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The authors are Sibasish Panda and Ishita Khandelwal, fifth-year students at National Law University, Odisha.
Introduction
The Indian corporate bond market has witnessed a 77% increase in the last five years, highlighting the rising interest of investors in fixed-income securities and the escalating need for capital among the various bond issuers. A Credit Default Swap (“CDS”) is a financial derivative that functions as a type of insurance against the risk of default on debt instruments such as bonds or loans, and is vital to the bond market's growth. However, the Indian embrace of CDS is in very nascent stages with the Reserve Bank of India (“RBI”) constantly striving for a flourishing derivatives market.
In a recent consultation paper, the Securities and Exchange Board of India (“SEBI”) has proposed increasing flexibility in the Mutual Funds (“MFs”) use of CDS and revamping the bond market in India. The proposal intends to stimulate the debt market by permitting significant non-bank regulated entities, such as MFs, to sell protection, in line with the RBI's updated regulatory framework for CDS. This article explores SEBI's recent initiatives to enhance the role of MFs in the CDS market, aiming to revitalise the Indian debt market by improving risk management, liquidity, and investor confidence.
New advancements for Mutual Funds as a Buyer of CDS
SEBI now suggests permitting MFs to buy CDS only to hedge the credit risk on debt securities they hold in all the schemes rather than limiting its participation only in the portfolio of schemes having a Fixed Maturity Plan (“FMP”) of one year. This gives the MFs an additional blanket against investment risks in low-rated corporate bonds.
SEBI has proposed a timeline to square off the CDS position within 7 days of selling the protected debt security. While this shorter period is suggested to prevent speculative positions from being held by the scheme, it creates a sense of urgency for the MFs to close these positions, which the liquidity providers might sense and widen the bid-ask spread (the difference between the highest price a buyer is willing to pay for an asset (the bid) and the lowest price a seller is willing to accept (the ask)). The authors believe this reduces the negotiation power of the funds and increases the funds’ pressure to find counterparts quickly, thereby affecting the profitability of the transactions.
The consultation paper suggests that schemes could buy CDS for both investment-grade and below-investment-grade debt securities aimed to protect against credit defaults if a bond's creditworthiness declines post-purchase. For instance, an MF initially invests in a BBB-rated corporate bond. If this bond is downgraded to BB, indicating a higher credit risk, the fund might have to sell it at a loss or accept the increased risk without CDS protection. By acquiring a CDS from an investment-grade issuer, the fund can offset the increased risk from the downgrade, thereby stabilising the portfolio and protecting investors from significant losses if the bond defaults.
The effectiveness of a CDS as a hedge relies on the financial health of the issuer. If the issuer encounters defaults or financial trouble, the MF faces counterparty risk i.e. the protection may not pay out when needed. This risk can lead to economic losses for investors, abnormal outflows, and negative returns for MFs.
Enhancing Debt Fund Stability: The Role of Selling CDS by Mutual Funds
According to the consultation paper, SEBI and proposals from the Mutual Funds Advisory Committee (“MFAC”) now permit MFs to sell CDS on a reference but only after covering its notional amount with cash or Government Security (“G-Sec”) or Treasury Bills (T-bills”).
Selling CDS that requires the buyer to hold risk-free investments, such as government bonds, is regarded as being just as secure as buying the insured company's debt outright (the reference entity). These bonds are secure and ensure the fund has the necessary money to pay if the company defaults. This arrangement limits the MF’s risk exposure because, by selling a CDS, the fund commits to paying if a company defaults. The maximum payment i.e. the notional amount is known upfront and is covered by buying a G-Sec of equivalent value. In case the company defaults, the MF sells the G-Sec to pay the notional amount, in exchange for the defaulted debt security of the company. Since the maximum loss remains the same, the process is akin to indirectly owning the company's debt security.
Debt funds invest in various kinds of fixed-income securities, whose liquidity varies significantly. In times of low liquidity or market stress, it can be challenging for the fund to sell these securities at favourable prices. It can be difficult for a debt fund holding a substantial portion of lower-rated, less liquid securities, to sell these assets quickly without affecting their prices. CDS selling also allows MFs to earn additional income from premiums paid by the companies, which can help mitigate potential losses from defaults or downgrades in the fund’s portfolio, thereby stabilising the fund's Net Asset Value (“NAV”) and making it more appealing to investors.
