What are Credit Default Swaps

CDS, or Credit Default Swaps is a form of fixed income derivate and makes for a complex investment vehicle which can be compared to a form of bond insurance (although it is a bit different) which protects the bond buyer from any defaults. CDS can be used in the event a bond issue fails on the debt agreement. In such case, the owner of the swap is eligible to collect the face value of the bond. Credit default swaps are usually used to reduce risks associated with buying risky bonds. Speculaters invest in the swaps in a way, betting on the probability of a bond being defaulted.

The price of credit default swaps is inversely proportional to the investor confidence. When CDS prices fall, it implies that the investor’s confidence in the bond issuer is growing and vice versa.

Definition of Credit Default Swaps

CDS is a financial contract where one party accepts a fee that is similar to an insurance premium which guarantees to protect the CDS buyer from loss of interest payments or principle if a bond defaults.

Credit Default Swap prices make a good indicator of the default risks. For example, if the spreads between the CDS prices increase, the default risk is known to be higher. However, with the exception of CDS that is linked to bond insurers, credit default swaps in other sectors are known to be influence by many other factors. Based on a study conducted by Fitch Ratings which monitored the CDS price movements and included various market participants such as banks, bond insurers and insurance companies, etc, came to the conclusion that given that CDS were thinly traded private transactions, there was a lot of external influences on the CDS prices.

Credit Default Swaps
Credit Default Swaps – Courtesy: Huffington Post

Credit Default swaps can be valuable in two ways to both the issuer of the CDS and the buyer of the CDS. If a bond is risky and then CDS can be valuable as an insurance and if the bond is known to be strong in its payouts, then CDS can be valuable in terms of the premiums that are paid out. In other words, if a bond does not default during its term, the buyer will have to pay premiums until the bond matures.

The premiums that are paid to the CDS seller is known as a spread and is expressed in the basis points of the notional value or the total face value of the underlying bond of the contract per year paid quarterly or semi-annualy.

Credit Default Swaps was formed in the late 1990 and was conceived to protect bonds against defaults on safe bond investments such as municipal bonds. The monthly payments on the premiums made CDS a steady source of extra income to the issuers. Over time CDS became popular with the issuing banks and soon CDS became bets on the health of a company or a bond.

CDS is mostly commonly used by banks as a bank’s basic business comes from credit risks arising from the loans they offer. Using the CDS, banks manage to shift the risks without involving the credit borrowers and without having to remove the assets off their balance sheets. Insurance companies are one of the leading participants in the CDS markets.

CDS’s performance is usually measured by the changes in the credit spreads and have become a hedging instrument which allows the participants to take the exposure to a default risk and the changing spreads and can be used to diverify or hedge credit portfolios.

References to Bond Markets