Last week, the capital markets regulator, Securities and Exchange Board of India (Sebi), allowed mutual funds (MFs) to participate in the credit default swap (CDS) market. This comes a year after the Reserve Bank of India (RBI) opened up the CDS market in India for corporate bonds. CDS became known during the 2008 crisis.
What is a CDS?
Say, one of the underlying securities in your bond fund defaults on either its interest or principal payment or both. In this case, the value of the bond becomes nil and your debt fund’s net asset value (NAV) falls drastically. You suffer a loss. But wouldn’t it be good if your debt fund had an insurance?
Enter a CDS agreement, wherein the user of the bond (your debt fund, for example) enters into a contract with a market maker that if there is a default by the reference entity (the original issuer of the bond against whom the protection is bought), the market maker would make good the loss.
In case of a default, your debt fund gets the money from the market maker and its NAV gets saved. In return, your MF pays a premium to the market maker. It is somewhat like buying insurance.
Can all MFs enter CDS?
No. As per Sebi guidelines, only fixed maturity plans (FMPs) can do so; open-ended debt funds are not allowed yet. Moreover, only those FMPs whose tenors are more than a year can enter into a CDS. Also, the fund has to limit its exposure to a single market maker to 10% of its net assets for CDS transactions.
If, during the underlying instrument’s tenor, the lender defaults on interest payments, the market maker makes good the payments. If there is a default on the principal, the market maker makes good the loss.
What about insurance companies?
In August, the Insurance Regulatory and Development Authority (Irda) issued draft guidelines allowing insurance companies to participate in the CDS market.
The draft guidelines have allowed them to act only as users of CDS. That means insurance companies can purchase CDS to hedge their credit risk, but can’t issue them. Globally, insurance companies issue CDS as well.
According to the draft Irda guidelines, CDS is not permitted on securitized assets such as mortgage-backed securities and asset-backed securities. insurance companies, meanwhile, are not enthusiastic. “CDS makes sense when I am buying a lower-rated bond and can hedge my risk by buying CDS from a high-rated company. But when I am allowed to buy only high-rated bonds, then there is little use for CDS,” says Prasun Gajri, chief investment officer, HDFC Standard Life Co. Ltd.
The CDS market in India
In over a year since CDS was introduced in India, there has hardly been any activity. Last year, soon after RBI allowed CDS, ICICI Bank Ltd entered into a CDS (bought insurance) from IDBI Bank Ltd to protect its lending to Rural Electrification Corp. Ltd, or REC, (whose debt instrument ICICI Bank held). That was just a token transaction, though, to get things started. Note, REC is a government-owned entity that hardly needs any insurance against it. The real CDS flavour will be felt when entities such as fund managers enter into CDS against low-rated instruments.
Also, it remains to be seen what kind of market makers step in. For now, RBI has allowed domestic banks, apart from non-banking finance entities and primary dealers (those who buy and sell government securities) with a minimum financial requirement. “But with banks already grappling with issues relating to gross net performing assets, it is to be seen whether they will take to CDS as this would increase their credit risk exposure,” says Akhil Mittal, senior fund manager (fixed income), Canara Robeco Asset Management Co. Ltd.
Time will also determine the pricing of these CDS. Say a debt fund holds a debt security that carries a mark-up (the difference in yield of the security from that of a government paper; these mark-ups change marginally every day), of say, 300 basis points (bps). In other words, if the government security on a given day carries a yield of 8%, then this debt security carries a yield of 11%. Since the security is a risky one, the high mark-up compensates for the additional risk that the lender (the debt fund or any other entity that invests in it) takes.
If the CDS premium cost is above 300 bps (say about 350 bps or so), it may not make sense for the debt fund—all things being equal- because the debt fund stands to lose more in CDS than in reality. But if the CDS premium is less than 300 bps, it may not make sense for the market maker, all things being constant. This is to put it very simply; we don’t know exact pricing contours yet. It will get clearer as we go along.
How will it affect you?
On account of a lacklustre debt market, CDS will not have any major impact now. “We expect CDS to help deepen the debt markets in the long term. This could in turn help corporate India to easily borrow from the capital markets and thereby help reduce their cost of capital,” says Vikrant Mehta, head (fixed income), PineBridge Investments Asset Management Co. Ltd.
Coupled with the recent measures such as RBI’s directive to banks to limit their investments in MFs and the finance ministry’s recent advisory to government-owned banks to cap their bulk deposits, these steps aim to strengthen the corporate bond market, which in turn will open more investing avenues for debt funds.
Deepti Bhaskaran contributed to this story.