Credit Default Swaps
Western Asset
4 November, 2008
Executive Summary
In a market that is characterized by unprecedented volatility, Western believes that credit default swaps, including single name issuer contracts (CDS) and index contracts (CDX), represent an effective tool for managing exposure to corporate risk quickly, at a low cost and, in the case of the CDX contract, with significant diversification. The size of the market relative to the size of the cash market also contributes to the importance of these instruments. Given the market's concern regarding these instruments, we continue to keep close watch on regulatory initiatives coming from within the industry and from Washington. Lastly, Western Asset is committed to providing transparency and communication on this and other complex issues in these extraordinary times.
Lately, much has been written about the mechanics of the credit default swap market including its size and the potential risk that it poses to the financial system. In this paper, we will examine these issues and address both how and why we choose to use these tools in many of our portfolios. We will also examine several of the index contracts that are actively traded in the market.
Size and Mechanics
The credit default swap market is very large. As of June 30, 2008, the notional amount outstanding was roughly $54.6 trillion and the size of the underlying cash market was approximately $5.5 trillion.
Portfolio managers use credit default swaps to reduce (buying insurance), increase (selling protection) or manage exposure to corporate spreads. The opening of a position can be for hedging purposes, for short-term trading or for investment.
The buyer is purchasing insurance against default. Another way to view this is that the buyer of a credit default swap is selling the issuer 'short,' meaning that they will benefit from a default of the issuer or from a widening of spreads. The buyer pays a periodic premium to the seller in order to obtain the insurance. If there is a credit event, such as a default, the buyer will have the right to sell a bond of the issuer to the credit default swap seller at par; if spreads widen, they will be able to close out the position with a profit.
The seller is providing that insurance. The writer or seller of the credit default swap will receive the periodic premium. The seller may have the obligation to buy the bond at par in the event of a default. Like the buyer of a bond, the seller of the credit default swap is effectively a buyer of the credit risk of the issuer. The yield is quoted as a spread over interest rate swaps, rather than as a spread over Treasuries, as is the case in the cash market. Therefore, the spreads between the cash market and the credit default swap market for the same issuer can vary substantially. This represents basis risk, the relative pricing differential between two similar instruments, the cash bond and the credit default swap of the same issuer. It is also important to note that there is no direct exposure to interest rates (the Treasury yield curve) as the credit default swap references only the credit risk of the issuer, not the interest rate risk associated with a comparable duration Treasury security.
The terminology used for credit default swaps-buyer, seller, writer, right and obligation-sounds very much like the terminology used for options. They are quite similar and a credit default swap closely resembles a put option on the underlying bond where the short put would be comparable to a sold credit default swap and a long put would be comparable to a purchased credit default swap. The credit default swap seller receives a premium and has the obligation to purchase a bond of the issuer in the event of a default. The credit default swap buyer pays a premium and has the right to sell the bond at par in the event of default.
If the credit default swap yield at the inception of the contract is comparable to its coupon, then there is no cash exchanged. Cash is paid by the buyer to the seller periodically at the coupon rate, producing income for the seller and an expense for the buyer. As the yield (spread) moves away from par, there will be an exchange of collateral (i.e. margin). If the yield goes down (spreads tighten), the seller may request collateral (unrealized profit, paid by the buyer) and if the yield goes up (spreads widen), the seller may be requested to post collateral (unrealized losses, received by the buyer). If the spread differs significantly from the periodic premium at inception, the seller would need to receive or pay an up front amount. Based on these cash flows, there is generally little net counterparty exposure, as there are regular collateral adjustments.
If the underlying reference entity experiences an event of default, the seller is obligated to buy the bond at par. The net experience is that a credit default swap seller agrees to accept the credit risk of an issuer, receives a periodic payment (coupon) for having done so and, in the event of a default, acquires a bond of the issuer and a claim on the issuer as a creditor. When buying a cash bond, the experience is highly similar. At inception, the investor pays a market price for the bond that is determined to be at a premium or a discount depending on whether the yield is lower or higher than the coupon, respectively. The biggest difference is that in a credit default swap contract the underlying bond does not have to be purchased unless there is a credit event such as a default.
The size of the market can impact these mechanics as the notional amount outstanding on an issuer can, and often is, larger than the par amount of the outstanding underlying bonds. Market participants can elect for a cash settlement of the contract in lieu of the physical settlement option (delivery of a bond). To facilitate a cash settlement, the International Swaps and Derivatives Association, Inc. (ISDA), the global financial trade association that represents participants in the over-the-counter derivatives market, has developed an auction process to determine the final settlement price. The resulting price is subtracted from par to determine the final cash settlement. Once the contract has settled, any movement of collateral that has been pledged to support the mark-to-market of the contract can be withdrawn.
