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INVESTING EXPLAINED: What you need to know about credit default swaps – insurance against going bust that hit the big time in the credit crunch
In this series, we bust the jargon and explain a popular investing term or theme. Here it’s credit default swaps.
A credit default swap, often referred to as a CDS, is a form of insurance against the possibility of default on a bond or a loan. Credit default swaps are themselves traded between investors.
At the end of 2021, the US market in credit derivatives was worth $3.9trillion (£3.1trillion).
The bulk of this – $3.3trillion (£2.6trillion) – was made up of credit default swaps. Derivatives are contracts whose value are derived from the value of an underlying asset like a bond or a loan.
In focus: A credit default swap, often referred to as a CDS, is a form of insurance against the possibility of default on a bond or a loan
Why are they in the news now?
It is the result of rising rates and the attempts by the US Federal Reserve to control inflation by cooling the economy.
A lot of attention is being paid to the Credit Default Swap index (CDX), which tracks a basket of US and emerging market single-issuer credit default swaps. It has fallen, seen as a sign that firms face challenging times as borrowing costs rise. These conditions raise the possibility of defaults.
Any other 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. War in Ukraine has radically altered that.
What is the mood in Europe?
The Markit iTraxx Europe index is also being 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 insuring against defaults on a range of European high-yield corporate bonds.
The rise in the index this year suggests investors in such bonds (dubbed ‘junk’ because of the sizeable risk of default) should prepare for stressful times ahead.
You may think that you already watch the movements of enough indices of every type, but it may be worth also taking a regular look at this index and the CDX as a gauge of sentiment.
When were they invented?
In the late 1990s, but their popularity surged in the period before the global financial crisis of 2008.
At that time about $45trillion (£35.7trillion) was invested in credit default swaps, twice the amount invested in the stock market. Many banks were active in the hugely lucrative market, believing that there was negligible risk of default – a confidence that proved misplaced.
Many of the credit default swaps were linked to ‘sub-prime’ loans granted to low-income home owners.
These borrowers almost immediately struggled to meet their commitments and were repossessed by their lenders.
Any high-profile casualties?
Some big Wall Street names came to grief, unable to meet their credit default swap commitments. But probably the best known were investment bank Lehman Brothers and AIG, the insurance company.
Before its collapse, Lehman’s debts were $600billion (£475billion), with credit default swaps accounting for a large portion of this.
AIG also apparently ignored, or dismissed, the huge gamble involved in the credit default swaps market and had insufficient cash to pay out.
Lehman failed. AIG, which was deemed ‘too big to fail’, was bailed out.