Is Credit Default Swaps a boon for mutual fund investors?

The Securities and Exchange Board of India (SEBI) recently proposed a significant change for the mutual fund industry? - allowing them to participate in the credit default swap (CDS) market. This move has the potential to improve risk management for mutual funds and offer more diversified investment options for investors. Credit Default Swaps (CDS) are a type of financial derivative that functions similarly to insurance for lenders. They are contracts between two parties, where the buyer of the CDS pays a periodic fee to the seller in exchange for protection against the risk of default by a borrower or issuer of a bond. The CDS is a financial agreement functioning like an insurance policy for bond investments. The borrower or the issuer of the bond whose default risk is being insured is called as Reference entity. The entity selling the CDS of reference entity is called seller who agrees to compensate the buyer in case the borrower defaults. The entity who purchases these CDS, often a lender or investor, is called a buyer who hedges against the risk of default on a particular loan or bond. For example, if a bank lends money to a company and wants to protect itself against the risk of that company not paying back the loan, the bank can buy a CDS from another financial institution. If the company defaults, the CDS seller compensates the bank for the losses.

SEBI's proposal outlines a framework for mutual fund participation in the CDS market. Mutual funds can buy CDS protection for both investment-grade and below-investment-grade bonds. Mutual funds with sufficient liquidity can also sell CDS contracts, allowing them to potentially profit from market fluctuations. To prevent excessive risk, SEBI proposes a cap on a mutual fund's total CDS holdings (bought and sold) at 10% of its Assets Under Management (AUM). Mutual funds will be required to disclose their CDS positions regularly to ensure transparency for investors. By buying CDS, mutual funds can mitigate the risk of losses if a bond issuer defaults. This allows them to invest in a wider range of bonds, including those with slightly lower credit ratings, potentially increasing returns. CDS can be used to manage a portfolio's overall risk exposure. By strategically buying and selling CDS contracts, fund managers can fine-tune their risk profile. Increased mutual fund participation in the CDS market could lead to a wider variety of investment products with varying risk-reward profiles. By allowing mutual funds to better manage risk, SEBI's proposal could potentially lead to more stable returns for investors.

SEBI's proposal to allow mutual funds to participate in the CDS market has the potential to benefit both mutual funds and investors. By offering more risk management tools and potentially more diversified products, this change could lead to a more robust and attractive mutual fund industry in India. However, staying informed about CDS and associated risks remains crucial for investors before making investment decisions.

References:

1.?Business Standard - Sebi proposes to open credit default swap market for MF

2.?Live Mint - SEBI suggests flexibility for MFs to buy, sell credit default swaps

3.?Financial Express – Sebi proposes to open CDS market for MFs

4.?Image by Freepik

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