Concern in the Markets
For exchange traded derivatives, there is a single, centralized counterparty (i.e. the exchange or the clearinghouse) that intermediates the transfer of risk between buyers and sellers. In the swaps market, in contrast, each participant faces a counterparty of their choosing. These counterparties are generally commercial banks or investment banks and the viability of the counterparty represents incremental risk to market participants. The periodic exchange of margin collateral and the governing ISDA documents mitigate this counterparty risk.
There has been much concern voiced about the size of the credit default swap market. It has been reported that certain institutions have enormous exposure, the largest concentrations of which are with certain insurers. The fear of systemic risk relates to concern that a significant market participant would not have sufficient funds to meet a collateral call in the event of a material downward move in the credit quality of an issuer(s) or in the event that a significant counterparty experiences a credit event themselves, both having occurred in recent weeks. Lehman Brothers, for example, was a significant market participant with numerous counterparties facing them. In addition, it is estimated that there were approximately $400 billion in outstanding notional exposure referencing Lehman Brothers itself as an issuer in the credit default swap market. The final settlement price of the contract determined by auction was $8.625, so the settlement payments required could have meant that as much as $365 billion would need to change hands. Physical settlement and netting features resulted in net payments between counterparties that were significantly lower. Given the capital condition of many Wall Street firms, it was feared that the failure of a protection seller to make good upon settlement could have precipitated the failure and/or collapse of another significant Wall Street firm.
This did not occur. But there continues to be considerable concern that it might still, given that default rate forecasts are rising due to the lack of available credit, the sudden increase in the cost of credit and the apparent slowdown in the economy. These concerns have led to calls for increased transparency and for greater regulation of the credit default swap market. These changes are likely given the enormity of the disruption that we have seen in the market in recent weeks. It is also a possibility that a clearinghouse will be formed to ensure the credit worthiness of buyers and sellers of credit default swaps, to monitor the maintenance and exchange of margin and to act as a single counterparty for all transactions. This structure already exists in the futures market and can be adapted for the unique characteristics of the credit default swap market.
How and Why Western Asset Uses Credit Default Swaps
Like other derivative securities, credit default swaps can be used to increase, decrease or manage exposure to the corporate sector. As a bond investor, we can sell protection and accept the risk of default in exchange for a periodic payment (the coupon). Western can also buy protection in the credit default swap market to reduce corporate exposure. Credit default swaps provide an effective tool for precisely calibrating the desired risk level and the desired position on the maturity spectrum.
In the current environment, Western believes that spreads are wide relative to risk. It is not just that they are wide by historical standards, but our research suggests that the level of defaults necessary over a five-year period to result in a return comparable to Treasuries approaches 30% for the broad investment-grade universe and 70% for the broad below investment-grade universe. Credit default swaps provide an alternative to purchasing cash bonds as they can be written for little or no cost, generally have a term of five years or less, and are more liquid than their cash counterparts. These instruments provide the opportunity to quickly, efficiently and effectively increase (or decrease) exposure to credit on the short end of the yield curve. The transaction also results in increased income for the portfolio.
Credit default swaps can represent a relative value opportunity. Due to technical (supply and demand) conditions in the market, it is sometimes cheaper (higher yield) to take exposure to an issuer through the credit default swap market rather than in the cash market, thereby creating an economic incentive to use the derivative rather than cash bond.
It is important to note that when protection is purchased, the coupon must be paid. This is a negative carry trade, meaning it reduces the level of income in the portfolio. When Western buys protection, the intent is to reduce the level of exposure to corporate spread risk. Often this is done in conjunction with existing positions in the portfolio; rather than selling a position in a given name or in a group of names, the purchased credit default swap represents an offset of risks that are already present.
Types of Credit Default Swaps
There are several types of credit default swaps. These include:
CDS-contracts on an individual issuer
CDX-contracts on an index of issuers (a portfolio of issuers where each individual issuer represents a fraction of the total exposure)
ABX-contracts on an index of mortgage securities
An important tool in managing credit risk is the CDX contract. Much like the S&P 500 Index (a market weighted index of 500 equity issuers), a CDX contract reflects the value of a number of different issuers with each individual issuer representing only a fraction of the overall exposure of the index. Available CDX contracts include:
Please note the series number. Series 11 is the current on-the-run contract. Every six months, a new contract is created with a term of five years. At the time series 11 was issued, series 10 had four years and six months to maturity, while series nine had four years to maturity. Each new series serves to keep the on-the-run contract close to five years in tenor while also allowing for substitution of the underlying issuers.
