An FYI on CDS (Credit Default Swaps)

Credit default swaps are a complex topic in the derivatives market. They were a hot topic in 2008, as they were usually part of the conversation with mortgage-backed securities. In this episode, we are joined by Caleb Silver, Editor-in-Chief at Investopedia. We explore some of the foundational aspects associated and discuss the part these products play in the market.

Summary – Cents of Security Podcasts Ep. 83

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content here at Interactive Brokers and today I’m your host for the podcast. Our guest is Caleb Silver, editor-in-chief at Investopedia. Credit default swaps are a complex topic in the complex derivative market.

They were a hot topic in 2008, and they were usually part of conversations that involved mortgage-backed securities. In this episode, we’re looking to explore the foundational aspects associated, and then discuss the part that these products will play in the market and how they have in the past. Welcome back to the program, Caleb.

Caleb Silver:

Good to be with you, as always.

Cassidy Clement:

Yeah, so just to kind of jump in here, I mentioned it in the intro a little bit, 2008 was a time where we heard a lot about credit default swaps or CDS or CDSs, if you will. But what exactly is a credit default swap and where would our listeners maybe be familiar with hearing it outside of 2008?

Caleb Silver:

Yeah, well, I’ll give you the Investopedia definition, because it is as clear as day. A credit default swap, or a CDS, as you often hear them referred to, is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. Swap the risk of default, the lender buys a credit default swap from another investor who agrees to reimburse them if the borrower defaults.

Think of it like insurance on a credit product, like bonds or mortgages, effectively buying an insurance policy against an underlying security. In terms of where people might have heard about it, well, certainly the great financial crisis. Credit default swaps were part of the financial products that were caught up in the mortgage crisis because a lot of mortgage backed securities, mortgages bundled into big security products, were then insured against by credit default swaps.

Well, when those mortgages went under, so did those credit default swaps. So you’ve often heard about them in that context, but you often hear about them, especially among institutional investors because they buy credit default swaps to ensure the securities or the bonds that they’ve purchased to offset their risk.

Cassidy Clement:

So it seems like a lot of the elements of this product, it involves, you know, credit exposure as you’re opening your portfolio to a derivative of something that derives its value from credit. So with that, you mentioned institutions. So are these products for any type of investor or maybe an advanced investor or more of an institutional versus a retail base?

Caleb Silver:

Yeah, I mean, most individual investors that have 401Ks or IRAs or brokerage accounts or retirement accounts don’t usually buy credit default swaps unless they are very advanced traders who are trying to offset risk on a daily basis or a weekly basis. You see more institutions, we’re talking about the big banks, the big broker dealers, sovereign wealth funds, hedge funds. You see them use credit default swaps because they have a lot more exposure to credit products in their portfolios. Think about a big sovereign wealth fund that might buy U. S. government bonds and wants to insure it’s credit risk against those bonds. Or think about a big institution like a bank that has a lot of mortgages on its books or issues a lot of mortgages, they might want to buy credit default swaps to offset their credit risk in issuing those mortgages or in buying those mortgage products.

It’s not something you see typically traded among individual investors unless they are heavily, deep into trading credit securities, and if so, you really need to know what you’re doing. These are complicated financial products. You mentioned the word derivative. That’s a really important word for people to understand here. A derivative, by definition, is not the asset itself, but it’s a derivative of the asset. So a credit default swap is an insurance policy against a bond, but not necessarily the bond itself, and not necessarily a classic insurance product, it’s a derivative of. That’s why you really need to know what you’re doing if you’re trying to invest with credit default swaps or use them to offset the risks in your portfolio.

Cassidy Clement:

So obviously derivatives, as you mentioned, they sometimes are used by retail, but a lot of times the CDS aspect, it’s going to be more of an advanced trader. So. When we think about how these would be used in a strategy or a portfolio, where exactly would that fall? Like are there certain trading or financial strategies that use CDSs or is that more of a standalone item?

Caleb Silver:

Well, you mostly see them in the credit market, and by that I mean bonds and other forms of securitized debt. You don’t buy credit default swaps against stocks or equities because they are not credit products, they are equity products by definition. So you’re not ensuring your losses there. There are other ways to do that in the equity market, but in the bond market, in the securities, the securitized market think about a mortgage for example. Suppose a company sells a bond or a corporate bond or a government bond. Suppose a company sells a bond with a 100 face value and a 10 year maturity to an investor. The company might agree to pay back the 100 at the end of the 10 year period with regular interest payments throughout the bond’s life.

But because the debt issuer can’t guarantee that it will be able to repay the premium or repay it in full, the investor who buys that bond assumes that risk and the debt buyer can then purchase a credit default swap to transfer the risk to another investor who agrees to pay them in the event that the debt issuer defaults on its obligation. So you’re effectively buying insurance against a bond, and you find broker dealers who sell these, who both sell the bonds themselves and the credit default swap to protect against the bond. You also see credit default swaps used in what we call arbitrage. That means an investor, usually an institutional investor, might buy bonds or a basket of bonds, and they also might buy, at the same time, credit default swaps to ensure that those bonds don’t default. So, they are trying to hedge their risk and find a little bit upside in doing so.

