Credit Default Swaps

One interesting development in the financial markets that has really gathered steam over the past few years is the use of credit default swaps (Wikipedia), or CDS for short.

CDS are basically a form of insurance against a company defaulting on its bonds. Say you lend $1,000 to a company and it agrees to pay you $5 a year for 10 years in exchange for the use of your $1,000. At the end of year 10, the company agrees to pay you your original $1,000 back. This is the way a typical bond works.

However, what if you are unsure as to the ability of this company to pay you the $1,000 back? What if the company is on shaky financial ground? From where I stand, you can do three things.
1) Don't lend the company the $1,000.
2) Charge the company a higher interest rate, say 10%. However, this is still no guarantee.
3) Buy a CDS.

A credit default swap is basically a guarantee that someone else will pay you back the $1,000 if the company defaults on the debt. Let's say for the sake of argument that you can buy a CDS from Banco Gigante for $1 on your $1,000 bond. You pay Banco Gigante $1, you both sign this agreement, and if the company ever misses an interest or principal payment, Banco Gigante will give you your $1,000 back and take the bond off of your hands. If the company never defaults on the bond, Banco Gigante keeps the $1.

Of course there's also the issue of Banco Gigante's creditworthiness. What if Banco Gigante sold 10 million of these swaps, and ends up on the hook to pay out $1 billion when the company defaults? (rhetorical question for you to think about on your own time)

The existence and widespread use of CDS as insurance against bond defaults makes for even more ways for hedge funds and institutional investors to make bets in the market. In general, the price of this CDS insurance goes up as the perceived credit risk of the company goes up. For example, if people thought the company mentioned above was going to be the target of a leveraged buyout, which would add significantly more debt to its balance sheet and thereby make it less likely to be able to pay you your $1,000 back, the price of its CDS might go up to $5 or $10.

Wikipedia points to another article about some fund managers have been able to make risk free returns using a CDS-based strategy.

News stories have been reporting on CDS more and more as people have gotten more familiar with them. For example, this story from Bloomberg about the firing of Home Depot CEO Robert Nardelli today talks about how "The perceived risk of owning Home Depot's bonds rose after the announcement. Credit-default swaps based on $10 million of the company's bonds jumped 22 percent to $25,000, from $20,500 yesterday, according to data compiled by Credit Market Analysis in London. An increase in price indicates deterioration in the perception of credit quality; a decline suggests improvement."

As far as I know, there is currently no way for individual investors to play the CDS market, but I think they are definitely something worth knowing about.