What are credit default swaps? Investing Explained

INVESTING EXPLAINED: What you need to know about credit default swaps – bankruptcy insurance that hit the big time in the credit crunch

In this series, we break the jargon and explain a popular investing term or topic. Here it is credit default swaps.

A what?

A credit default swap, often called a CDS, is a form of insurance against the possibility of default on a bond or loan. Credit default swaps are themselves negotiated between investors.

At the end of 2021, the US credit derivatives market was worth $3.9 trillion (£3.1 trillion). The bulk of that – $3.3trillion (£2.6trillion) – was made up of credit default swaps. Derivatives are contracts whose value is derived from the value of an underlying asset such as a bond or loan.

In short: A credit default swap, often called CDS, is a form of insurance against the possibility of default on a bond or loan

Why are they in the news now?

This is the result of rising rates and attempts by the US Federal Reserve to control inflation by cooling the economy.

Much attention is paid to the Credit Default Swap Index (CDX), which tracks a basket of single-issuer credit default swaps in the United States and emerging markets. It has fallen, which is seen as a sign that businesses are facing tough times as borrowing costs rise. These conditions raise the possibility of payment defaults.

Another reason ?

Last year, some US fund managers, including big names such as Pimco, were selling credit default swaps based on Russian debt to their investors. They believed that Russia would be able to meet its debts. The war in Ukraine has radically changed that.

What is the mood in Europe?

The Markit iTraxx Europe index is also closely watched. This tracks a basket of credit default swaps and is seen as a measure of the ups and downs in the cost of default insurance on a range of European high yield corporate bonds.

The rise in the index this year suggests that investors in these bonds (nicknamed “junk” due to the high risk of default) should prepare for the stressful times ahead.

You may think that you are already watching the movements of enough indices of each type, but it can also be useful to take a regular look at this index and the CDX as a sentiment indicator.

When were they invented?

In the late 1990s, but their popularity surged in the run-up to the 2008 global financial crisis. At that time, around $45trillion (£35.7trillion) was invested in credit default swaps , which is twice the amount invested in the stock market. Many banks were active in the hugely lucrative market, believing there was negligible risk of default – a confidence that proved misplaced.

Many of the credit default swaps were linked to subprime loans made to low-income homeowners.

These borrowers almost immediately struggled to meet their commitments and were taken over by their lenders.

High level victims?

Some big names on Wall Street have failed, unable to meet their credit default swap commitments. But probably the best known were the investment bank Lehman Brothers and AIG, the insurance company.

Prior to its collapse, Lehman’s debts stood at $600bn (£475bn), with credit default swaps accounting for a large part of it.

AIG also apparently ignored or rejected the huge bet involved in the credit default swap market and did not have enough cash to pay.

Lehman failed. AIG, which was considered “too big to fail”, was bailed out.

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