What Is a Credit Default Swap (CDS)?
The term credit default swap (CDS) refers to a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk.
- Credit default swaps are credit derivative contracts that enable investors to swap credit risk on a company, a country, or another entity with a different counterparty.
- Lenders purchase CDSs from investors who agree to pay the lender if the borrower ever defaults on its obligation(s).
- CDSs are traded over-the-counter and are often used to transfer credit exposure on fixed income products in order to hedge risk.
- There are normally three parties involved in a CDS: the debt issuer, the buyer, and the seller of the CDS.
- Contracts are customized between the counterparties involved, which makes them opaque, illiquid, and hard to track for regulators.
How Credit Default Swaps (CDSs) Work
A credit default swap is a derivative contract that transfers the credit exposure of fixed income products. It may involve bonds or other related securities—basically loans that the issuer receives from the lender. If a company sells a bond with a $100 face value and a 10-year maturity to a buyer, the company agrees to pay back the $100 to the buyer at the end of the 10-year period as well as regular interest payments over the course of the bond's life. Because the debt issuer cannot guarantee that it will be able to repay the premium, the debt buyer assumes the risk.
CDSs require at least three parties:
- The first party is the institution that issues the debt. This party is also known as the borrower.
- The debt buyer is the second party, who will also be the CDS buyer if the parties decide to engage in the contract.
- The CDS seller is the third entity involved in the CDS. This entity is most often a large bank or insurance company that guarantees the underlying debt between the issuer and the buyer.
Debt securities often have longer terms to maturity, making it harder for investors to estimate the risk of the investment. That's why these contracts are an extremely popular way to manage risk. The buyer makes payments to the seller until the contract's maturity date. In return, the seller agrees that (in the event that the debt issuer defaults or experiences another credit event) the seller will pay the buyer the security's value as well as all interest payments that would have been paid between that time and the maturity date.
The credit event is a trigger that causes the buyer of protection to terminate and settle the contract. Credit events are agreed upon when the trade is entered into and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers:
Credit default swaps are traded over-the-counter (OTC), which means they are non-standardized and not verified by an exchange. That's because they are complex and often bespoke. There is a lot of speculation in the CDS market, where investors can trade the obligations of the CDS if they believe they can make a profit.
Although CDSs guarantee payments through maturity, they do not necessarily need to cover the entirety of the bond's life. For example, imagine an investor is two years into a 10-year security and thinks that the issuer is in credit trouble. The bond owner may choose to buy a credit default swap with a five-year term that would protect the investment until the seventh year when the bondholder believes the risks will fade.
It is even possible for investors to effectively switch sides on a CDS to which they are already a party. For example, if the seller of a CDS believes that the borrower is likely to default, that party can buy their own CDS from another institution or sell the contract to another bank in order to offset the risks. The chain of ownership of a CDS can become very long and convoluted, which makes tracking the size of this market difficult.
Here's another thing to remember about CDSs. When a credit event occurs, the contract may be settled physically, which has historically been the most common method, or by cash. In a physical settlement, sellers received an actual bond at part by the buyer. Cash settlement, though, became the more preferred method when the purpose of CDSs shifted from hedging tools to speculation. In this type of settlement, the seller is responsible for paying the buyer for losses.
The U.S. Comptroller of the Currency issues a quarterly report on credit derivatives and in a report issued in December 2021, it placed the size of the entire market at $3.9 trillion, of which CDS accounted for $3.3. trillion.
Mitigating the Risk
A credit default swap is effectively an insurance policy against non-payment. The buyer can shift some or all that risk onto an insurance company or other CDS seller in exchange for a fee. By doing this, the buyer receives credit protection while the seller guarantees the creditworthiness of the debt security. This means the buyer is entitled to the par value of the contract by the seller along with any unpaid interest if the issuer ever defaults.
Remember, the credit risk isn't eliminated. Rather, it is shifted to the CDS seller. If the debt issuer does not default and if all goes well, the CDS buyer ends up losing money through the payments on the CDS. The buyer, on the other hand, stands to lose a much greater proportion of their investment if the issuer defaults and didn't buy a CDS. As such, the more the holder of a security thinks their issuer will default, the more desirable a CDS becomes. As such, it ends up costing more.
A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities (MBS), or corporate bonds.
Example of a CDS
Here's a hypothetical example to show how credit default swaps work. Let's assume there is a CDS that earns $10,000 quarterly payments to insure a $10 million bond. The company that originally sold the CDS believes that the credit quality of the borrower has improved so the CDS payments are high. The company could sell the rights to those payments and the obligations to another buyer and potentially make a profit.
Alternatively, imagine an investor who believes that Company A is likely to default on its bonds. The investor can buy a CDS from a bank that will pay out the value of that debt if Company A defaults. A CDS can be purchased even if the buyer does not own the debt itself. This is a bit like a neighbor buying a CDS on another home in her neighborhood because she knows that the owner is out of work and may default on the mortgage.
If Lender A advances a loan to Borrower B with a mid-range credit rating, Lender A can increase the quality of the loan by buying a CDS from a seller with a better credit rating and financial backing than Borrower B. In this case, the risk doesn't go away, but it is reduced through the CDS.
CDSs played a key role in the credit crisis that eventually led to the Great Recession. One of the primary causes of the meltdown stemmed from the risk that CDS sellers defaulted at the same time the borrower defaulted. CDS sellers like Lehman Brothers, Bear Stearns, and AIG all defaulted on their CDS obligations.
European Sovereign Debt Crisis
Credit default swaps were widely used during the European sovereign debt crisis. In September 2011, investors believed that Greece's government bonds had nearly a 100% probability of default. Many hedge funds even used CDS as a way to speculate on the likelihood that the country would default.
How Does a Credit Default Swap Work?
A credit default swap is a financial derivative contract that shifts the credit risk of a fixed income product to a counterparty in exchange for a premium. Essentially, credit default swaps serve as insurance on the default of a borrower. As the most popular form of credit derivatives, buyers and sellers arrange custom agreements on over-the-counter markets which are often illiquid, speculative, and difficult for regulators to trace.
What Is an Example of a Credit Default Swap?
Consider that an investor buys $10,000 in bonds with a 30-year maturity. Because of its lengthy maturity, this adds a layer of uncertainty to the investor because the company may not be able to pay back the principal $10,000 or future interest payments before expiration. To ensure themself against the probability of this outcome, the investor buys a credit default swap.
A credit default swap essentially ensures that the principal or any owing interest payments will be paid over a predetermined time period. Typically, the investor will buy a credit default swap from a large financial institution, who for a fee, will guarantee the underlying debt.
What Are Credit Default Swaps Used for?
Credit default swaps are primarily used for two main reasons: hedging risk and speculation. To hedge risk, investors buy credit default swaps to add a layer of insurance to protect a bond, such as a mortgage-backed security, from defaulting on its payments. In turn, a third party assumes the risk in exchange for a premium. By contrast, when investors speculate on credit default swaps, they are betting on the credit quality of the reference entity.