What Is Credit Default Insurance?
Credit default insurance is a financial agreement—usually a credit derivative such as a credit default swap, total return swap, or credit-linked note—to mitigate the risk of loss from default by a borrower or bond issuer.
Understanding Credit Default Insurance
Credit default insurance allows for the transfer of credit risk without the transfer of an underlying asset. The most widely used type of credit default insurance is a credit default swap. Credit default swaps transfer credit risk only; they do not transfer interest rate risk. Total return swaps transfer both credit and interest rate risk.
Credit Default Swap as Credit Default Insurance
A credit default swap (CDS) is, in effect, insurance against non-payment. Through a CDS, a buyer can reduce the risk of their investment by shifting all or a portion of that risk onto an insurance company, or other CDS seller, in exchange for a periodic fee. In this way, the buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the creditworthiness of the debt security. For example, the buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, should the issuer default on payments.
If the debt issuer does not default and all goes well, the CDS buyer will end up losing some money, but the buyer stands to lose a much greater proportion of their investment if the issuer defaults, and they have not bought a CDS. As such, the more the holder of a security thinks its issuer is likely to default, the more desirable a CDS is and the more the premium is worth it.
Credit default swaps have existed since 1994. CDSs are not publicly traded, and they aren't required to be reported to a government agency. CDS data can be used by financial professionals, regulators, and the media to monitor how the market views the credit risk of any entity on which a CDS is available, which can be compared to that provided by the credit rating agencies, including Moody's Investors Service and Standard & Poor's.
Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives Association (ISDA), although there are many variants. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset-backed securities.