The Credit Default Swap became a household name in 2008 when it became clear that its widespread use contributed to the financial crisis. While the CDS market has shrunk since its heyday and looks very different today, CDS contracts continue to be used by banks and hedge funds as a way of managing risk and speculating on debt.
What is a Credit Default Swap
Credit Default Swap contracts are simply insurance policies on bond investments. If I own a bond issued by Company A, and am concerned that Company A might go bankrupt and not be able to pay back the full principal amount, I can protect my investment against the potential default entering into a CDS contract. I pay the insurance provider an annual fee in exchange for a promise to receive the full principal amount of my bond investment if Company A defaults.
There are few key attributes that specify a CDS contract:
Reference Entity: The bond issuer on which the insurance policy is written.
Notional Amount: The notional amount of bond that is being protected by the contract.
Tenor: The time length of the contract (e.g. 5 years, or as specified by a given maturity date).
Coupon Rate: The annual insurance premium as a fraction of the notional amount, usually expressed in basis points.
Here’s an example of a investor that purchased a bond issued by Netflix, and entered into a CDS contract to protect that investment.
Here we say that the Bond Investor has purchased protection on Netflix, and the Counterparty has sold protection.
Historically, the coupon rate on a CDS contract was set according to how risky the bonds on the Reference Entity were. For risky companies, the coupon rate could be as high as 1000 bps and for safer companies as low as 50 bps. However, to simplify the CDS market, ISDA (the International Swaps and Derivatives Association) standardized CDS contracts to only pay either 100bps or 500bps in coupon. Older contracts that were written before this standardization are called legacy CDS contracts.
The granularity once offered by the coupon rate is now available in an upfront payment made to either party. For example, if Netflix were a very risky company, protection sellers might require an additional upfront payment of 10% of notional to compensate for a 500bps coupon rate that they deem is too low. Conversely, if Netflix were a very safe company, protection buyers might demand an upfront payment to compensate for a coupon rate they think is too high.
In the event of default, the protection seller doesn’t actually exchange the full notional for the defaulted bond. Rather, the value of cheapest defaulted bond is decided by an auction process and deemed to be the Recovery Rate. The protection seller then pays the protection buyer and does not receive the defaulted bond in exchange.
Here are the cashflows of the Netflix CDS described above where Netflix defaults a little after 3.5 years with a recovery rate of 40%.
Notice that a small upfront payment is made to the protection buyer. This is because the 500bps coupon is too high for Netflix’s level of risk. On default, the protection seller pays but also receives a tiny bit of Accrued Coupon, the portion of the next coupon payment that’s owed since Netflix defaulted in the middle of two coupon payment dates.
The CDS Market
You can find market data on some CDS contracts at the Wall Street Journal Market Data Center here. Notice that CDS market prices are generally quoted as either Price or a Spread.
The price of a CDS, (sometimes called the bond price) is equal to where the convention is that a positive upfront indicates a payment to the protection seller, and a negative upfront indicates a payment to the protection buyer. For example, a CDS is trading at a price of 94 (points), then the upfront payment is 6pts made to the protection seller. This is a convenient way of thinking about CDS market price since it mimics the price of a hypothetical bond that the protection seller has purchased from the protection buyer.
The spread, or more accurately par spread of a CDS contract is the theoretical fair coupon rate that would require no upfront payment. Smaller par spreads indicate a safer reference entity, while larger par spreads indicate a riskier reference entity. Before the standardization of CDS contracts, the coupon on a CDS would be equal to the par spread at the time it was written. Par spreads are a convenient way of quoting CDS since you don’t need to know the coupon rate on the contract, to understand how the market is pricing the riskiness of the reference entity. Let’s take a look at the market spreads on some sovereign CDS.
Remember that these are the par spreads of 5 year CDS contracts written on the debt of each country. We can see from this that the market considers the debt of France, New Zealand and Canada very safe compared to Brazil, Serbia, and Italy.
Why do people trade CDS?
While CDS contracts were originally invented as insurance products for bond investments, banks and hedge funds started using them to speculate on debt by entering into a CDS without actually owning a bond issued by the reference entity. CDS can be an attractive way to bet on a company because CDS trades don’t require a lot of cash to put on.
Suppose Netflix has a 5% bond outstanding that will mature in 5 years and currently trades at 90. Furthermore, suppose that 5-year Netflix 500bp CDS trades at 91. As a speculator, if you wanted to put on a bet that Netflix will be a safer company in the future, you could either buy the bond, or buy the CDS (sell protection). If you bought the bond, you would have to put down $9,000,000 today on a $10,000,000 notional investment, but if you bought the CDS you would receive $900,000 today on the same $10,000,000 notional investment.