SEBI eases credit default swap rules for mutual funds to boost bond market liquidity

The Securities and Exchange Board of India ( SEBI ), has introduced new measures to allow mutual funds to both buy and sell credit default swaps (CDSs) under certain conditions. The decision, outlined in a circular on Friday, is aimed at enhancing liquidity within the corporate bond market.

A credit default swap is a financial instrument that enables an investor to transfer credit risk to another party, functioning similarly to an insurance contract. Previously, mutual funds were only permitted to act as buyers of CDSs, which they used to hedge against credit risks on corporate bonds with maturities of more than one year.

SEBI 's new guidelines provide mutual funds with greater flexibility by enabling them to also sell CDSs. "Flexibility to participate in CDSs shall serve as an additional investment product for mutual funds and also aid in increasing liquidity in the corporate bond market," the regulator said in its statement.

To mitigate potential risks, SEBI has outlined several conditions for mutual funds engaging in selling CDSs. They must maintain adequate collateral, which could be in the form of cash, government bonds, or treasury bills. Additionally, mutual funds can only buy CDSs from sellers that hold investment-grade ratings, indicating a higher likelihood of meeting their debt obligations.

SEBI further stipulated that the total exposure to CDS, whether from buying or selling, should not exceed 10 per cent of the mutual fund’s assets under management (AUM). This measure is designed to ensure that funds manage their risk exposure effectively while benefiting from the added liquidity CDSs can bring to the bond market.

(With Reuters inputs.)