In a bid to deepen the corporate bond market, the Securities and Exchange Board of India (Sebi) has proposed allowing allow mutual funds (MFs) to buy and sell credit default swaps (CDS) in their schemes. “The same shall serve as an additional investment product for mutual funds and also aid in increasing liquidity in the corporate bond market,” Sebi said in a consultation paper on Friday, inviting public comments by July 1.

Sebi’s proposal comes after the RBI issued revised CDS framework 2022, which sought to increase the base of protection sellers, including selling of protection by all major non-bank regulated entities, including mutual funds. CDS is a credit derivative contract that allows an investor to swap or offset their credit risk with that of another investor, and is akin to insurance. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.

The CDS market hasn’t really taken off in India because it is not useful in case of debt papers which is AAA-rated or backed by sovereign guarantee. At the same time, there isn’t much appetite for lower grade papers. In fact, the liquidity for the corporate bonds below AA-rate credit is extremely low. Debt fund managers taking risk on lower rated papers for higher returns have often found themselves in deep trouble at times due to their sheer inability to sell at the slightest whiff of trouble.  

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In fact, Sebi had allowed MFs to participate in the CDS market a decade back as protection for buyers – only for hedging their credit risk – the market did not take off. Even the current proposals have caps for fund houses’ investment in CDS. Sebi has put a cap of 10% of the AUM of the scheme as these contracts are less liquid, and should be within the overall limit of derivatives assets as mentioned in the scheme information document.

In addition, it has proposed that all schemes of a mutual fund be allowed to buy default swaps, which is currently limited to only fixed maturity plans of more than one year. But has maintained that mutual funds can buy these only for the purpose of hedging their credit risk on debt securities they hold in all schemes.
Any naked exposure may not be allowed as it leads to speculative positions being held by MFs, Sebi said.

Further, a mutual fund can buy CDS only from programmes that are rated by credit rating agencies, and they can buy CDS for both investment grade and below-investment grade debt securities. The consultation paper has sought comments on allowing participation of mutual funds in CDS buying for all schemes and CDS selling for all schemes except overnight and liquid ones.