Tag Archive for credit default swap

CDS For Retail Investors?

Last year Risk Magazine’s Peter Madigan wrote about the prospect of algorithmic trading of swaps.  His point was that all that is needed for investors to employ algo strategies is a central limit order book with concentrated liquidity.   “Algorithmic trading can take place anywhere you have a liquid central limit order book, but I don’t think you’ll get a liquid order book in anything other than a few sought-after benchmark points along the yield curve.  ”These conditions do not just support sophisticated electronic strategies for institutions, they are the same building blocks that give life to retail investor markets.

Why has there never been a robust retail market for corporate bonds?  Do individual investors only care about income statements?  Aren’t balance sheets important as well?  Maybe if issuers didn’t have that ubiquitous built-in call option?  Or if underlying interest rates were more predictable?  What if they were more liquid or easy to compare?  What if bond prices were as transparent as equity prices?

Credit default swaps have endured a horrible reputation and were assigned a substantial portion of blame for the banking crises of 2007-2009 but their danger has never lied in what they are.    They wreaked havoc because the vast majority of them were overleveraged and non-collateralized.  PIMCO’s Bill Gross described them as “the most egregious offenders in a pyramid scheme of leverage”.   What if they weren’t so highly leveraged and what if they were all covered with collateral?  Those safety nets are hallmarks of exchanges.

CDS: Bonds Simplified

What would be left just might be an attractive instrument for active retail investors.  Credit default swaps strip out most of the variables that can cause bond values to whipsaw.  Their value is based on one specific bet; will the issuer default on its debt?  The value of a five year credit default swap is the amount one must pay to insure both principal and interest of the issuer’s debt for a specific amount of time. 

The price of a CDS is actually based on the yield spread between the issuer’s most liquid bond and the “risk-free” benchmark it is pegged to; for bonds of U.S. companies that means U.S. Treasury bonds.  That means changes in prevailing interest rates don’t affect CDS.  Since most CDS are not price- quoted, currency fluctuations are factored out of CDS valuations as well.  Although institutions can negotiate CDS contracts for any length of time the most actively quoted term for CDS is 5 years. The value of a 5 year CDS strips out interest rates, currency, and call schedules.  Liquidity is concentrated on the 5 year term.  The result is a single number that reflects the risk of an issuer defaulting on its debt.  New 5 year CDS are issued and quoted every day.  Indexing CDS every day to the current 5 year quote would further simplify the product by removing time decay from the equation. 

Equity securities are only available on publicly traded companies.  CDS are traded on any issuer of public debt including private companies, U.S. states and sovereign governments.  This allows for some interesting bets.  Most people have never wondered whether government of the United Kingdom is more or less likely to default on their debt than Verizon in the next 5 years.  According to the leading aggregator of CDS prices they are exactly the same; it costs 46.5 basis points to insure either.

If we are sure that we will own a corporate or sovereign bond until the day it matures, and don’t worry about reinvesting the interest, predicting our return is easy.  When the bond matures we’ll get back 100% of its original face value, plus the stated interest rate.  As you peer into the rabbit hole of valuing corporate and sovereign bonds it is easy to underestimate just how deep it goes.  Interest rates go down, prices go up.  Look a little closer and it’s not long before you’re stressing over day counts, call schedules, duration and convexity.