The mutual fund industry has welcomed the Securities and Exchange Board of India’s (Sebi) initiative to allow MFs to participate in the credit default swaps (CDS) market as well as in the repo in the corporate debt securities space.
Fixed income managers said the move would help develop the corporate bond market, especially if the activity in the infra debt fund space picks up pace. However, they said the impact would not be immediately visible as the corporate bond market itself was significantly under-developed in India because of factors like lack of consensus in evaluating credit risk among various entities.
The regulator has allowed MFs to participate in CDS transactions only as users (protection buyer) and has barred them from selling protection or entering into short positions in the CDS contracts.
Fixed income managers said the step was taken to ensure that MFs mitigated the risk on the bonds they held by buying protection and refrained from exposing themselves to contingent liabilities by becoming sellers. “Mutual funds are permitted to buy credit protection only to hedge their credit risk on corporate bonds they hold,” said the regulator. Buyers of CDS pay a premium to get insured against credit defaults whereas sellers make good the loss in case of defaults.
MFs can participate as users in CDS within the portfolio of fixed maturity plans (FMP) schemes having tenure of more than one year. According to Killol Pandya, head, fixed income, Daiwa MF, this was a logical step as a fund manager's control over an FMP scheme is higher because of the lock-in and fixed tenure. “If the experiment is successful, I am sure the regulator will include more types of schemes to participate as users in CDS,” said Pandya.
As a cautionary step, the regulator had also mandated that the exposure to a single counterparty in CDS transactions would not exceed 10% of the net assets of the scheme. “It's a conservative number, but the idea is to distribute risk as overexposure to a single party can make the CDS meaningless in case of a default,” said Pandya.
The move to allow mutual funds to participate