In recent weeks you may have seen an increasing number of references to activity in the CDS markets particularly among doom and gloom merchants on social media. Much of the commentary is bullsh*t and in this piece I will provide just some of the reason why.
What are CDS?
CDS stands for Credit Default Swaps. They are a product that allows one counterparty to swap the credit risk of a company or even a Sovereign State with another. The buyer of a CDS will pay a regular fee to the seller who in return must compensate the buyer in the event that the company or country incurs a specific type of credit event such as a default on their bonds or bankruptcy. In essence, it is a type of insurance with one side buying insurance against a credit event and the other side willing to underwrite that insurance. Prices are quoted in basis points (bp) and can range from just a few bp for high quality issuers to hundreds or even higher for lower quality (as the cost of buying protection rises). For more you can see an explanation from Pimco here
Who Uses Them?
Hedging
Typical buyers of CDS include bond holders who wish to strip out the credit risk of the bonds they own thereby just leaving them with the yield on the bond. This is an example of using CDS to hedge risk.
For example, if I buy $10 million of Company GAZ Bonds which are yielding 9% but I don’t want exposure to GAZ’s potential credit risk, I might buy $10 million of CDS that repays me if GAZ defaults or goes into bankruptcy. I will pay a fee for this insurance which will of course, reduce my effective yield from that bond but I have eliminated the credit risk.
Those who buy CDS for hedging purposes are therefore not speculating that the company/country will go broke, rather they are just hedging out credit risk. You could argue that if they really thought the bond issuer was going to fail, the CDS buyer wouldn’t buy the bonds in the first place (the process for settlement in the event of a credit event can be lengthy).
Some fund/bank risk management systems will only allow a trader to build a large bond position if some/all of the credit risk is reduced.
Speculators
CDS are also traded by speculators. If a trader thought the credit risk of a bond issuer was weaker/stronger than the current market price of that issuer’s CDS (s)he could sell/buy CDS from that issuer and would profit if the price of that CDS changed accordingly. This is similar to someone buying or shorting a stock because they thought the price would go up/down.
Arbitragers
There can be some arbitrage opportunities involving buying/selling CDS and selling/buying bonds and/or shares.
Counterparty Risk
One point to note is that when buying CDS you should ensure that the counterparty (the seller) does not have a significant exposure to or connection with the issuer. For example, I once wanted to buy CDS on Japanese bank Mizuho and got a very low offer through my credit desk. When I asked who the counterparty was, they told me it was Mizuho! I clearly do not want to buy insurance against Mizuho going under from Mizuho themselves!
BS #1 – Percentage Moves
Similar to my previous article about VIX bullsh*t, quoting CDS moves in percentage terms can be misleading. You often hear fear mongers say things like “CDS in XYZ jumped 10% today” suggesting this is a big move. CDS markets are not like shares; they are not traded on a one or two cent bid/ask price and therefore they don’t move in the same way as shares. It is not uncommon for a CDS price to move from say 100bp to the next price of 105bp.
Rather like with the VIX, for a high quality credit to move from say 20bp to 22bp looks like a 10% jump but in reality this is still a very low price and still a high quality credit. Similarly if a CDS is trading at 800bp and it rises to 900bp, this would reflect a very poor quality credit being priced even wider (higher) and doesn’t really reflect anything new.
Further, sometimes it doesn’t take too much volume to move a CDS price. In the right (wrong) market conditions, CDS prices of some issuers can reprice after only a few hundred million dollars of trades (sometimes even less).
So measuring activity in the CDS market in terms of percentage moves, while providing lots of headlines, does not necessarily mean there has been a noteworthy move.
BS#2 – Buyers of CDS Are Expecting Default
It has become common for doom-mongers to relate CDS activity to mean traders are expecting default. This is an example from twitter:
As I have shown earlier, a lot of activity in CDS is traders hedging long bond positions. These traders are not betting on a default.
Even speculators who buy CDS do not necessarily expect a default, they just expect prices to go higher. Given the previous debt ceiling wrangling and bank failures, this was not a surprise. Saying that CDS buyers are betting on a default is like saying all share short sellers are betting on bankruptcy. The vast majority of short sellers simply think the stock is too high and will fall. Most CDS speculators are just looking to buy low and sell high. Tweets like the above are misinformed fear-mongering.
CDS on a Sovereign such as the US raises the issue of counterparty risk again. If the US did default, who would be able to pay out? This further suggests that CDS buyers are not really expecting default, just either hedging some positions or speculating on higher prices.
Summary
In the world of financial social media, fear creates clicks. The tweet above was seen by over 150k people (far more than will read this piece). But fear is often driven by ignorance or at least fuelled by ignorance. We must be able to see through it to see what is really happening.
Keep Grinding
Gary
