CDS Usage

Credit Curve

The credit curve is the relationship between credit spreads for different bonds issued by an entity, and the bonds’ maturities. The credit curve is similar to the term structure of interest rates. If the longer maturity bonds have a higher credit spread compared to shorter maturity bonds, the credit curve will be upward sloping.

However, if the hazard rate is constant, the credit curve will be flat.

CDS can be used to manage credit exposures of a bond portfolio. For example, in anticipation of declining (increasing) credit spreads, a portfolio manager may increase (decrease) credit exposure in the portfolio by being a protection seller (buyer).

In a naked CDS, an investor with no underlying exposure purchases (or sells) protection in the CDS market. In a long/short trade, an investor purchases protection on one reference entity while simultaneously selling protection on another (often related) reference entity. The investor is betting that the difference in credit spreads between the two reference entities will change to the investor’s advantage.

This is similar to going long (protection seller exposure) in one reference entity bond and simultaneously going short (protection buyer exposure) in the other reference entity bond.

A curve trade is a type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity. If the investor expects that an upward sloping credit curve on a specific corporate issuer will flatten, she may take the position of protection buyer in a short maturity CDS and the position of protection seller in a long maturity CDS.

An investor concerned about the credit risk of an issuer in the near term while being more confident of the long term prospects of the issuer might buy protection in the short term CDS and offset the premium cost by selling protection in the long term CDS. An investor who believes that the short term outlook for the reference entity is better than the long term outlook can use a curve steepening trade; buying protection in a long term CDS and selling protection in a short term CDS. The investor will profit if the credit curve steepens; that is, if long term credit risk increases relative to short term credit risk.

Conversely, an investor who is bearish about the reference entity’s prospects in the short term will enter into a curve flattening trade.

Uses of CDS

Earning arbitrage profits is another motivation for trading in the CDS market. Differences in pricing between asset and derivative markets, or differences in pricing of different products in the market, may offer potential arbitrage profits.

A basis trade is an attempt to exploit the difference in credit spreads between bond markets and the CDS market. Basis trades rely on the idea that such mispricing will be temporary and that disparity should eventually disappear after it is recognized. For example, if a specific bond is trading at a credit spread of 4% over MRR in the bond market but the CDS spread on the same bond is 3%, a trader can profit by buying the bond and taking the protection buyer position in the CDS market.

If the expected convergence occurs, the trader will make a profit.

Another arbitrage transaction involves buying and selling debt instruments issued by the same entity based on which instruments the CDS market suggests to be undervalued or overvalued.

In a leveraged buyout (LBO), the firm will issue a great amount of debt in order to repurchase all of the company’s publicly traded equity. This additional debt will increase the CDS spread because default is now more likely. An investor who anticipates an LBO might purchase both the stock and CDS protection, both of which will increase in value when the LBO eventually occurs.

In the case of an index CDS, the value of the index should be equal to the sum of the values of the index components. An arbitrage transaction is possible if the credit risk of the index constituents is priced differently than the index CDS spread.

Collateralized debt obligations (CDO) are claims against a portfolio of debt securities. A synthetic CDO has similar credit risk exposure to that of a cash CDO but is assembled using CDS rather than debt securities. If the synthetic CDO can be created at a cost lower than that of the cash CDO, investors can buy the synthetic CDO and sell the cash CDO, engaging in a profitable arbitrage.

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