Credit Default Swaps

What are “Credit Default Swaps”?

A credit default swaps (CDS) is the most common type of credit derivative. The CDS is a derivative contract that allows one investor to transfer credit risk on an underlying fixed-income instrument or loan to another counterparty. For example, a lender might buy a CDS from another investor who agrees to pay the lender/buyer should the borrower (bond issuer) default. Lenders who have concerns about a borrower potentially defaulting on an obligation can buy a CDS to mitigate that risk.

Credit default swaps are customized agreements that involve three parties: the borrower, typically a bond issuer; the buyer, or the lender/bondholder; and the seller, which is typically a financial institution such as a bank or insurance company. The buyer makes premium payments to the seller throughout the contract period. Like a bond, a CDS has a maturity date. If at any time during the contract period the borrower defaults, the CDS seller will pay the buyer the bond’s value as well as all of the coupon payments that would be due until the bond matured. In essence, the credit default swap functions as insurance on the loan.

The most common type of credit default swaps involves asset-backed securities, although investors may purchase a CDS to offset the risk on any fixed-income security, including corporate bonds, emerging market bonds, or government bonds. CDS agreements are often highly complex and specifically tailored to the needs of the counterparties. They are traded in the over-the-counter market but are both opaque and relatively illiquid.

Credit Default Swaps – Key Terms Defined

In order to understand credit default swaps, there are certain key terms that must be defined.

Buyer: the counterparty seeking protection against default on an underlying security.

Seller: the counterparty assuming the credit risk of the underlying security in exchange for an annual premium. If the issuer of the underlying security defaults, the seller must pay the buyer the security’s value plus all interest due until maturity or until the maturing date of the CDS agreement. CDS agreements can be written for any period and need not match the tenor of the underlying security.

Notional Value: refers to the face value of the underlying fixed income securities.

Reference Obligation: the underlying security against which the CDS provides default protection.

Premium: since a CDS functions as a type of insurance, the buyer pays a premium to the seller, typically on a quarterly basis. The premium is a percentage (expressed in basis points) of the notional value. This is usually paid quarterly and is payable in basis points of the notional amounts. The annual total of premiums paid during the agreement period, expressed as a percentage of the notional value, is called the spread. The spread reflects the view on credit quality. The higher the credit quality, the lower the spread. As credit quality deteriorates, the spread increases.

Settlement: settled in a cash transaction with the term defined as the duration of the contract.

Credit Default Swaps – Credit Event

A credit event occurs when a borrower becomes unable to meet its obligations in full and triggers settlement of the swap. This may take place in the event of default, debt restructuring, or bankruptcy of the issuer of the underlying security.

Formula

When a credit event occurs, the seller of the CDS pays the buyer according to the following formula:

Payout Amount ($) = V * Payout Ratio = V * (1-Recovery Rate)

V = Notional Value

Payout Ratio: the loss incurred by the bondholder expressed as a percentage of the bond’s par value. It is equal to 1 – Recovery Rate.

Recovery Rate: the percentage of the amount owed that a bondholder recovers when a credit event has occurred.

Credit Default Swaps – An Example

Assume that a bank lends US$ 50 million to a company. The loan matures in five years with an annual interest rate of LIBOR +2.2%. The bank purchases a credit default swap on the notional value of the loan, or US$ 50 million.

Assume an annual premium of 2% on the CDS, which the bank will pay to the seller every year for the duration of the loan. At 2%, the annual premium is US$ 1 million.

Let’s assume that the borrower defaults on the final principal payment of the loan and the bank collects only 40% of the principal. In this scenario, the seller will pay the bank the difference. The seller will pay the bank US$ 50 million * (1-40%), or US$ 30 million.

If the borrower does not default, the seller will pay nothing and will have profited from collecting the premium payments. Counterparties exist on the buy and sell side because investors have differing views on creditworthiness. Let’s assume that the borrower defaults on the final principal payment of the loan and the bank collects only 40% of the principal. In this scenario, the seller will pay the bank the difference. The seller will pay the bank US$ 50 million * (1-40%), or US$ 30 million.

Conclusion

Investors buy credit default swaps to protect themselves against default on debt they hold. Credit default swaps are bespoke instruments and can customize exposure to the credit market. While buyers seek protection, sellers are making bets on creditworthiness, hoping that they will be able to profit from collecting premiums without experiencing a credit event that will trigger a payment.