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).
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.
- 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)
- 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?
* 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
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”)