Testing the fund manager

Allowing purchase of CDS to insure portfolio may lead to investments in riskier papers to spike returns

Retail investors in debt mutual funds mostly seek safety with reasonable returns. But they could soon have a choice of risky debt schemes. Last week, Securities and Exchange Board of India (Sebi) said it has allowed mutual funds (MFs) to participate in credit default swaps (CDS) with some riders.

CDS is like an insurance policy issued by sellers that the buyer will be compensated in the event of a default. It became famous for all the wrong reasons during the financial meltdown in 2008. Financial behemoths like Bear Stearns, Lehman Brothers and American Insurance Group (AIG) found themselves in trouble, directly or indirectly because of CDS. Bear Stearns was, in fact, sold to J P Morgan and Lehman Brothers went bankrupt.

No wonder, many investors are worried that exposure to CDS may make debt funds riskier. Industry experts like Dhirendra Kumar of Value Research differ. “This could help in deepening the corporate bond market and also help MFs actively manage credit risk in their portfolio and diversify,” he adds.

On its part, Sebi has put safeguards. “Mutual funds will participate in CDS transactions only as users (protection buyers) to hedge their credit risk on corporate bonds they hold. They will not be allowed to sell protection or take short positions in CDS contracts ,” says the circular.

Also, only fixed maturity plans (FMPs) of tenures of more than one year can buy these products. And, exposure to a single counterparty in CDS transactions shall not exceed 10 per cent of the net assets of the scheme and the overall exposure cannot be over 20 per cent of the scheme.

All these are comforting, but there are hitches as well. First, there will be minor additional costs. Like Amar Ranu, senior manager, Motilal Oswal Private Wealth says this would reduce returns marginally – at worse, by two to three basis points.

The worrisome part is the improved risk-taking ability of the fund manager. Since 20 per cent of the portfolio can have insurance from CDS, the fund manager can use it to buy riskier, lower-rated papers, which offer higher rates of return. The debate lies there: Should debt fund managers be taking higher risk because part of their portfolio is insured?

The answer could be both ‘yes’ and ‘no’ , depending on the profile of the investor. The Rs 1,00,00-crore FMP segment has both retail and corporate investors. While the risk appetite of corporate and high networth individuals is higher, to spike their returns, they could be quite willing to invest for higher returns. On the other hand, retail investors may not be willing to take that risk.

But companies are also known to pull out money in a jiffy when times are bad. For instance, in 2008, Lotus Mutual Fund was sold to Religare AEGON when around Rs 2,500 crore was withdrawn by various institutional investors in less than a month.

Says an investment expert, “The risk-taking ability of the debt fund manager has improved. But he has to decide how much he is willing to take for a spike of a few percentage points.” It will be testing times.