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January 2018

Demystifying credit default swaps

Used responsibly and judiciously credit derivatives can help reduce the risks that come with bond investing.

Derivatives aren’t popular in Hollywood. In the films recounting the story of the 2007 financial crisis, such instruments are invariably cast as villains.

There is nothing particularly unusual about that, though: it’s a role they have been assigned many times, and in several different settings, over the years.

Warren Buffett famously described derivatives — contracts which derive their value from the performance of a specific underlying asset or reference index — as “financial weapons of mass destruction”. Authorities worldwide have, meanwhile, sought to limit or abolish them altogether.

At first glance, the case that Buffet and movies like 'The Big Short' make seems pretty compelling.

Certain types of derivative were indeed partly responsible for US debt bust. The more complex products not only encouraged excessive risk taking but also obscured the true value of the underlying assets upon which their payoffs were based. That, as we now know, proved disastrous.

But dig deeper and it becomes clear that much of the criticism heaped on derivatives is somewhat misguided. There are several instruments that, used responsibly, serve as useful tools for managing the risks that come with bond investing. Having evolved into a more transparent and better-regulated part of the fixed-income market since the 2008 crisis, the credit default swap (CDS) are among these. 

insurance against default: how credit default swaps work
credit default swap

Source: Pictet Asset Management

At the most basic level, CDS are insurance policies that fixed income investors buy to protect themselves against the risk of a default on any or all of the bonds they hold. They also act as insurance against other 'credit events' - such as financial restructurings - that impact company's debt payments to creditors.

There are two types of CDS. Single-name CDS are contracts taken out against the possibility of default by individual bond issuers, typically governments and companies. CDS indices, by contrast, provide information about the financial health of an entire group of bond issuers, and can be used to express a positive or negative view on the entire bond market.

CDS are tradeable, rising and falling in price to reflect perceived changes in borrowers’ ability to service their debts. And because CDS gain in value when defaults are considered more likely, they can protect the capital of a bond portfolio during periods of financial market turbulence. 

CDS in action

This explains why, in the weeks leading up to the UK’s momentous decision to leave the European Union,  portfolio managers of Pictet AM’s European corporate bond fund chose to raise  investments in CDS indices. The defensive move was specifically designed to shield investments in the event of a “Leave” vote, which at the time was thought highly improbable.

The strategy proved effective.

But the benefits of using CDS in a portfolio don’t stop there.  For one thing, the index CDS in particular are more liquid than corporate bonds, which are in short supply and trade infrequently. 

Another attractive feature of CDS is their insensitivity to changes in the outlook for interest rates. Bonds of all stripes are deeply affected by shifts in the economy. Unexpected economic developments can upend the prevailing view on how quickly interest rates may rise or fall, with dramatic effects for bond prices. 

Because CDS only reflect changes in the financial strength of bond issuers, they’re usually less responsive to fluctuations in the broader economy. For that reason, these instruments can be used to reduce a bond portfolio’s sensitivity to changes in interest rates, or what investment managers call duration.  

Much of the criticism heaped on derivatives is somewhat misguided. There are several instruments that, used responsibly, serve as useful tools for managing the risks that come with bond investing.

To see how CDS perform this function, it’s useful to take a closer look at some of the investment strategies deployed by managers of Pictet AM’s corporate bond funds.

Earlier this year, portfolio managers in one of our European funds were attracted to certain bonds issued by auto makers. They believed that some of these securities had been unfairly tainted by the diesel scandal that had engulfed German car maker Volkswagen; many therefore looked very cheap.

Even so, investing in automakers’ bonds carried excessive risks, chiefly because they could lose value in the event of interest rate rises in the US. The solution, our managers determined, was to invest in auto makers’ CDS, which were as cheap as bonds but unlikely to depreciate if central banks in Europe or the US hiked borrowing costs.  

All this is not to say that CDS are risk free. Like all derivatives, they expose investors to a number of risks. Among these is counterparty risk, or the risk that one of the parties involved in a CDS contract fails to meet their obligations.  Nevertheless, used prudently, CDS can perform a useful role in a bond portfolio whatever the economic weather.