Sebi allows mutual funds to buy, sell credit default swaps

On Friday, markets regulator SEBI allowed mutual funds to both buy and sell Credit Default Swaps (CDS) to boost liquidity in the corporate bond market. This added flexibility will provide mutual funds with an additional investment option, according to SEBI's circular.

Previously, mutual funds were only allowed to use CDS to buy protection against the credit risk of corporate bonds they held, and this was limited to Fixed Maturity Plan (FMP) schemes with a duration of over one year.

Now, SEBI has decided to give mutual funds more flexibility to both buy and sell CDS, provided they have proper risk management in place. CDS are essentially insurance contracts that protect against a borrower defaulting. When a mutual fund buys a CDS, it pays a premium to the seller in exchange for protection in case a specific bond defaults.

Under the new rules, mutual funds can buy CDS to hedge the credit risk of their debt securities, but the CDS exposure can't exceed the value of the protected debt. Mutual funds can only buy CDS from sellers with an investment-grade rating or higher.

Mutual funds can also sell CDS as part of synthetic debt investments backed by cash, government securities, or treasury bills, but overnight and liquid schemes are not allowed to sell CDS. Total CDS exposure, including both buying and selling, cannot exceed 10% of a scheme's assets.

SEBI added that CDS will be valued based on actual traded levels or credit spreads, and mutual funds must disclose their CDS transactions, including the seller's rating and any deals with sponsor group companies. These changes take effect immediately.