.

CDS assists mutual funds in managing the risk of debt securities they hold. When a mutual fund purchases a CDS, it pays a premium to the seller in exchange for protection if a specific bond defaults.

Under the revised framework, mutual funds can now purchase CDS to hedge the credit risk of debt securities in their portfolios, provided that CDS exposure does not exceed the value of the security being protected.

Mutual funds will only be allowed to buy CDS from sellers with an investment-grade rating or higher. When selling CDS, mutual funds can do so as part of synthetic debt investments backed by cash, government securities, or treasury bills. However, overnight and liquid mutual fund schemes are prohibited from selling CDS.

The total CDS exposure for a scheme, including both buying and selling, must not exceed 10 percent of the scheme's assets, according to Sebi.

Additionally, CDS will be valued based on actual traded levels or credit spreads.

Sebi has mandated that mutual funds disclose details of their CDS transactions, including the ratings of CDS sellers and any deals involving sponsor group companies. The new guidelines are effective immediately.

(With inputs from agencies.)