I don’t understand the purpose of credit default swaps. I understand that they transfer the risk of the underlying asset defaulting from the CDS buyer to the CDS seller. What I do not understand is why an investor would buy a risky bond and then buy a CDS to hedge the default risk associated with the risky bond to neutralize the risk. If the investor wants a bond without having to worry about default risk, why not just buy a risk-free bond instead?
My question, then, is what’s the difference between the following two types of investments:
- A risky bond + a CDS that hedges the default risk of the risky bond.
- A risk-free bond (e.g. a US treasury).
I suppose (1) would still be riskier than a US treasury because of the possibility that the CDS seller defaults on the CDS when the underlying’s credit event occurs? So investment (1) would have a higher yield than investment (2)? Short of this difference, buying a risky bond and then hedging that risk looks like a convoluted way of creating a risk free position (which should yield the risk-free rate).
What am I missing?
Greetings friend! There are numerous different types of risk related to bonds. Credit risk is one of the risk types but it is not the only one. There is also liquidity risk, interest rate risk, reinvestment risk, market risk etc.
When you are buying a CDS, you are often doing so as insurance against a bankruptcy or credit rating downgrade of a bond issuer. You are buying insurance against a specific subset of credit risk related events and keeping the rest of the risk. You are not “derisking” the bonds to any full extent. You instead are buying some insurance to protect the picture from getting worse than currently in terms of the credit rating of the bond issuer (i.e. a downgrade from AAA to BBB). You for instance can buy CDS in this scenario if you have a substantial investment (or are contemplating one) in company X corporate bonds and you’re worried about a possible bankruptcy or credit downgrade for company X, due to bad news or your own macro or micro level analysis etc. Does this help?
Cheers - good luck - you got this👍
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Yes this does help, thanks for your explanation!
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+1. Perfect explanation with a small one liner addendum from my end
“ Credit downgrading automatically do not qualify for credit event. It is what is written in the bond indenture. If it is so defined that downgrading from AA to BBB+ leads to spread widening to 50 Bps and anything above the 50 Bps will be considered a credit event ( technical default) then the Insurer will bear such liability”.
Basically what and how it is written in the bond prospectus
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Absolutely - great further clarification 