First credit default swap deal struck on ‘AAA’ rated bonds.
While the objective of introducing the instrument was to supplement lower rated bonds, the first credit default swap (CDS) deal has been struck on ‘AAA’ rated bonds. Experts said it would take time for the risk-protection tool to start serving its real purpose.
CDS finally made its debut in India, with ICICI Bank buying protection from IDBI Bank on bonds of Indian Railway Finance Corporation and Rural Electrification Corporation last week.
According to the central bank’s mandate, CDS cannot be written without exposure to an underlying security. In India, the corporate bond market is primarily dominated by top rated bonds. “To start with, CDS would largely be written on bonds of issuers that are high rated and those who frequently access the debt market,” said Gaurav Pradhan, Deutsche Bank’s chief for global credit trading in India. “Once the CDS market is in place, low grade, but frequent, issuers would also come into play.”
Crisil, in a note, said since investors could buy CDS protection against potential credit losses, they would be more open to investing in instruments rated below the ‘AA’ category, which was critical for the growth of India’s bond market. The ratings agency said under its coverage, more than 500 entities came under the ‘A’ category alone.
In terms of buying protection, foreign institutional investors (FIIs) would be interested in taking hedges on their exposure in India. “From an international rating scale perspective, FIIs may want to hedge their risks on even top rated Indian corporate bonds,” said Rajesh Mokashi, deputy managing director, CARE Ratings. He added insurance companies and mutual funds were the biggest investors in the Indian corporate bond market. Entities from both these sectors need approvals from their respective regulatory bodies. “A coordinated action by other regulators can allow insurance companies, pension funds and provident funds to participate in this space through the CDS route,” said Crisil.
While the Insurance Regulatory and Development Authority does not allow insurance companies to invest in lower rated bonds, there is no such obligation on mutual funds or banks. “Since public sector banks are not bound by regulatory obligations, they may be willing to invest in lower rated bonds, and then write a CDS to hedge the risk,” said Mokashi.
“We have seen interest from public sector banks. They would be more active in the CDS market because they have the largest concentration of risks that they would like to take a hedge against,” said Pradhan.