What are Credit Default Swaps? Paul Roberts proberts@arlingclose.com

Analysing and assessing the financial strength of an institution, be it a bank, a corporate or a sovereign, requires more than just relying on credit ratings. For some time now Credit Default Swaps (CDS) have been used as an additional indicator of risk alongside other measures, and one determined by supply and demand rather than a single rating agency’s view of an entity’s creditworthiness. 

Within our credit advice, we use CDS for exactly that reason, to be able to see at any given time how financial markets perceive the risk of the institutions we monitor, both in absolute and relative terms. But apart from being used in our analysis, what are CDS and what are they used for? 

In essence, a CDS is an insurance policy whereby one party wishing to reduce their credit risk enters a contract with another party who agrees to provide protection against that risk. The majority of CDS are written on the debt/bonds issued by corporate borrowers, but they can be written against portfolios of loans, mortgages, or other debt securities. 

As part of the CDS contract the buyer agrees to make a series of payments to the seller over the life of the contract on the promise that if a default occurs the seller will compensate the buyer for the loss. The perceived risk of loss is captured in the CDS ‘spread’ (quoted in basis points) with a higher figure representing a higher degree of risk and a lower figure representing lower risk.  

A CDS on one specific borrower (i.e. a particular bank) is known as a single-name CDS, within which the contract states the name of the borrower, called the ‘reference entity’ and the ‘reference obligation’, which is typically a particular debt instrument being covered, and usually is a senior unsecured obligation (clients will see this as the ‘S’ in our bail-in analysis). 

Each CDS contract specifies a notional amount, representing the amount of protection being bought. For example, if an organisation is holding £10 million of a specific bank’s senior bonds, a CDS can be bought for that amount. The contract will also specify a maturity date, typically within the range of 1 to 10 years, with 5 years being the most common and actively traded maturity (and what we use in our analysis). 

The periodic payment made by the CDS buyer to the seller is based on the spread. Conceptually, the spread is similar to the credit spread on bonds whereby the spread of one over another (i.e. between a UK bank and the UK sovereign) reflects the compensation required for bearing the higher risk of the former against the latter. Using our example of the £10m contract, if the CDS spread is 100bp (i.e. 1%), the buyer will pay £100,000 each year for the protection. 

Convention is now for CDS contracts to have fixed standardised coupons, with 1% typically used for investment grade companies (or index) and 5% for high yield. As not all investment grade or high yield grade companies carry equivalent risk, the standard coupon may be too high or too low, with any discrepancy captured by an upfront payment/premium. Where the standard coupon is too low, the buyer will pay the upfront premium to the seller, and vice versa if the standard rate is too high. The amount to be paid/received is based on the present value of the spread minus the present value of the fixed coupon. 

As a traded instrument, a CDS has a value that fluctuates over time as the credit risk of the reference entity changes, offering the potential to unwind the position to capture a gain or realise a loss. However, assuming the buyer does not trade the CDS and is holding it until maturity purely to mitigate credit risk, one of three general ‘credit events’ must usually happen for the contract to pay out, namely bankruptcy, failure to pay, or restructuring. 

Once the credit event has occurred, settlement can either be made physically, involving actual delivery of an appropriate debt instrument in exchange for the notional amount of the contract, or as a cash settlement from seller to buyer, with the latter being most common. 

While many buyers of CDS use them a risk mitigation tools to hedge an underlying credit exposure, they can also be used for speculation where a party has no exposure to the reference entity, but simply has a view of the perceived creditworthiness of the entity and seeks to profit from either an improvement or deterioration in credit quality. Such a position is referred to as a naked CDS and has caused controversy in regulatory or political circles. For naked buyers of CDS, where a deterioration in credit quality is expected, this is one of the reasons the instruments courted such controversy during the global financial crisis of 2007-08 as investors holding these benefitted from the misery that was caused to many around the world at the time. 

Although the CDS market is much smaller than it was before the global financial crisis, it remains a large and very liquid market, allowing a highly efficient means of managing and trading credit risk to a variety of market participants.

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