Credit Default Swaps

A Credit Default Swap (CDS) is a financial derivative used to hedge the risk of corporate debt holders. Used by larger investors such as pension funds and municipal governments, a CDS protects the insurance buyer from losses should their investment lose value for any reason outlined in the CDS agreement.

Credit Default Swaps are of particular interest to three parties – lenders, investors, and speculators. Lenders that have provided funds to a company may arrange a CDS to protect their interests should the borrowing company find that it is unable to make payments. Investors with substantial holdings in the form of corporate bonds for instance, are likewise susceptible to risk should the issuer be unable to make interest and maturity payments.

Speculators are willing, in exchange for a fee, to guarantee payments in the event of default, and there is a very active market for the trading of Credit Default Swaps. This is where most of the speculation occurs as groups buy and sell CDS contracts on an established over-the-counter (OTC) market administered by the International Swaps and Derivatives Association (ISDA).

Credit Default Swaps – Basic Terms

The Credit Default Swaps market has several unique terms that can be confusing at first, particularly around the concept of the buyer and seller of protection. The following table summarizes the participants and defines these terms:

Credit Default Swaps – Hedging Default Risk

Simple Credit Default Swaps – often referred to as “plain vanilla credit swaps” – involve a single Reference Entity and act as a form of insurance for the debt holder. There are two basic situations where Credit Default Swaps are used to hedge against the risk of default:

Scenario 1 – Debt Lenders Seek to Protect Themselves

A CDS with a single Reference Entity is usually purchased by organizations to whom the Reference Entity owes considerable debt. For example, Company X acquires a significant loan from Bank A with which it intends to finance an expansion into new product lines. While there is potential for Company X to dramatically increase revenues, there is also a risk that it will be unable to meet its short-term obligations – including the additional loan payments – until these new revenue streams materialize.

In order to reduce its exposure to this risk, Bank A may approach Bank B with a CDS offer that could benefit both institutions. In short, Bank A will offer a premium to Bank B in exchange for guaranteeing some agreed-upon portion of the loan. If Company X defaults on the loan, Bank A will receive payment from Bank B – if Company X does not default on the loan, then Bank B keeps the premiums it receives from Bank A.

Bank A could also have chosen to sell part of the loan to another bank which would also accomplish the goal of reducing its exposure to the loan. However, by using a CDS, Bank A effectively hedges its risk yet still maintains its full relationship with Company X. In this situation, a CDS is the more attractive option for Bank A to hedge against the risk of the loan going into default.

Scenario 2 – Bond Purchasers Seek to Protect Investment

For investors dealing with specific corporate bonds, there is always the risk that the issuer of the bond may fail to meet its obligations – this could negatively impact the investor’s strategy. Therefore, some large-scale bond investors rely on the CDS market to provide asset protection for their holdings. This is the one vehicle available to investors that enables them to transfer risk should the Reference Entity default or suffer a ratings downgrade – either situation would lead to a devaluation of the original bond.

The CDS agreement in this case would be structured so that the Protection Buyer pays a premium to the Protection Seller. The contract would include specific examples of what constitutes a Credit Event – this could be a ratings downgrade, payment default, or even bankruptcy of the Reference Entity. Should one of the Credit Events occur, the Protection Seller would be obligated to make payment to the Protection Buyer as outlined in the CDS contract. Note that a number of bond insurers exist that specialize in providing insurance for bond investors.

Credit Default Swaps – Speculating

In the last decade or so, there has been a great deal of growth in the use of Credit Default Swaps derivatives as a means of speculating. In the U.S., much of the speculation-based trading is concentrated on a group consisting of several hundred of the larger companies and most of the trading in this area is conducted by professional traders.

When using a CDS as an investment opportunity, as the Protection Seller, you are speculating that a Credit Event will not occur during the term of the contract and you will not be required to provide remedy to the Protection Buyer. Should a Credit Event occur, the payment you will be required to pay will greatly exceed the total premium received, and this is the risk that all Protection Sellers must bear.

Corporate and Debt Ratings

To help make informed decisions regarding the financial health and future prospects of a Reference Entity, investors rely on risk ratings provided by various rating services. Organizations such as Moody’s and Standard and Poor’s – as well as the Dominion Bond Rating Service (DBRS) in Canada – provide independent evaluations of a company’s creditworthiness and this rating is used to help determine the appropriate premium required to buy the CDS.

The rating assigned to a bond issuer has an enormous impact on the entity’s ability to take on debt through the issuing of bonds or even direct loans. The highest ratings are reserved for governments because – in theory at least – governments can increase revenue simply by levying new taxes. There are limitations to this of course but generally, governments in countries with strong economies have higher ratings than all corporations.

After governments, major Fortune 500 companies have the next highest ratings and are deemed investment grade. Because these companies are less likely than companies with lower ratings to default on credit payments, the premiums required to purchase debt protection is much less. As the rating of a Reference Entity lowers, the greater the likelihood of a default situation and, as a result, the premium increases accordingly.

At the bottom of the scale is “junk status” which just as its name implies, is a very poor recommendation. Therefore, the premium required to protect debt for entities with this status is very high, assuming you can even find a counterparty willing to underwrite the risk. In all likelihood, the premium would be so high for riskier entities that it may not make sense to even consider purchasing CDS protection.

Because the premiums for buying and selling Credit Default Swaps are so closely tied to the overall health of the Reference Entity, investors often look at the CDS markets as a barometer revealing additional information about the strength of a particular company. This is certainly the case if there is a change in a company’s rating, but even a sudden increase in CDS transactions could be a sign that the future of company is somewhat in question.