Mutual funds allowed to participate in CDS transactions

Credit Default Swap transactions allow business entities to hedge risks associated with the bonds market

Market regulator Sebi today allowed mutual funds to participate in Credit Default Swap (CDS) transactions, which allow business entities to hedge risks associated with the bonds market.

Besides, the regulator said that mutual funds can invest in repo or short-term repurchase of forward contract of corporate debt securities having ratings of AA and above that.

In a circular, Sebi said that mutual funds can participate in the CDS market for hedging their debt risks, but can not enter into short positions in the CDS contracts.

"Mutual funds shall participate in CDS transactions only as users (protection buyer)," Sebi said.

CDS is a specific kind of counter-party agreement which allows the transfer of third party credit risk from one party to another.

The regulator said that mutual funds can participate as users in CDS for the securities having Fixed Maturity Plans (FMP) with tenor exceeding one year.

It also said that such funds can buy CDS only from a market maker approved by the RBI and can enter into master agreement with the counterparty as stipulated under apex bank's guidelines such as exposure to a single counterparty in CDS transactions would not exceed 10 per cent of the net assets of the scheme.

Sebi also said that mutual funds are permitted to exit their bought CDS positions in case the cumulative gross exposure in corporate bonds along with equity, debt and derivative positions not exceed 100 per cent of the net assets of the concerned scheme.

Mutual funds are required to disclose the details of CDS transactions of the scheme in corporate debt securities on the monthly as well as half yearly basis.

Before undertaking CDS transactions, mutual funds need put in place a written policy on participation in CDS approved by the Board of the Asset Management Company and the Trustees.

In addition, Sebi said mutual funds are allowed to participate in repo in corporate debt securities.

In repo transactions, also known as a repo or sale repurchase agreement, securities are sold with the seller agreeing to buy them back at later date. The instrument is used for raising short-term capital.

The repurchase price should be greater than the original sale price, the difference effectively representing interest.

"In order to encourage growth of the corporate bond market, it has been decided that 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," Sebi said.