While many perceive debt market investing to be a very safe avenue, the fact is, it is not so. Investing is debt markets also entails with it risk such as interest rate risk, default risk, inflation risk, liquidity risk and re-investment risk, amongst host of other economic risk as well. Recently the capital market regulator – the Securities and Exchange Board of India, facilitating mutual funds to hedge their risk, allowed mutual funds to participate in the Credit Default Swap (CDS) market (vide a circular).

However the circular has distinctly stated "mutual funds shall participate in CDS transactions only as users (protection buyer)," and thus cannot enter into short positions in CDS.

Moreover, the circular has directed mutual funds to buy CDS only from market makers approved by the Reserve Bank of India (RBI), and enter into master agreement with the counterparty as stipulated under apex bank's guidelines. However before entering into CDS transaction, mutual funds will need to place a written policy on participation in CDS approved by the Board of the Asset Management Company (AMC) and the Trustees. The exposure to a single counterparty in CDS transactions shall not exceed 10% of the net assets of the scheme.

As far as disclosure of CDS transactions is concerned, mutual funds would be required to disclose the details under corporate debt securities on a monthly as well as a half-yearly basis.

It is noteworthy that CDS is a credit derivative contract, wherein transfer of credit risk of fixed income products between parties takes place. The buyer of the contract makes payment until maturity of the contract and therefore receives a credit protection, while the seller in return agrees to pay off third party defaults on loan.

Also in order to encourage growth of the corporate bond markets, the base of eligible securities is also expanded thereby allowing mutual funds to participate in repo in corporate debt securities, from 'AAA' rated to 'AA' and above.

We believe that, the initiative taken by SEBI would enable mutual funds to hedge their default risk in the corporate bond market - especially in case of longer maturity papers. Moreover, the guidelines issued by SEBI which allow them to use CDS only as users (i.e. protection buyers), helps in being an effective hedge with control in place with a written policy approval required from the Board of AMC and the Trustees, before the mutual fund enters into a CDS transaction. The disclosure norms to such transactions too seem to be fair and in the interest of investors. Allowing mutual funds to participate in repo in corporate debt securities, from 'AAA' rated to 'AA' and above is also a good move intended to facilitate growth of the corporate bond market.
 

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