- 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.
- Read more stories from Personal Finance Insider.
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 how financial institutions attempt to mitigate risk.
Whether it’s insurance against defaulted loans, or fixed income products such as municipal bonds, mortgage-backed securities (MBS), or corporate debt, CDSs, which reached notational valuation of $61.2 trillion in 2007 and sit at $11.7 trillion today, 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 involves the actions of three parties: an issuer, an investor, and a CDS seller. The issuer offers debt securities such as bonds or MBSs. In a typical scenario, the investor owns the debt securities and purchases a CDS contract from the CDS 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.
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 CDS contract. This could result in a substantial loss to the CDS seller.
How do credit default swaps work?
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 about 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 view on the creditworthiness of the issuer while the investor could be seen as taking a short view.
The price of the premiums paid to the seller are referred to as the spread and reflect the market’s view of the issuer’s creditworthiness. The better the creditworthiness, the lower the premiums and the smaller the spread. As creditworthiness worsens, the reverse is true — premiums rise and the spread goes higher.
CDS contracts, which are traded over the counter (OTC) have historically been non-standardized and unregulated. Since the 2008 financial crisis, clearing houses have provided standardized contracts and some regulation to the CDS market.
How to buy credit default swaps
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 ETFs, TYTE and WYDE. 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.
Pros and cons of credit default swaps
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..