Quick Takes: Credit Default Swaps
Bonds have always been viewed as a safe haven asset, almost guaranteeing returns, and acting as the anchor of your portfolio. But holding corporate bonds leaves you exposed to credit risk, and liquidating the bond isn't always optimal... So how do investors who are risk averse hedge against defaults?
The answer: Credit Default Swaps (CDS)!
Credit Default Swaps
A Credit Default Swap is a financial derivative that operates as an insurance policy against the default of a specific bond.
The protection buyer makes fixed, quarterly payments to the protection seller.
In exchange, if the bond issuer suffers a credit event such as bankruptcy, the seller compensates for the buyers principal investment.
The protection buyer hedges against any risk associated with the bond, and the seller inherits the risk, while also making a premium.
Real Life Scenario: Hedging a Corporate Bond
Imagine a pension fund holds $10,000,000 in 5-year corporate bonds issued by Company X, paying a 6% annual coupon.
The Worry: Company X experiences operational troubles, raising fears that it might default within two years. The pension fund wants to keep collecting the 6% coupon but cannot afford to lose $10M in capital.
The Trade: The fund buys a 5-year CDS on Company X from an investment bank at a CDS spread of 150 basis points (1.50%) per year.
The Cost: The fund pays the bank $150,000 annually ($10M × 1.50%) in exchange for default protection.
The Outcome (Default Event): Two years later, Company X files for bankruptcy and its bonds crash to 30 cents on the dollar ($3M total market value).
Under cash settlement rules, the investment bank pays the pension fund the 70% loss difference ($7,000,000).
Combining the $3M bond recovery value with the $7M CDS payout, the pension fund recovers its full $10,000,000 principal, completely neutralizing the credit loss.
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