Credit Default Swaps

To this point, this blog has focused largely on the stock market and on stock-related things. However, the stock market pales in comparison to the fixed-income market. As of 2006, the fixed income market's size was an estimated $45 trillion. The vast majority of this market trades OTC (over the counter). That is, bonds and fixed income securities are not generally traded on an exchange as stocks are. They are instead carried out by market makers, using inter-dealer trading programs. Thus, the fixed income market doesn't often get much recognition in the financial press (except for when the assets underlying a structured product - like a subprime asset-backed security - blowup), as it is not as visible to the average Joe Public.

So this market is not as visible to you or me, unless you are working on the credit trading floor of an investment bank (in which case, you can probably skip the rest of this blog, and go wait for the rain delay in the Wimbledon finals to end). So, if it's not as visible, what is it all about? Well, basically, banks create a market for these securities by matching buyers and sellers. They make their cut on the bid-offer spread. Think of this as the commission the dealers make in return for providing liquidity. What are they trading you ask? Well, they are trading everything. Some desks trade corporate bonds, while others government bonds, or municipal bonds, etc. Often times though, a company will issue many bonds. Each of these bonds is subject to a variety of risks: credit risk, interest rate risk, and foreign exchange risk.

So with all these different types of debt floating around, how do we isolate the credit risk (the risk of default) for a certain company? Well, in 1994, in London, a JP Morgan employee formulated an answer in the credit default swap (CDS). The CDS is essentially a form of insurance on a company's credit (read: debt). It is an OTC contract between two parties, and it allows you to go long or short on the risk that the company has a credit event (bankruptcy, default, restructuring). The basic structure of a CDS is as follows. Party A buys protection from Party B on a reference entity (call this reference entity a bond issued by Company TML). Party A pays party B a periodic payments (say every year) in return for the guarantee that if there is a credit event on TML Co's debt, Party B will return the full face/par value to Party A. In other words, Party A is selling risk, and Party B is buying it. If no credit event occurs during the life of the contract (typically 5 years), then Party B will have to do nothing, and will have received a nice yield. If TML Co's defaults on its debt (because it can't sell enough tickets now that Mats Sundin is gone, and it can't pay the interest on its debt), then Party A delivers the defaulted company's debt and gets 100 cents on the dollar from Party B (i.e., par value). One of the beautiful aspects of the CDS is that neither company needs to actually own TML's debt. That is, you don't need to own the underlying in order to buy or sell credit risk on said entity.

The payment that Party A (the buyer of protection a.k.a the seller of risk) makes to Party B (the seller of protection a.k.a. the buyer of risk) is measured in basis points. This premium is often referred to as the spread. The spread is, as mentioned, paid in basis points per annum and is usually paid quarterly. For instance, if 5-year protection for AT&T bonds are trading at 200 basis points, in order to protect a $10 million notional exposure to AT&T bonds, you'd have to pay 50 bps every quarter, or $50,000 each quarter on the $10 million notional.

If you're a keen observer, you'll have said, "hey, wait a minute here chief, why the hell are you calling this a spread, it's not at all like the yield spread of a corporate bond over a government bond". To which I would respond, "yes, that is correct, thank you for your concern." CDS spreads, as you can see from the example above, are not based on any risk-free bonds or benchmark interest rates. They are simply the annual price of protection on a reference entity, quoted in basis points (bps).

If it helps, try to think of a CDS as a put option written on a corporate bond. The protection buyer is protected from losses resulting from a decrease in value of the bond resulting from a credit event. Therefore, you can look at the CDS spread as the premium on the put option. This premium is spread out over the life of the contract.

As I mentioned earlier, the CDS allows for the isolation of credit risk. The CDS also provides liquidity to the markets, as the contracts are standardized, and concentrated around certain maturities (5-year being the most common). These two factors have helped make the CDS market worth about $45 trillion in 2007. The explosion of CDS-related instruments in the past few years has been helped by the creation of CDS-indices around the world. In Europe, the main index is iTraxx. The iTraxx Europe CDS index is used as a benchmark, and is composed of 125 equally weighted names as selected by a poll of financial dealers (the dealers select the CDSs based on volume traded over the last 6 months). Each 6 months, a new series is issued.

There are 1, 3, 5, 7, and 10 year maturities. Put them all together, and you get a nice little curve. If the curve flattens (that is, the premium paid on 1-year CDSs is roughly similar to that paid on 7 or 10 year CDSs), it is a bearish scenario, as investors believe that there will be more defaults in the short term. This is quite bizarre if you think about it, as it means that investors are worried about credit events in the immediate term. Naturally, you'd think that given a long time frame, there'd be more probability of a negative credit event. So when the curve flattens, or even inverts, it's not a great sign.

One of the other interesting aspects of credit default swaps alluded to earlier is that leverage can very easily be utilized. This is because a CDS does not require funding initially. In other words, you have to only commit a portion of the capital of the notional. As all good finance students know, leverage can be both good and bad, so it's important to be careful with credit default swaps. In order to reduce your risk, you can hedge by buying protection at a certain level on a reference entity, and sell protection on the same reference entity, at either a different spread, or a different maturity.

So basically, you now know how credit default swaps work. If tomorrow Ford comes out with an announcement about how bad U.S. auto sales are, you can be darn sure that the CDS spread on its debt will increase, as there is a greater chance of default. That is, it will cost you more to buy protection on it, as the risk of default is higher.

CDSs are incredibly useful tools for hedging risk, and a great deal of money can be made using these derivatives. With the market in its current state, the volatility of CDS contracts is extremely high, which makes for an incredibly fascinating time. Keep a close eye on credit default swaps, as I guarantee you'll be hearing more of them.