Insure Your Investment Portfolio with CDSs
Many UK investors, especially in the institutional space, use credit-risk measures based on swaps, which in turn price in the likelihood of default. These financial instruments are known as credit default swap (CDS) spreads and were first introduced in 1997.
They’re essentially an agreement between two parties (based on bonds) to insure the face value of the assets (their original value at issue) if anything goes wrong, such as a default: this arrangement is called the reference obligation.
On a very simplified level, swaps are a form of insurance in which the seller offers protection against default to a buyer who wants to insure against the risk of a debtor going bust. That insurance or protection comes with a fee attached to it – when the buyer pays that fee the CDS compensates the seller if a credit event (a default, for instance) hits the borrower.
Credit default swaps are quoted in the market as an annualised percentage spread, over LIBOR, known as the CDS spread. For example, the CDS spread quoted for a bond issued by XYZ company may be 100 basis points (bps). If the CDS buyer wants to protect a US$10 million investment in an XYZ bond, the buyer has to pay the CDS seller an annual fee of US$100,000 (typically paid quarterly).
This table (from UK-based financial services firm Catley Lakeman) shows the current range for CDS spreads associated with the largest UK-based banks as well as debts issued by leading developed-world governments. This wealth of information reveals that some banks (and governments) are seen as more trustworthy in terms of their bonds than others, but remember that the cost of this insurance can change radically over time.
As you read this table, keep these points in mind:
Five Year: The averaged CDS spread over a period of five years, shown in basis points.
Year End 2011: The CDS spread at the end of 2011, in basis points.
Tier 1 Capital %: A measure of the bank’s financial strength, determined by the bank’s core capital (capital from shares and disclosed capital). A capital ratio of 6 per cent or higher is considered well-capitalised.
Rating: The credit rating S&P assigned to this entity.
|Five Year||Year End 2011||Tier 1 Capital %||Rating|
|Royal Bank of Canada||58.073||101.668||13.3||AA|
Many hedge funds look at the direction or dynamic of the CDS spread and then bet that it will change markedly over time. Loads of hedge funds made a lot of money betting that the CDS spread for Greek sovereign debts would continue to increase while the CDS spreads for state-backed banks in the UK would fall back, when the UK government promised not to let those high-street banks go bust.