Like an option, if the contract matures and no issuers default, the seller keeps all premiums received while the buyer of protection pays an insurance premium and receives nothing in exchange. If one or more of the issuers in the index defaults, then a cash settlement is arranged, following shortly after the event. The seller would be required to pay the difference between the settlement price and par to the buyer. The amount would be based on the notional value of the contract multiplied by the percentage of the index allocated to the particular issuer(s).
To illustrate the construct of these contracts, provided below is a list of issuers in the current CDX.NA.IG.11 contract. This is an index of 125 issuers with each issuer representing 0.80% of the total notional exposure:
While not necessarily widely known, these indices behave much like other well-known indices, reflecting the performance of the underlying constituents.
Like the indices listed above, CDX securities provide a low cost, liquid and highly diversified tool for managing portfolio exposure. Much like buying S&P 500 Index futures to increase exposure to equities following a decline in price, a credit default swap index contract can be sold to increase portfolio exposure to corporate spreads following a widening. Conversely, we can buy protection on an index contract to decrease portfolio exposure to credit spreads.
Amidst the unprecedented volatility in the markets today, there continues to be concern about credit default swaps and related instruments. They continue to be a significant tool in the management of fixed income portfolios and, by the virtue of the size of the market, share importance with the underlying cash market while at times providing superior liquidity. While it is likely that there will be structural changes to the market, it is unlikely that the importance of these instruments will diminish. Western remains committed to monitoring changes in sentiment, performance and regulation while providing our clients and constituents with transparency, information and research on these and other complex instruments as they evolve.
Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).
Western Asset
4 November, 2008
In a market that is characterized by unprecedented volatility, Western believes that credit default swaps, including single name issuer contracts (CDS) and index contracts (CDX), represent an effective tool for managing exposure to corporate risk quickly, at a low cost and, in the case of the CDX contract, with significant diversification. The size of the market relative to the size of the cash market also contributes to the importance of these instruments. Given the market's concern regarding these instruments, we continue to keep close watch on regulatory initiatives coming from within the industry and from Washington. Lastly, Western Asset is committed to providing transparency and communication on this and other complex issues in these extraordinary times.
Lately, much has been written about the mechanics of the credit default swap market including its size and the potential risk that it poses to the financial system. In this paper, we will examine these issues and address both how and why we choose to use these tools in many of our portfolios. We will also examine several of the index contracts that are actively traded in the market.
The credit default swap market is very large. As of June 30, 2008, the notional amount outstanding was roughly $54.6 trillion and the size of the underlying cash market was approximately $5.5 trillion.
For exchange traded derivatives, there is a single, centralized counterparty (i.e. the exchange or the clearinghouse) that intermediates the transfer of risk between buyers and sellers. In the swaps market, in contrast, each participant faces a counterparty of their choosing. These counterparties are generally commercial banks or investment banks and the viability of the counterparty represents incremental risk to market participants. The periodic exchange of margin collateral and the governing ISDA documents mitigate this counterparty risk.
Like other derivative securities, credit default swaps can be used to increase, decrease or manage exposure to the corporate sector. As a bond investor, we can sell protection and accept the risk of default in exchange for a periodic payment (the coupon). Western can also buy protection in the credit default swap market to reduce corporate exposure. Credit default swaps provide an effective tool for precisely calibrating the desired risk level and the desired position on the maturity spectrum.
There are several types of credit default swaps. These include:
An important tool in managing credit risk is the CDX contract. Much like the S&P 500 Index (a market weighted index of 500 equity issuers), a CDX contract reflects the value of a number of different issuers with each individual issuer representing only a fraction of the overall exposure of the index. Available CDX contracts include:
While not necessarily widely known, these indices behave much like other well-known indices, reflecting the performance of the underlying constituents.
Like the indices listed above, CDX securities provide a low cost, liquid and highly diversified tool for managing portfolio exposure. Much like buying S&P 500 Index futures to increase exposure to equities following a decline in price, a credit default swap index contract can be sold to increase portfolio exposure to corporate spreads following a widening. Conversely, we can buy protection on an index contract to decrease portfolio exposure to credit spreads.© Western Asset Management Company 2012. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients and their investment consultants. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.
Past investment results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management Company and its affiliates ("Western Asset"). Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. This material may not be used or reproduced in any form without express written permission. © 2012
Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).