Financial instruments called Credit Default Swaps (CDS) are derivative securities that have been getting more attention recently. They are widely used in the financial markets especially by bond insurers. Exposure to these securities is not limited only to bond insurers but also to investment banks and bond fund. Many largest bond funds have exposure to Credit Default Swaps.
The Credit Default Swaps are commonly used to beef up yield. Many investment managers use CDS to create a kind of synthetic bond. Yields of the synthetic bonds are usually more than that of bond the CDS protects. In a basic form, Treasury bond is married with the swap. The result is a higher yield than managers could get on a Treasury bond, or even by holding the corporate bond that the CDS insures.
The CDS is also used by investment managers to hedge bond positions.
In reality, any financial player can place a bet on a company’s credit quality; neither side has to actually own the bond. All of those bets help explain why the credit default swap market is larger than the entire bond market.
Credit Default Swap is a private contract between a buyer and a seller who bet on their different views on whether a company's credit rating will get better or worse. For the buyer, the contract acts as an insurance policy against a company defaulting on its bonds. For the seller, the swap delivers a payment stream over a certain time for providing that protection.
Fund A, for example, has a CDS contract with an Investment Bank B to insure $10 million issued by Company C. In this example, Fund A acts as a seller while Investment Bank B acts as buyer of CDS. In return for such insurance, Investment Bank B pays Fund A 1.5% per quarter on the $10 million. If the Company C goes bankrupt, Fund A will pay Investment Bank B some or all of the $10 million.
Some investment managers cover their credit default swap positions with liquid, highly rated collateral. In many instances a swap position is covered by liquid assets such as Treasury bonds or cash. The amount of highly liquid collateral is usually only the difference between the bond's par value and its current market value. So if a bond has a par value of $100 and trades at $90, the manager would need to set aside $10 in collateral to sell CDS insurance on the whole $100. Investment managers like this because they have to set aside just $10 per bond in fund assets as collateral, but they get paid to insure the whole $100. The manager is still exposed to $90 per bond of losses if the issuer defaults. And if that happens, the manager may need to sell other less liquid assets, which could hurt the investment’s performance.
Securities & Exchange Commission rules wouldn't allow the value of a fund's swaps to exceed that of the rest of its portfolio. So a fund with $100 million in assets couldn't sell more than $100 million of swaps.
A manager acting as CDS seller is exposed to credit risk not just from the issuer of bond that is subject to the CDS contact but also from the institution on the other side of the deal (the counterparty) acting as CDS buyer. If the counterparty ran into serious problems, the seller might not get its quarterly fee payments, and the value of the swap would fall. Therefore judging the creditworthiness of the counterparty is same important as analyzing the bond issuer’s credit.
Difficulty of valuing CDS is a primary concern. If swap positions would be sold because of redemptions or a market crisis, it could be hard to know what they'd get in a illiquid market. In many cases, a swap is priced using complex algorithms to get its fair value, which is more of an art than a science.
Disclosure about CDS is still an industry problem. Shareholders looking for clarity on a fund's derivative holdings won't find it in fund reports.