Credit default swaps explained

How and why credit default swaps are used.

A credit default swap (“CDS”) is a derivative contract that is similar to an insurance policy where the buyer of the contract makes periodic payments to the seller, and in return receives a one off payment from the seller if there is a default on an underlying financial instrument.  Underlying financial instruments are typically bonds or loans.

As an example, an investor could purchase a five year CDS on a $10 million parcel of Telstra bonds from NAB at a price (or credit spread) of 0.80% per annum.  The investor will pay NAB $20,000 every three months ($80,000 per annum) for five years.  If Telstra defaults on the bonds during the five years, for example it fails to make an interest payment on time or goes into administration, NAB will make a $6 million compensation payment to the investor based on the assumed loss incurred on the particular Telstra bonds.  Most CDS assume a 40% recovery rate, that is they assume that if Telstra defaults on its bonds, investors won’t lose all their money, but will recover 40% of their investment.

In this example, if the investor wished to sell CDS,  in return for receiving the regular premium the investor would need to provide a margin deposit so that the buyer of the CDS could be confident of receiving the $6 million compensation payment if Telstra defaulted on its bonds.

CDS are traded over-the-counter and are used for a variety of purposes including hedging or reducing default risk, as well as speculating on changes in the price of credit for a particular entity.

The CDS market was first developed in 1997 by JPMorgan Chase to shift the risk of default on certain companies that it had lent to.  As at the end of 2017, the estimated notional value of outstanding CDS contracts is over US$9 trillion.

The iTraxx Australia Index measures the average cost of a five-year CDS on the 25 most-traded CDS in the Australian market.  Companies in the index include Woolworths, the big four banks, Rio Tinto and Amcor.  The current iTraxx Australia Index price is around 0.73% per annum but the index has traded in a range of as low as 0.24% in June 2007 before the financial crisis to a high of 4.41% in the March 2009 in the depths of the financial crisis and since then the index has tended to move inversely with equity markets - falling when equity markets rise and vice versa.
 


Important notice

This article is prepared for information purposes only. It does not purport to contain all matters relevant to any particular investment or financial instrument, or to a general investment approach.

This article contains general advice only. It does not take into account your investment objectives, financial situation or particular needs.  You should consider whether this advice is suitable for you and your personal circumstances.

JBWere Ltd (‘JBWere’) and its related entities distributing this article and each of their respective directors, officers and agents (‘JBWere Group’) believe that the information contained in this article is correct and that any estimates, opinions, conclusions or recommendations contained in this article are reasonably held or made as at the time of compilation. However, no warranty is made as to the accuracy or reliability of any estimates, opinions, conclusions, recommendations (which may change without notice) or other information contained in this article and, to the maximum extent permitted by law, the JBWere Group disclaims all liability and responsibility for any direct or indirect loss or damage which may be suffered by any recipient through relying on anything contained in or omitted from this article.  JBWere Group may provide investment recommendations, market commentary or trading strategies to clients reflecting opinions that are contrary to the opinions expressed in this article, or that are inconsistent with the recommendations or views expressed in this article.

This article may contain information based on JBWere’s understanding of taxation and other laws. JBWere does not hold itself out as providing professional taxation advice. You should consult with your professional taxation advisor before acting on the information or data contained in this article or contact a financial advisor if you require further assistance.