CDS Features And Terms
What you'll learn
- LOS 27.aDescribe credit default swaps (CDS), single name and index CDS, and the parameters that define a given CDS product.
- LOS 27.bDescribe credit events and settlement protocols with respect to CDS.
Credit Default Swaps
A credit default swap (CDS) is essentially an insurance contract. If a credit event occurs, the credit protection buyer gets compensated by the credit protection seller. To obtain this coverage, the protection buyer pays the seller a premium called the CDS spread.
The protection seller is assuming (i.e., long) credit risk, while the protection buyer is short credit risk. Note that the CDS does not provide protection against market wide interest rate risk, only against credit risk. The contract is written on a face value of protection called the notional principal (or “notional”).
Even though the CDS spread should be based on the underlying credit risk of the reference obligation, standardization in the market has led to a fixed coupon on CDS products: 1% for investment grade securities and 5% for high yield securities. Hence, the coupon rate on the CDS and the actual credit spread may be different. The present value of the difference between the standardized coupon rate and the credit spread on the reference obligation is paid upfront by one of the parties to the contract.
For example, a CDS on an investment grade bond with a credit spread of 75 basis points (bps) would require a premium payment of 100bps (CDS coupon rate) by the protection buyer. To compensate the protection buyer (who pays a higher than market premium), the protection seller would then pay upfront to the buyer the present value of 25bps of the notional principal.
For a protection buyer, a CDS has some of the characteristics of a put option, when the underlying performs poorly, the holder of the put option has a right to exercise the option.
The International Swaps and Derivatives Association (ISDA), the unofficial governing body of the industry, publishes standardized contract terms and conventions in the ISDA Master Agreement to facilitate smooth functioning of the CDS market.
Single Name CDS
In the case of a single name CDS, the reference obligation is the fixed income security on which the swap is written, usually a senior unsecured obligation (in the case of a senior CDS). The issuer of the reference obligation is called the reference entity. The CDS pays off not only when the reference entity defaults on the reference obligation but also when the reference entity defaults on any other issue that is ranked pari passu (i.e., same rank) or higher.
The CDS payoff is based on the market value of the cheapest to deliver (CTD) bond that has the same seniority as the reference obligation.
Party X is a protection buyer in a $10 million notional principal senior CDS of Alpha, Inc. There is a credit event (i.e., Alpha defaults) and the market prices of Alpha’s bonds after the credit event are as follows:
Bond P, a subordinated unsecured debenture, is trading at 15% of par. Bond Q, a five year senior unsecured debenture, is trading at 25% of par. Bond R, a three year senior unsecured debenture, is trading at 30% of par.
What will be the payoff on the CDS?
Solution
The cheapest to deliver senior unsecured debenture (i.e., same seniority as the senior CDS) is Bond Q. The payoff will be the difference between the notional principal and market value of the CTD.
Index CDS
An index CDS covers multiple issuers, allowing market participants to take on an exposure to the credit risk of several companies simultaneously in the same way that stock indexes allow investors to take on an equity exposure to several companies at once. In this case, the protection for each issuer is equal (i.e., equally weighted) and the total notional principal is the sum of the protection on all the issuers.
Party X is a protection buyer in a five year, $100 million notional principal CDS for CDX IG, which contains 125 entities. One of the index constituents, Company A, defaults and its bonds trade at 30% of par after default.
- What will be the payoff on the CDS?
- What will be the notional principal of the CDS after default?
Solution
- The notional principal attributable to Entity A is $100 million / 125 = $0.8 million. Party X should receive payment of $0.8 million − (0.3)($0.8 million) = $560,000.
- Post the default event, the remainder of the CDS continues with a notional principal of $99.2 million.
The pricing of an index CDS is dependent on the correlation of default (credit correlation) among the entities in the index. The higher the correlation of default among index constituents, the higher the spread on the index CDS.
A default is defined as the occurrence of a credit event. Common types of credit events specified in CDS agreements include bankruptcy, failure to pay, and restructuring.
Bankruptcy. A bankruptcy protection filing allows the defaulting party to work with creditors under the supervision of the court so as to avoid full liquidation.
Failure to pay. Occurs when the issuer misses a scheduled coupon or principal payment without filing for formal bankruptcy.
Restructuring. Occurs when the issuer forces its creditors to accept terms that are different than those specified in the original issue. Restructuring is less common in the United States as issuers prefer to go the bankruptcy protection route.
A 15 member group of the ISDA called the Determinations Committee (DC) declares when a credit event has occurred. A supermajority vote (at least 12 members) is required for a credit event to be declared.
When there is a credit event, the swap will be settled in cash or by physical delivery. With physical delivery, the protection seller receives the reference obligation (i.e., the bond or loan) and pays the protection buyer the notional amount, as shown in Figure 27.1.
Figure 27.1: Physical Settlement on Credit Default Swap After a Credit Event
In the case of a cash settlement, the payout amount is the payout ratio times the notional principal. The payout ratio depends on the recovery rate (i.e., the proportion of par that the bond trades at after default) as shown in Figure 27.2.
Figure 27.2: Cash Settlement on Credit Default Swap After a Credit Event