In today’s Finshots, we tell you why SEBI has proposed to open the Credit Default Swap (CDS) market for Mutual Funds.

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The Story

A company can raise money in many different ways. It could borrow from banks or other financial institutions. Or it could issue its shares to the public.

But these options come with their fair share of problems. A bank loan for instance could come with a high interest cost. And offering shares to the public would mean diluting existing shareholders, because external shareholders get a say over how the company operates. It could weaken the management’s control over the company’s decisions.

So what could it do?

Well, it could issue something called a corporate bond. It could take a loan from the public for a fixed period of time, in exchange for regular interest payouts. And when that term expires or on the maturity of the bond, it could pay them back the amount it initially borrowed. The interest on this won’t be as high as a bank loan. Besides, issuing bonds won’t even dilute the management’s control on the company’s affairs. So it’s a win win.

But here’s the thing. Corporate bonds aren’t a very mature market in India. And one reason for it could be because these instruments come with a very real risk. Corporates may not repay investors back if they go belly up.

So investors would rather invest in safer government bonds or even fixed deposits , where the risk of losing their money is pretty low. Sure, these investments may come with lower returns. But if they’re so keen on taking massive risks, investors would rather warm up to the stock market, no?

That explains why India’s corporate bond market is just about a quarter of the size of its $5 trillion stock market. That’s a stark contrast to developed economies like the US where the corporate bond market outdoes the equity market.

But India’s Central Bank, the RBI (Reserve Bank of India) and its market regulator SEBI (Securities and Exchange Board of India) want to change that. They’re consistently bringing in new rules and frameworks so that more investors can trust the bond market. That way companies can raise money and fuel their growth without having to worry about high interests or equity dilution.

A couple of years ago for instance, the RBI revised the regulatory framework for Credit Default Swaps (CDS). It allowed folks like you and me to buy these CDS, while letting insurance companies, pension funds, mutual funds and some other entities buy and sell them too. And a few days ago, SEBI backed this up as well. It proposed a framework to expand the CDS market for mutual funds so that they could effectively manage their risks.

But what the heck are CDS, you ask?

Well, think of these as instruments that protect you from the risk of a bond issuer defaulting on its debt.

To put things into perspective, let’s assume that you’ve invested ₹1,00,000 in a 3-year corporate bond issued by Company A, an infrastructure firm. But since there was news of another infrastructure company going bankrupt recently, you fear that Company A could default on its bonds too. So you go to a bank and buy a CDS.

This means that you simply pay the bank a certain percentage of your bond value as premium, in return for a guarantee that the bank will repay you your principal, in this case ₹1,00,000, with interest if Company A defaults on its debt at any point over the next 3 years.

Now imagine that Company A actually defaults two years later. Without a CDS you’d lose the entire amount you’d invested in its corporate bond. But since you already bought a CDS, the bank simply takes over the company’s debt, while repaying you and other investors the money they’d put in.

It’s like an insurance of sorts where you pay a nominal amount to protect your bond investments from bigger losses due to a default risk.

And if you apply the same principle to a mutual fund you’ll see how it can work wonders not just for the bond market, but for investors too.

That’s because mutual funds pool money from investors and re-invest them in different kinds of instruments. And if that includes bonds, they could risk losing investors’ money if and when the bond issuer defaults. The mutual fund could then perform badly, and returns could nosedive.

On the flip side, when a mutual fund buys a CDS, it can simply translate into more predictable returns for its investors and increase their trust in the bond market. While the fund itself continues to focus on its investment strategies rather than being overly concerned about the default risk associated with the bonds.

But here’s something we haven’t told you yet. Mutual funds have been allowed to buy CDS for a few years now. So what we’ve explained so far isn’t anything new. What’s new really is that SEBI has allowed a few of these mutual funds to sell CDS too. So that could mean that they could now guarantee other entities or retail investors that they will pay them back in case a bond doesn’t.

But wait… a mutual fund selling CDS essentially means taking the risk of default upon itself. And that could seem quite counterintuitive to the idea of buying CDS, no?

That’s a valid question. But what if we told you that dabbling in both buying and selling CDS opens new avenues for mutual funds?

You see, not every bond comes with a default risk. So when a mutual fund builds a portfolio of investments, it could throw in some risky bonds and some not so risky ones. And low risk bonds are highly unlikely to default on their debts. So selling CDS for them could actually mean that the mutual fund pockets some extra income in the form of premiums.

That’s not it. SEBI won’t let a mutual fund sell CDS without having sufficient funds and investments in the form of government securities or treasury bills. Treasury bills for context are short term instruments that help the government meet its short-term funding requirements. The bottom line is that a mutual fund will have to buy sufficient government bonds to back the CDS guarantees they’re taking up. And these government bond purchases will only boost the bond market further.

Sounds like a neat plan, eh?

Until next time…

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