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How Does a Credit Default Swap Work?

Rebecca Lake
What is a credit default swap?

Credit default swaps are a portfolio management tool that gained notoriety during the peak of the 2008 financial crisis. These derivative investments are bit more complex than stocks, mutual funds or bonds, but they can be an effective way to manage market risk. Here are the most important things to know about how a credit default swap works, the players involved and what it’s used for.

What Is a Credit Default Swap?

A credit default swap is a derivative investment that’s similar in nature to an insurance contract. Credit default swaps or CDS for short (not to be confused with certificates of deposit) were first introduced in the 1990s. Their chief purpose is to help manage the credit exposure of fixed-income investments between two or more investors. A CDS can allow investors to hedge against unexpected market volatility and other risk factors.

Typically, credit default swaps are the domain of institutional investors, such as hedge funds or banks. However, retail investors can also invest in swaps through exchange-traded funds (ETFs) and mutual funds. There are a handful of funds that include credit default swaps and other credit derivatives in their basket of investments.

How a Credit Default Swap Works

What is a credit default swap?

In a CDS transaction, there are a minimum of two parties: one who’s selling risk and another who’s buying risk. The seller is selling risk protection for an underlying asset, which may take the form of municipal bonds, mortgage-backed securities, corporate bonds or emerging market bonds. The buyer’s part of the transaction is to pay the seller a premium to cover the possibility of a credit event that affects the quality of the underlying asset. A CDS covers risk that includes mortgage defaults, bankruptcy filings, debt restructuring and downgrades in a bond’s credit rating.

For example, let’s say an investor owns a group of municipal bonds and is worried that the credit rating for those bonds will be downgraded. They can “swap” that risk by buying a CDS from another investor who will reimburse them if the bonds end up being downgraded.

The seller charges a premium for this risk protection and also makes an agreement as part of the bargain. If a negative credit event affects the underlying asset – in this example, municipal bonds – the seller will pay the buyer of the CDS the value of the asset or security, along with any interest that would have been paid up until the bonds’ maturity date. So both sides can benefit through a swap arrangement.

The nature of a CDS is what makes it like an insurance contract. You have one party agreeing to pay the other if something unforeseen happens. In a life insurance contract, for instance, the insurance company agrees to pay your beneficiaries a death benefit if you pass away.

Pros of Credit Default Swaps

The main benefit of credit default swaps is the risk protection they offer to buyers. In entering into a CDS, the buyer – who may be an investor or lender – is transferring risk to the seller. The advantage with this is that the buyer can invest in fixed-income securities that have a higher risk profile.

The seller of a CDS, on the other hand, can leverage swaps to collect the premium fee that applies during the maturity contract. Contracts can be short-term, lasting a period of months, or long-term, lasting a period of years.

In this scenario, the seller assumes that no negative credit event will require them to make a payment to the swap’s buyer. If a credit event occurs and the seller is required to issue a payout, they may be able to offset it through the fees they’ve collected in connection with other swaps. Sellers can diversify and insulate themselves against risk by offering multiple swap contracts to different buyers.

Cons of Credit Default Swaps

There are some downsides to credit default swaps. For starters, the buyer could lose money assuming that no negative credit event occurs. Again, that’s like buying life insurance. If you have a term life policy, you could pay premiums for 20 or 30 years. And if you stay healthy, your beneficiaries will never see a death benefit.

The seller of the CDS is also taking on risk because they may have to make good on the payments to the buyer if a default or another credit event occurs. Again, sellers can sell multiple swaps to spread out this risk.

One of the main risks historically associated with credit default swaps is the lack of federal regulation. However, that was eliminated in 2010. The Dodd-Frank Act, which addresses many of the key issues that lead to the 2008 financial crisis, increased federal regulation for CDS trading. Specifically, the act introduced a regulatory agency to oversee swaps and prohibit swaps that are deemed too risky.

Credit Default Swaps and the 2008 Financial Crisis

For context, here’s how credit default swaps played a role in the financial crisis. The Lehman Brothers firm had approximately $400 billion in debt that was covered by credit default swaps. Several companies were involved in selling the swaps that Lehman Brothers purchased, notably American International Group (AIG). Lehman’s subsequent bankruptcy declaration meant that AIG didn’t have sufficient capital to cover all of the swap contracts.

The company was bailed out by the federal government but a trickle-down effect occurred. Other financial institutions involved in buying and selling swaps were also impacted. This resulted in a slowdown of the CDS market, which in turn affected lending. With lenders tightening the reins on loans, Americans had fewer opportunities to borrow to buy homes or start businesses.

The Greek debt crisis is another instance of credit default swaps having negative repercussions. The crisis lasted from 2009 to 2018. JP Morgan Chase also reported losses as a result of credit default swaps in 2012. While credit default swaps continue, the size of the market has changed considerably. At the end of 2007, just prior to the 2008 crisis, the CDS market was valued at $61.2 trillion. As of 2018, it’s valued at around $9 trillion.

The Bottom Line

What is a credit default swap?

Credit default swaps are largely a speculative investment, since each side of the swap is hedging their bets for or against a credit default. When used correctly, a CDS can be a useful way to manage portfolio risk associated with the underlying fixed-income securities. However, there are still dangers associated with credit default swaps. Investors may want to consider the investment strategy that is best for their financial future.

Tips for Investors

  • Including bonds in your portfolio is a way to diversify beyond stocks. And you don’t need a credit default swap to do it. If you’re investing in bonds, consider their credit rating, the type of bond involved and the bond’s maturity term, in relation to how interest rates are moving. Understanding the correlation between interest rate movements and bond yields can help you decide which bonds are best suited to reaching your investment goals.
  • Speculative investments aren’t right for every investor and it’s important to understand what you’re dealing with before diving in. Consider talking to a financial advisor before moving into new territory with your portfolio.Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

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