Credit Default Swaps for Retail Investors: Balancing Risk and Opportunity Through Mutual Funds

By Rahul Guhathakurta

Cover Image Attribute: SEBI's headquarter in Mumbai, India

The Securities and Exchange Board of India (SEBI) has recently made a groundbreaking decision,  allowing mutual funds to buy and sell credit default swaps (CDS). A CDS is a financial tool that enables investors to transfer the risk of a bond defaulting to another party. This move marks an exciting shift in the Indian economic landscape, potentially offering mutual fund investors new avenues for enhanced returns and diversification. However, it also introduces complex risks that demand expert management and robust regulatory oversight. The potential benefits include enhanced returns and diversification, while the risks include higher costs, volatility in fund performance, and systemic risk. It's a step towards developing India's corporate bond market, promising a brighter future for Indian investors, but it's crucial to understand and manage these risks.

The potential of CDS in mutual funds is significant. With professional portfolio managers at the helm, mutual fund investors stand to benefit from expert management, avoiding the complexities of credit risk and default recovery. Armed with in-depth credit market analysis, fund managers can strategically assess which CDS contracts to enter, how much exposure to take on, and when to adjust positions, all while keeping investor interests at the forefront. Also, mutual funds can mitigate risk by diversifying CDS exposure across companies, sectors, and countries. For instance, combining CDS contracts with other assets like stocks, bonds, and commodities can lead to a more balanced portfolio and potentially more substantial returns. A fund might, for example, hold a mix of CDS contracts on corporate bonds, stocks in the technology sector, and government bonds to spread risk across different asset classes.

However, it's important to note that the risks and complexities associated with CDS need to be carefully considered. While mutual funds simplify CDS exposure for retail investors, the underlying product remains intricate. Retail investors may need to fully grasp how much exposure impacts a fund's risk profile. Further, funds using CDS-related strategies often face higher costs, including management fees, trading costs, and counterparty risk management. The performance of a CDS-heavy mutual fund could also be volatile, especially during broader economic downturns. In such cases, misjudgments by fund managers or amplified risks through leverage could lead to significant losses. Additionally, the use of leverage in CDS trading introduces systemic risk, which, if widespread across multiple funds, could destabilize the financial system.

SEBI's regulatory safeguards play a crucial role in ensuring CDS exposure remains a balanced opportunity for retail investors. These measures, including the requirement for high-quality collateral and daily risk management, provide a safety net for investors. Exclusions for liquid and overnight schemes, alongside limits on leverage and diversification requirements, further ensure that funds do not take on excessive or concentrated risk. Regular stress testing and risk assessments are also critical to ensuring CDS positions remain within acceptable limits, providing a sense of security for investors.

SEBI's approval of CDS trading within mutual funds is a double-edged sword. On one side, it offers mutual funds a tool to enhance returns and diversify risk, contributing to the growth of India's corporate bond market, particularly for lower-rated bonds with a higher default risk. This could potentially lead to increased liquidity and efficiency in the bond market. On the other side, it introduces complex risks that demand expert management and robust regulatory oversight. With the right balance of opportunity and protection, this could be a pivotal moment in the evolution of the Indian financial market, offering both growth and stability for retail investors and the broader economy.

NOTE: Earlier this year (in January 2024), SEBI allowed alternative investment funds (AIFs) to engage in the CDS market as both protection buyers and sellers. This decision was aimed to enhance the domestic corporate bond market and allow businesses to hedge against risks associated with bond investments. According to the regulations, Category-I and Category-II AIFs can purchase CDS on underlying investments in debt securities solely for hedging purposes. At the same time, Category-III AIFs can buy CDS for hedging or other purposes as long as they remain within permissible leverage limits, as stated in a circular from SEBI. Regarding sales, Category-II and Category-III AIFs must set aside unencumbered government bonds or Treasury bills equal to their CDS exposure. These earmarked securities may also fulfill the margin requirements related to the CDS exposure, and such exposures will not be classified as leverage.

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