Understanding Investing

Credit Default Swaps

Originally formed to provide banks with the means to transfer credit exposure, CDS has grown as an active portfolio management tool. The performance of CDS, like that of corporate bonds, is closely related to changes in credit spreads. This makes them an effective tool for hedging risk, and efficiently taking credit exposure.

What is a credit default swap?

A CDS is the most highly utilized type of credit derivative. In its most basic terms, a CDS is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, investors buy credit default swaps for protection against a default, but these flexible instruments can be used in many ways to customize exposure to the credit market.

CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, from one investor to another.

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk – who also tends to own the underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades. (For a more detailed list of CDS credit events see the Commonly Established CDS Credit Events table below).

The graphic below illustrates the credit default swap transaction between the risk “seller,” who is also the protection “buyer,” and the risk “buyer,” who is also the protection “seller.”

What are the characteristics of credit default swaps?

The credit default swap market is generally divided into three sectors:

  1. Single-credit CDS referencing specific corporates, bank credits and sovereigns.
  2. Multi-credit CDS, which can reference a custom portfolio of credits agreed upon by the buyer and seller,
  3. CDS index. The credits referenced in a CDS are known as “reference entities.” CDS range in maturity from one to 10 years although the five-year CDS is the most frequently traded.

Credit default swaps provide a measure of protection against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk “buyer” to the risk “seller” in a CDS.

The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.

The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. Today, CDS have become the engine that drives the credit derivatives market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customize exposure to corporate credit. Today the CDS market represents more than $10 trillion in gross notional exposure1.

In addition to hedging credit risk, the potential benefits of CDS include:

  • Requiring only a limited cash outlay (which is significantly less than for cash bonds)
  • Access to maturity exposures not available in the cash market
  • Access to credit risk with limited interest rate risk
  • Investments in foreign credits without currency risk
  • At times, more liquidity than investing in the underlying cash bonds

The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective tool for portfolio managers to hedge or gain exposure to credit. Credit default swaps also allow for arbitrage opportunities.