Transferring Credit Risk

     Print Edition: January 2013

In November 2012, market regulator Securities and Exchange Board of India, or Sebi, allowed Fixed Maturity Plans, or FMPs, which are close-ended mutual fund schemes, to buy credit default swaps (CDS), a product which insures debt investments. This is expected to make FMP investments more secure and attractive.

Sebi said FMPs with tenure of more than a year and which are exposed to corporate debt can use this facility.

Let's see how this will make a difference to your portfolio.

DEBT SYNDROME

Herd mentality is common. Many people invest on advice from relatives and friends rather than financial planners and so miss out on investment opportunities. For instance, in 2012, equity markets did well, but retail investors continued to be skeptical and stayed away from stocks. Every stock market jump triggered a fall in assets under management of the fund industry. Debt funds were the flavour of the season. With liquidity remaining tight, many companies issued debt papers, which got a good response. The poorly-rated companies had to borrow at high rates but their issues, too, were fully subscribed.

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However, most people do not realise that debt, often considered safe, has its own set of risks that are little understood. First, there is a rate risk, which means you lose the chance to earn more if interest rates rise further. Second, there is a default risk, that is, the company is unable to pay either interest or principal or both. Third, there is a liquidity risk, which means there is no buyer for the bonds when you want to sell. The biggest of these is the default risk, when a company defaults on payment. In such a case, you may lose both interest and principal.

To insure themselves against this, the funds can now buy CDS. But the question everyone is asking is-will the product find favour with Indian mutual funds? "The recent move by Sebi to allow mutual funds to participate in the CDS market is part of the government's effort to develop a vibrant corporate bond market. Given the market situation, from the mutual fund industry's viewpoint, the scope for participation appears limited at this stage," says Santosh Kamath, chief investment officer, fixed income, Franklin Templeton Investments.

CDS SIMPLIFIED

Imagine that a fund buys corporate bonds or debt to protect the principal and earn some interest. Now, if the firm defaults, the fund may lose both interest and principal. To protect itself if something like this were to happen, it can enter into a CDS agreement and transfer the risk to a third party. So, just as people pay insurers, the fund will pay a fee for transferring its risk. Thus, if the firm defaults, the market maker or the third party will pay the fund both interest and principal that he was promised by the defaulter firm.

Once the CDS market becomes active, it will be up to the fund manager to determine if a bond or an underlying needs protection, and at what cost or premium.

Simply put, the buyer gets credit protection, whereas the seller of the swap guarantees the credit worthiness of the security. In doing so, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Sebi has put certain conditions for funds that wish to take CDS protection. Only FMPs with tenure of over one year can enter into such agreements. Also, exposure will be limited to 10% of the fund's net assets. In addition, the funds can enter into these contracts only with the market makers, the banks approved by the Reserve Bank of India. Also, the funds will have to seek approval from the board and the trustees of their asset management company. They will also have to disclose CDS transactions on monthly and half-yearly basis.

MARKET IN INDIA

The CDS market in India is new and is yet to evolve, say experts. "There are some teething issues. A lot of background work needs to be done. People are still negotiating on the legal and execution aspects," says Amit Tripathi, head of fixed income, Reliance Capital Asset Management.

While the rules have been laid, the product is new and the industry will take time to arrive at proper pricing, say experts. "In any market, participants often do not want to trade in new instruments/structures until liquidity in the underlying market improves. Even globally, credit derivatives were initially seen as esoteric instruments and became mainstream only after being in existence for years," says Kamath.

RETURNS AFTER CDS

Once the CDS market becomes active, it will be up to the fund manager to determine if a bond or an underlying needs protection, and if yes, at what cost or premium.

"I will buy protection only if the return from the underlying bonds is more than or equivalent to that from a triple AAA security and pricing is commensurate with the risks involved," says Tripathi.

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Also, the fund manager's perception about how a company in which he has invested is likely to perform will play a big role.

If a fund manager thinks a particular company is likely to be downgraded at any future date, he may enter into a CDS transaction before the event to get a better price for the cover.

After the CDS market takes off, the funds will be able to protect investments against defaults and yet try to earn better returns compared to the most secure government securities.


HOW CDS WORKS

> A mutual fund buys corporate bonds and wants to transfer the risk to a third party
> It enters into a CDS transaction with the market maker
> The market maker charges a fee and promises to make good the loss if the company defaults
> Only FMPs with tenure of over one year can enter into such agreements


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