The Securities and Exchange Board of India has said mutual funds can sell a credit default swap (CDS) only when they want to exit an existing ‘bought position’.

However, this can be done only if the fund house’s total exposure through CDS in corporate bonds along with equity, debt and derivative positions exceeds 100 per cent of the scheme’s net assets.

A credit default swap is an insurance against potential non-payment by a counter party. In other words, it is a protection a lender seeks against possible default by borrower.The seller of a CDS assumes the obligation and guarantees the creditworthiness of the debt instrument against default. For this, the CDS buyer has to pay a premium to the CDS seller.

RBI had allowed fund houses only as buyers of CDS in its guidelines issued in May last year. In addition, the SEBI has prescribed that MFs can buy CDS for the eligible securities as reference obligations (underlying) only for fixed maturity plans exceeding one-year tenor.

Mutual funds have been directed to strictly comply with extant the RBI norms on CDS.

SEBI has capped the maximum exposure to a single counterparty in CDS transaction at 10 per cent of the scheme’s net assets.

The regulator has also capped the premium paid for all derivatives positions including CDS at 20 per cent of the scheme’s net assets.

To enable investors take an informed decision, MFs also have to disclose their intention to buy CDS in the scheme information document.

(This article was published on November 15, 2012)
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