A Credit Default Swap (CDS) is a financial agreement that is contractual in nature and which allows an investor to share credit risk with another investor. In simple terms, a CDS is a default insurance on a loan or bond.
If a lender is concerned that a borrower will default on a loan, the lender applies CDS to offset or swap the risk. Swapping or offsetting risk is a common thing with CDS.
In a bid to offset the risk of default, the lender purchases a CDS from an investor who signs a contract to reimburse the lender should the borrower default. CDS contracts are sustained with a continuous premium payment like the one paid on an insurance policy.
The most common method of creating credit liquidity that involves municipal bonds, mortgage-backed securities, corporate bonds, and emerging market bonds is a credit default swap.
A credit default swap transfers the risk of sharing credit of fixed income products between the parties involved. The buyer of the swap pays the seller of the swap until the maturity date on the contract expires.
There is an express agreement about the payment structure should the issuer of the debt default. The payment structure contains the full payment of the funds within the stipulated period and all interest payments in the contract and the maturity date of the security.
A borrower does not default only as a result of borrowing alone, a credit event is another factor that stymies a borrower from honoring a financial obligation. A credit event in CDS is a trigger that influences the buyer of a swap to terminate and meet the contract’s obligations since the maturity of the security has not been fulfilled.
Credit events are part of the contractual agreements and securities traded. A CDS offers compensation to a buyer when a prespecified event happens. To get the protection, a seller or investor purchases a premium in the form of an annuity that remains valid as the period of the swap or credit event.
Several single name CDSs are traded with the following credit events triggering them: repudiation, reference entity bankruptcy, obligation acceleration, failure to honor payment, and moratorium.
Because bonds and other debt securities have a likely risk that a borrower may not repay the debt or its interest, a credit default swap is considered a better way to hedge risk, especially in the long term.
Also, the downside of debt securities is its extended period of maturity, usually up to 30 years. This extended period of maturity is difficult to ascertain present and future risks by the investor throughout the duration of the instrument’s validity.
In terms of hedging risk, how does a credit default swap happen? Let us say an investor purchases $100,000 bonds with a 30-year maturity. The long-term nature of the security increases the uncertainty of the investor.
A reason is that the company may not have the means to pay the principal or its interest payments in the future before the security expires. What does the investor do to cover himself? The investor purchases a credit default swap to insure against default happening in the future.
Therefore, a credit default swap is a form of insurance that guarantees the full payment of the principal and interest payments over the period stated. Investors purchase CDS from a huge financial institution.
These institutions provide security for the debt at a fee that the investor pays. A third party, which is usually a large financial institution assumes or shares risk with the investor for a premium.
The investor goes to sleep knowing that he has shared his risk with an entity to protect mortgage-backed security and a bond, a form of insurance against defaulting on payment.
Apart from using CDS to hedge risks, investors also speculate about it. Speculating a CDS basically means betting that a reference entity has a sustainable credit quality.
CDS market in Canada
A recent valuation of Canadian 5 years CDS was released by World government bonds in May 2021. It is historical data that attributed 37.9 value to Canadian CDS for a maturity period of 5 years. Further down, the value indicates a 0.63% implied probability of default and an assumed recovery rate of 40%.
CDS activity in Canada is difficult to quantify since they are private bilateral contracts. The growth of CDS in Canada is not easily assessed because participation in collecting data is voluntary, not obligatory.
Credit default swaps on Canadian entities trade are issued on a U.S.-dollar basis and completely OTC. The absence of an organized exchange for credit default swap in Canada and its limited number of contracts issued by Canadian-based entities reduced the trading of CDS to transactions by financial institutions.
North American banks, dealers, and brokerages exchanged more than $2.7 trillion outstanding credit derivatives. Because of insufficient data on the Canadian debt market, Canadian institutions struggled with only a percentage of the aggregate.
Regardless of the non-performance of Canadian banks and entities compared to their U.S. counterparts, Canadian financial institutions are pulling their weight in categories of the credit-risk-transfer market.
Canadian institutions now accept managing credit risk in the CDS market on their loan portfolios. The rise of Canadian dealers has also transformed CDSs into a source of liquidity from intermediation.
Not only are brokerages and dealers getting in on the action to trade CDSs in Canada, but non-financial corporations are also trading the credit derivative too.
Non-financial corporations in Canada use CDSs to share funding requirements in the long term in the event that a borrower’s credit rating worsens, thereby making the servicing of the debt difficult. They offset the cost with the protection offered by a pre-existing CDS position.
Canadian pension funds have also moved into the CDS market to have credit exposure. They are moving into diversifying their portfolios by adopting more liquid credit derivatives in foreign rather than domestic markets.
A study carried out by Merril Lynch in 2004 revealed that the corporate debt market in Canada is about 1.2% of the global corporate market. Canadian-based- CDS-issued entities are small but growing at a slow pace.
This is due to the volume of credit information that is available to investors and outstanding debt. Both have a direct connection to the size of the corporate market.
Because the relevance of CDS hedges credit risk to a third party that does not have a lending relationship with the underlying entity, the new party sharing a credit risk does not have the same level of credit data as the originator of the loan.
Consequently, a new risk holder relies on credit-rating agencies and personal research to get the necessary credit information. Both rating and conducting analysis are very costly, actively traded CDSs on Canadian reference entities are done.