Insights

What is a Credit Default Swap?

A CDS is essentially an insurance contract providing protection against default by a bond issuer (or basket of issuers).

Diagram of What is a Credit Default Swap?

How are CDS used?

CDS was created as tool for market participant to hedge credit risk , but over time developed into the default instrument for short and long credit exposure.

Buying protection

- Effectively short credit risk
- Can hedge credit component of existing bond position
- Can adjust credit exposure without selling long-term (potentially illiquid) bond positions
- Can take a view on spread widening, without having to source and short bonds (difficult)

Selling protection

- Effectively long credit risk
- Gives you credit exposure without holding bonds and without interest rate risk
- Easy to increase or decrease your exposure
- An attractive source of income (typically implied default rates exceed realised defaults, so you are well paid for the risk you are taking)

What are CDS indices?

Diagram of What are CDS indices?

* Source: JP Morgan - Regulatory risk warning: When selling CDS on subordinated debt, such debt may be subordinated to senior debt

CDS indices are ideal building blocks for passive strategies

Diagram of CDS indices are ideal building blocks for passive strategies

What drives CDS index returns?

Diagram of What drives CDS index returns?

Return drivers: rolling down the curve

Credit curves are typically upward sloping due to greater uncertainty over longer time horizons and investors’ preference for shorter-dated debt

  • When entering into a CDS contract, investors are buying or selling protection for a specific tenor (eg 5.5y) and paying or receiving a spread
  • When exiting the contract to roll into a new one, investors are effectively selling (or buying) protection for a shorter tenor (eg. 5y), typically receiving (or paying) a lower spread

All else equal, a protection seller generates a positive return from rolling contracts when the curve is upward sloping (“sell high, buy low”)

Diagram of Return drivers: rolling down the curve