Market regulator Securities and Exchanges Board of India (Sebi) has permitted mutual funds to participate in credit default swaps (CDS) market, as per the guidelines issued by RBI. This follows the RBI notification issued in May 2011 stating the guidelines on CDS for corporate bonds.
A swap agreement is that the seller of the CDS will compensate the buyer in the event of a loan default.
In a note issued on Thursday, Sebi allowed mutual funds to participate in CDS transactions only as users (protection buyer). Thus, mutual funds are permitted to buy credit protection only to hedge their credit risk on corporate bonds they hold. They shall not be allowed to sell protection and hence are not permitted to enter into short positions in the CDS contracts, said Sebi. However, they shall be permitted to exit their bought CDS positions.
It clarified that mutual funds can participate as users in CDS for the eligible securities as reference obligations, constituting from within the portfolio of only Fixed Maturity Plans (FMP) having tenor exceeding a year.
Mutual funds shall buy CDS only from a market maker approved by the Reserve Bank of India and enter into Master Agreement with the counterparty as stipulated under RBI guidelines. Exposure to a single counterparty in CDS transactions shall not exceed 10 per cent of the net assets of the scheme.
The cumulative gross exposure through credit default swaps in corporate bonds along with equity, debt and derivative positions shall not exceed 100 per cent of the net assets of the scheme.
The total exposure related to premium paid for all derivative positions, including CDS, shall not exceed 20 per cent of the net assets of the scheme.
Before undertaking CDS transactions, mutual funds shall put in place a written policy on participation in CDS approved by the Board of the Asset Management Company and the Trustees as per the guidelines specified by RBI and Securities and Exchange Board of India (SEBI). The policy shall be reviewed by mutual funds, at least once a year.
Mutual funds also need to disclose the details of CDS transactions of the scheme in corporate debt securities in the monthly portfolio statements as well as in the half yearly trustee report, as per the format. Further, mutual funds shall disclose the scheme-wise details of CDS transactions in the notes to the accounts of annual report of the mutual fund.
In order to encourage growth of the corporate bond market, Sebi has also decided that the base of eligible securities may be expanded for mutual funds to participate in repo in corporate debt securities, from AAA rated to AA and above rated corporate debt securities.
(Edited by Prem Udayabhanu)