Cassidy Clement:

Yeah, I saw a lot in my research that the main areas that it was utilized in terms of strategy was and of course speculation, but also arbitrage and then hedging, as you mentioned, to kind of have both sides of the coin. But when we’re talking about it as a financial product, what exactly would you consider pros and cons about it?

Caleb Silver:

Yeah. Well, they do help with risk management, credit default swaps. They help you manage credit risk. Investors can use these credit default swap contracts, the hedge against the risk of default on a specific bond or portfolio of bonds. That’s good for that purpose. And also for diversification, especially those investors that have a wide array of assets in their portfolio. And if they’re holding debt securities, and again, we’re talking about municipal bonds, corporate bonds, mortgage bonds, mortgage backed securities, even corporate and government bonds. It helps you diversify your portfolio so that you have some credit protection and then they have liquidity enhancements.

They’re very highly liquid products. That’s why I say they’re not for long-term investors. They’re for short-term trading opportunities and short-term insurance opportunities to protect your portfolio. And then for some investors, they do provide some speculative opportunities. If you wanted to speculate on whether or not a credit security, is going to make it all the way to maturity, this is a good way to do it. It’s a very effective way to do it and they can also be very customizable. You’ll see credit default swaps really created against almost any securitized product. Now, that can be very useful for some investors, but we also know it can be very dangerous, like what happened in 2008, 2009. There were mortgage-backed securities that were of dubious value and when any of those mortgages in those securities or that group of securities went under, so did the credit default swap. So, you had two ways to lose money. They can be very risky when not applied to a risk free product, so you have to be very careful when using these.

Cassidy Clement:

Yeah, I mean, there’s a portion of the, or we’ll say an element of the security that kind of

lends itself to the word liquidity because these might not be as liquid as other types of investments. Can you speak a little bit on that?

Caleb Silver:

Yeah, these are insurance products, basically, so when you think about the fact that you can’t just buy them and sell them like trading a stock throughout the course of the day, they are not liquid in that respect, but they do provide that insurance liquidity in case that underlying security goes under. So these are again, don’t think of these in any way like a stock or an ETF or an index fund or a mutual fund. This is a different type of animal altogether that is principally used to ensure losses against credit backed products. So they don’t trade as frequently, and if you are an individual investor trying to gain exposure to these, you have to deal at a very high level with a broker dealer who will help you insure against the portfolio or against the portfolio credit assets that you might be holding at that time.

So again, a very advanced product, very technical in nature. It’s a derivative. It’s not as simple as buying into security and watching it go up or down. You can buy the credit default swap, but you have to be patient and you have to make sure that the underlying security is healthy as well.

Cassidy Clement:

So that kind of leads me into my last question which has to do with incorporating any type of CDS into your portfolio. So what exactly are some things to keep in mind? Because it seems that the risks associated are a little bit more advanced than, as you said, a standard issue idea of stocks trading on the daily or selling on the daily.

Caleb Silver:

Yeah, well let’s start with the product you’re trying to buy insurance against. You have to do due diligence on any securitized credit or debt that you might be buying. So if you’re buying corporate bonds, or government bonds, or municipal bonds, you want to make sure that that debt is sound and that there’s a very high likelihood that you get paid, uh, for owning that security over time as it matures and you get those regular payments.

Similarly, when you’re buying a credit default swap, you have to do due diligence on the seller of that credit default swap. That’s only as good as the seller who backs it. So you want to do due diligence and you can search SEC filings through the databases there to see if there’s any red flags on the seller of that credit default swap.

How many of these have gone under? What’s their track record? Is it a reputable firm that is actually selling you the insurance because if you actually end up needing that insurance, if something happens to the underlying bond that is securitizing, you want to make sure you get paid for owning that insurance. You want to make sure you get paid in due time. So you have to really establish the fact that this is a trustworthy seller. And then you have to ask yourself as an individual investor, do you really need this product? A credit default swap? Do you really need to insure against credit losses in your portfolio?

What is in your portfolio that you are protecting against? And if there’s anything that volatile or that dangerous in your portfolio, think twice about that firstly. But if you feel like you do need to insure it, you can buy credit default swaps to protect you against it. Just make sure you’re knowing what you’re protecting against and the likelihood that something does not go right with the underlying bond, that you will get paid on that insurance.

Cassidy Clement:

Yeah. That’s a really good point actually about looking at your underlying assets if that was the reason or your additional assets, if that was the reason that you started getting into the research of a CDS because the complexity of the item and also the way that it is meant to help you hedge, could definitely add another element of risk and complexity or advanced layers to your portfolio. They’re not for everyone. So it’s something definitely to look into before just jumping into the pool.

Caleb Silver:

Absolutely. This is not, you don’t need a solution to a problem you don’t have. So make sure you have the problem and that you have securities in your portfolio, credit securities, that you feel that you need to buy insurance against. If you do, you should be asking yourself why you have those, are you trying to capture upside with those and if you feel that they’re so volatile or that there is a high risk that those bonds will default. Then you might want to have credit default swaps to back them up, but you really need to look closely at your portfolio to make sure you’re not buying a solution to a problem you don’t yet have.

Cassidy Clement:

Yeah, that’s a great point. Well, thanks so much for joining us today, Caleb.

Caleb Silver:

You got it. Anytime.

Cassidy Clement:

So as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening, everyone.

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