Additionally, selling CDS can enhance the MF’s portfolio by diversifying investments and reducing risk. By selling CDS on high-credit-risk entities and balancing this with low-risk insurance purchases, MFs can achieve higher returns without altering the portfolio’s overall risk profile.
Impact of CDS Trading by Mutual Funds on Investor Strategies
CDS trading appeals to investors who see long-term possibilities without a firm view of the direction of credit risk or wish to trade fast based on their expectations about a company's credit risk. When opposed to directly purchasing or selling the company's bonds, CDS contracts are more flexible and need less initial capital, making them the ideal option for short-term investors. Therefore, investors who require greater liquidity in their trades are likely to prefer taking short positions in the more liquid CDS market rather than long positions in the underlying bonds.
Long-term investors on the other hand can employ a tactic known as a "negative basis trade" if they lack a precise credit risk estimate. Purchasing the CDS and the company's bonds is required. By taking advantage of the customary negative spread between bond yields and the CDS, this technique makes up for the decreased liquidity of the bond.
Because MFs behave like both long-term and short-term investors, they help research how large investors use the CDS market. They can trade in response to liquidity requirements or market information. MFs can profit from liquidity premiums without superior knowledge because they are long-term and diversified investments.
This approach allows MFs to enhance returns through liquidity premiums and manage credit risk more effectively, balancing short-term trading opportunities with long-term investment strategies. Consequently, investors in these MFs can enjoy improved risk-adjusted returns and a more dynamic response to market conditions.
Challenges and the Way Forward
One challenge is that SEBI prohibits MFs from selling CDS unless they hold adequate funds and investments in G-Sec or T-bills. Recently, MFs have been net sellers of G-Secs due to the high duration risk associated with fluctuating interest rates. G-Sec also needs to be held longer, and the return is received only at the end of the bond's maturity. Consequently, investors prefer shorter-duration funds and are shifting their investments away from long-duration funds to those with shorter durations. This restriction inhibits MFs' ability to manage their portfolios and may impair their liquidity and return characteristics.
Entities quoting both buy and sell CDS spreads must have a minimum Capital Adequacy Ratio (“CAR”) of 11% and net Non-Performing Assets (“NPA”) of less than 3%. Smaller MFs with smaller risk profiles may need slightly lower CAR and NPA criteria than larger funds, enabling smaller funds to enter the market while maintaining overall stability. Since such MFs may struggle to meet these high eligibility requirements, initially the regulator should let MFs into the market with slightly reduced CAR and NPA and gradually enhance these requirements as the funds acquire expertise and the market matures. This technique can assist MFs in progressively adjusting to new requirements, lowering the initial stress and increasing market participation.
The Indian CDS market is still in its early stages, with few participants and modest trading volume. Due to a lack of market depth, MFs may struggle to find counterparties and execute trades efficiently. Given that most Indian business bonds are AAA-rated, the perceived requirement for credit protection is reduced. This diminishes demand for CDS and makes MFs less likely to participate actively, as retail investors also have a low appetite for risk-taking. However, SEBI has suggested a laudable approach for MFs selling CDS to ensure a two-way credit support Annex (“CSA”) as a part of CDS contracts and decrease the counterparty risk. Both sides would keep a two-way CSA contract margin (or collateral), which can provide additional protection against the higher credit risks carried by bonds rated AA or below. However, the regulatory environment and MFs’ operational capabilities will require a boost to maintain the effectiveness of these measures.
Conclusion
The use of CDS by MFs for hedging credit risks was allowed by SEBI almost a decade ago, but the market didn't grow. CDS applied only to AAA-rated or sovereign-backed debt papers, while there's little demand for lower-rated ones. Liquidity for bonds below AA is extremely low, and debt fund managers taking risks on these for higher returns often face trouble due to their inability to sell quickly in crises.
SEBI's strategy for revising the Indian debt market is encouraging, but several critical elements must come into play for it to succeed. A thorough regulatory framework is necessary to handle the intricacies of CDS trading, like risk management, margin requirements, and reporting standards. A robust market infrastructure is also required for effective and transparent CDS trading, including clearinghouses, trading platforms, and data repositories. Developing a more active secondary CDS market can attract a broader investor base, including hedge funds and insurance companies, thus increasing the liquidity in these markets. Together, these factors can help create a more dynamic and efficient CDS market in India, ultimately supporting the growth of the corporate bond market and broader financial system.
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