Credit default swaps (CDS) are widely used financial derivatives, or contracts, that give investors the ability to “swap” their credit risk with another investor. They’re a popular type of investment, especially for institutional investors.
Investors use CDS for many types of credit investments, including mortgage-backed securities, junk bonds, collateralized debt obligations, corporate bonds, emerging market bonds, and municipal bonds.
Credit Default Swaps, Explained
Credit default swaps are the most common type of credit derivative, and they help investors reduce the risk that borrowers on the securities they own will default on their loans. To reduce their risk, the investor purchases a CDS from another investor, who will pay the lender back if the borrower defaults on the loan. There is generally an ongoing payment as part of the contract, which serves as an insurance policy.
The investments used to create credit-default swaps include many types of credit, such as mortgage-backed securities, junk bonds, collateralized debt obligations, corporate bonds, emerging market bonds, and municipal bonds. However, while the contract references a specific security or set of securities, it is not actually connected to it. Most CDS investors are institutional investors, such as hedge funds, due to the securities’ complex and risky nature.
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The credit-default swap contract lays out the responsibilities of the seller in the event that the borrower experiences a credit event or defaults on their loan. Credit events can include failure to pay, bankruptcy, moratorium, repudiation, and obligation acceleration. If any of these events occur, the buyer of the CDS may terminate the contract and the seller will need to pay. The specifics of these credit events are outlined in the contract that both parties sign.
The agreement between the borrower and the lender is separate from the lender’s agreement with the CDS seller, in which the lender becomes the CDS buyer.
Here’s a credit default swap example: A company sells a $200 bond with a 20-year maturity term. An investor buys that bond from the company, who agrees to pay back the money to the investor plus interest within 20 years. However, the company can’t guarantee its ability to pay back that money and the interest. This is the risk involved in investing in a bond.
In order to mitigate the risk, the investor who bought the bond purchases a CDS, which guarantees they will get their investment back if the company defaults on the loan. Just as with other types of insurance, the CDS buyer makes regular payments, typically every quarter, on the contract. The CDS seller is usually a bank, insurance company, reporting dealer, or hedge fund.
These sellers protect themselves against risk by diversifying their sales into many different companies, industries, or sectors. If one of their sales falls through, they have income from all the others to carry on their business.
Riskier Credit Default Swaps
The higher the risk of default, the more expensive a CDS will be. Some investors use credit-default to speculate on the credit quality of a company. Essentially, people use the CDS system to place bets on the bond issuer through the CDS system.
Investors can also switch sides on CDS if they come to decide that a borrower might default. The CDS seller can buy its own CDS or sell it to another bank. This makes it extremely difficult to track the market and decide how to invest in it.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
The Benefits of Credit Default Swaps
The main reason that people choose to buy CDS is as an insurance policy against the risks of loans in their portfolio. Using a CDS allows the investor to transfer some of the risk to the seller of the CDS or an insurance company.
The credit risk does not disappear with a CDS, the seller simply takes on that risk. However, if the borrower defaults on their loan, the seller of the CDS will default on the contract, and the debt goes back to the buyer.
One benefit of CDS is that they enable bond investors to buy into riskier ventures than they otherwise would, since they know they have some protection. This helps funds go towards innovative and unexplored ideas, which help grow the economy and solve world problems.
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Downsides of Credit Default Swaps
Although there are several benefits to credit default swaps, they have some significant downsides as well. CDS are an investment focused on managing risk, and it can be difficult to figure out which ones are safer investments due to the complexities of the market.
Introduced in 1994, the CDS market went largely unregulated until the financial crisis of 2008, and was a key contributor to the problems that led up to it. Since it wasn’t regulated, CDS sellers often did not have the money available to pay the buyer in the case of a default. Many sellers only held a fraction of what would be needed to pay back all their buyers.
As long as nobody defaulted, this system worked, but in 2008, this resulted in a massive financial meltdown. Large scale sellers of CDS, including some of the largest financial institutions in the United States were unable to make good on theirCDS contracts, creating a wave of economic effects around the world and requiring multiple bailouts by the Federal Reserve.
Dodd-Frank Reforms
After the 2008 financial crisis, regulators stepped in to try and prevent the same thing from happening again.
The Dodd-Frank Wall Street Reform Act of 2010 required the regulation of swaps by the Commodity Futures Trading Commission and the Securities and Exchange Commission. It also mandated reporting of all credit-default swaps and imposed capital requirements on CDS sellers.
The Takeaway
Credit-default swaps are complicated securities, but some institutional investors can use them to reduce the risk of other investments or to bet that another company might be close to default.
While credit-default swaps are complex investments, they may have a place in a diversified portfolio. However, due to their complexity, it may be a good idea to consult with a financial professional before diving in.
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