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- A credit default swap (CDS) is a contract that allows one party (an investor) to transfer some or all risk to a third party for a period of time.
- The investor who's buying the CDS pays protection premiums to the third party to assume that risk.
- If the original issuer defaults, the third party pays; if not, the third party profits from the premiums.
From their birth in the aftermath of the Exxon Valdez oil spill to the unregulated chaos of the 2008 financial crisis, credit default swaps (CDSs) have played a major role in helping financial institutions participate in effective risk management.
Whether it's insurance against defaulted loans, or fixed-income products such as municipal bonds, mortgage-backed securities (MBS), or corporate debt, CDSs, whose notional value reached $61.2 trillion at the end of 2007 and fell close to $8.5 trillion at the end of 2020, remain an important part of the investing landscape.
Here's what you need to know about these unique products.
What is a credit default swap?
A CDS is a financial derivative that investors can use to hedge the risks associated with debt-based securities. In this capacity, a CDS basically functions like an insurance contract.
More specifically, buyers purchase these contracts in order to mitigate risks associated with debt-based securities.
Usually, investors buy CDSs to protect themselves against the risk of default. However, these contracts can mitigate many risks associated with debt-based securities.
Alternatively, investors can use CDSs to speculate, potentially earning a profit by doing so.
How credit default swaps work
A CDS is a contract that involves a buyer and a seller. The issuer, or seller, offers to manage some of the risks associated with debt-based securities such as bonds or MBSs.
In exchange, the buyer pays the seller premiums for providing this risk management. In a typical scenario, the investor owns the debt securities and purchases a CDS contract from the seller to hedge or protect their investment.
"Essentially, the investor 'swaps' the risk to the CDS seller," says Dean Kaplan, president and CEO of the Kaplan Group. "The seller of the CDS is like an insurance company — it collects premiums for selling credit default swaps and then hopes that the amounts it pays out on defaults that occur cost less than the amount collected."
If the original debt securities covered by the CDS perform as promised, the CDS seller keeps the premiums as profit and has no further obligation. The investor receives the principal and interest from the issuer as promised and, assuming the premiums were reasonable, enjoys any profit that is generated.
Important: The issuer is not a party to the CDS and, in fact, the CDS is not tied to the debt securities but only refers to them as "reference obligations."
The purpose of credit default swaps
Risk management and speculation
When a CDS functions as insurance, it is effectively a hedging tool to protect against a negative event related to the reference obligations. CDS contracts have another use as well. Some investors use CDS contracts to speculate on the creditworthiness of specific debt issuers.
Someone with a positive view of the credit quality of a company, for example, could become a CDS seller to an investor with a negative view. The seller would be taking a long, or optimistic, view on the creditworthiness of the issuer while the investor could be seen as taking a short, or pessimistic view.
Note: Neither party in a CDS contract needs to own the underlying debt securities in order to buy or sell the CDS
The price of the premiums paid to the seller is referred to as the spread and reflects the market's view of the issuer's creditworthiness. The more creditworthy the issuer is perceived as being, the lower the premiums and the smaller the spread. As creditworthiness worsens, the reverse is true — premiums rise and the spread goes higher.
Risks associated with credit default swaps
Counterparty risk
Counterparty risk is the possibility that one side in a contractual obligation will fail to make good on its agreement.
If a party buys a CDS, it might fail to make all the payments associated with purchasing this contract. In order to recoup this lost income, the party that sold the first CDS could sell a new one to a different party. However, this new contract might sell for less than the first one.
Other risks
If a negative event such as default occurs, the CDS seller is required to meet the terms of the contract including paying the investor the principal and any unpaid interest payments the issuer failed to make through the maturity of the contract. This could result in a substantial loss to the CDS seller.
Alternatively, the buyer of a CDS could end up paying significant premiums and receive nothing in return.
Other risks stem from the fact that CDS contracts are traded over the counter (OTC). As a result, they have historically been nonstandardized and unregulated. In the aftermath of the 2008 financial crisis, clearinghouses have provided standardized contracts and some regulation to the CDS market.
Note: Premiums on investment grade debt are typically set at an annual rate of 1% of par value and 5% on high-yield debt.
The impact of CDS on financial markets
Role in the 2008 financial crisis
CDSs generated significant visibility during the financial crisis of 2008 by contributing to the meltdown that took place. Financial institutions held significant amounts of these contracts, but they faced substantial losses when many of them defaulted at the same time.
These highly visible developments coincided with U.S. lawmakers enacting the Dodd-Frank Act, comprehensive legislation designed to provide a more regulated financial system.
Current regulatory landscape and oversight
As a result, the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodities Futures Trading Commission (CFTC) both have jurisdiction over CDSs, with the former having authority over security-based swaps and the latter having the ability to regulate "swaps."
Evaluating CDS as an investment tool
Considerations for investors
The primary purpose and main advantage of credit default swaps is risk protection or insurance against a negative credit event for institutional investors and hedge funds. For those who have access, CDSs have two additional important advantages — the ability to enhance portfolio yield for sellers and the fact they do not require exposure to the underlying fixed income products.
Despite improvements since 2008, CDS contracts are still less regulated than exchange-traded products. In addition to the risk of default by the borrower, CDSs have an additional risk for the investor if the seller defaults. This "double whammy" is known as double default. Finally, the seller stands to lose a substantial amount of money if the borrower defaults.
Potential rewards and challenges
Interested market participants should keep in mind that CDSs are primarily sold by hedge funds and banks and bought by institutional investors like pension funds, other banks, and insurance companies. "[Because of] the size and nature of a CDS, retail investors cannot invest directly," says Matthew Stratman, lead financial advisor, South Bay Planning Group at Western Financial Securities.
"CDS funds targeted at retail investors have struggled to perform well," adds Kaplan, including two exchange-traded funds, which are the CDS North American HY Credit ETF (TYTE) and ProShares CDS Short North American HY Credit ETF (WYDE). These two funds are actively managed, which introduces additional risks.
Another ETF that had been announced earlier last year by Simplify Credit Hedge with ticker CDX withdrew their application before they launched.
Among the few survivors is Fidelity® Global Credit Fund (FGBFX), which has a strategy that includes investing at least 80% of fund assets in debt securities, hedging those investments with derivatives — including credit default swaps.
FAQs
A credit default swap helps the buyer manage risk by compensating the purchaser if the party issuing the reference obligations defaults on its payments or another credit event occurs.
Credit events could include defaults, bankruptcy, restructuring of debt, and other situations.
Hedge funds, pension funds, and other institutional investors buy and sell these contracts in order to hedge or speculate. They can purchase CDSs to manage the risk of default or sell them to collect premium income.
The financial crisis revealed that these financial contracts needed more regulation and greater transparency. Further, the event made it clear that market participants needed a better understanding of the systemic risks posed by these contracts.
Individual retail investors cannot purchase CDSs directly, but they can gain exposure to these contracts by investing in different securities like ETFs.
