Flexibility in Participation of Mutual Funds in Credit Default Swaps

SEBI has issued a new circular that allows mutual funds in India to have greater flexibility in participating in credit default swaps (CDSs).

𝐖𝐡𝐚𝐭 𝐢𝐬 𝐚 𝐂𝐫𝐞𝐝𝐢𝐭 𝐃𝐞𝐟𝐚𝐮𝐥𝐭 𝐒𝐰𝐚𝐩?
A CDS is a financial instrument designed to mitigate the risk associated with investments. In a CDS contract is between the buyer and the seller, where the buyer pays a premium to the seller in exchange for protection against the potential default.

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

𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐑𝐞𝐠𝐮𝐥𝐚𝐭𝐨𝐫𝐲 𝐅𝐫𝐚𝐦𝐞𝐰𝐨𝐫𝐤:
Under the current regulatory framework, Mutual Funds in India can only use CDS to buy credit protection as a hedge against credit risk on corporate bonds they hold, and only for Fixed Maturity Plans with terms longer than one year. However, the Reserve Bank of India (RBI), through its revised guidelines issued on February 10, 2022, aims to boost the CDS market by allowing a wider range of entities, including Mutual Funds, to sell credit protection as well.

𝐍𝐞𝐰 𝐂𝐢𝐫𝐜𝐮𝐥𝐚𝐫:
Mutual Funds are now allowed greater flexibility to both buy and sell CDS, providing an additional investment tool and enhancing liquidity in the corporate bond market, with appropriate risk management in place.

Accordingly, clause 12.28 of the Master Circular for Mutual Funds dated June 27, 2024 stands modified.

𝐌𝐮𝐭𝐮𝐚𝐥 𝐅𝐮𝐧𝐝 𝐒𝐜𝐡𝐞𝐦𝐞𝐬 𝐚𝐬 𝐛𝐮𝐲𝐞𝐫 𝐨𝐟 𝐂𝐃𝐒:
·         Mutual Fund schemes can buy CDS only to hedge credit risk on debt securities they hold, with CDS exposure not exceeding the debt security exposure and not counted towards the scheme’s gross exposure.
·         If the protected debt security is sold, the CDS position must be closed within 15 working days.
·         For limits and risk assessment (single issuer, group, sectoral, Risk-o-meter, and PRC matrix), exposure is counted based on the higher credit rating of the debt issuer or CDS seller.

𝐌𝐮𝐭𝐮𝐚𝐥 𝐅𝐮𝐧𝐝 𝐒𝐜𝐡𝐞𝐦𝐞𝐬 𝐚𝐬 𝐬𝐞𝐥𝐥𝐞𝐫 𝐨𝐟 𝐂𝐃𝐒:
·         Mutual Fund schemes can sell CDS only within synthetic debt securities backed by Cash, G-Secs, or T-bills, except for Overnight and Liquid schemes.
·         The notional amount of synthetic debt must comply with single issuer, group issuer, and sectoral limits.
·         The credit risk rating of the synthetic debt must match that of the reference obligation, with liquidity risk for the Risk-o-meter calculated as reference obligation liquidity risk plus 2.

The Circular is enclosed herewith.

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