The Role Of Credit Default Swaps In Corporate Bond Markets
Over the past few years, Credit Default Swaps (CDS) have gained traction in the Indian financial sector as they offer investors and market players an effective way to manage credit risk. CDS were initially meant to provide banks with a way of transferring credit exposure, but recently, they have grown as a portfolio management tool. This article offers oversight of what CDS are and how they work, their role as hedging tools, and the regulatory reforms surrounding CDS in India.
Understanding Credit Defaults Swaps (CDS)
Credit default swaps (CDS) refer to financial instruments that investors can use to hedge against default risk on debt instruments like loans or bonds issued by a bank, company, or government1. Usually, government or Corporate Bond investors expect to receive interest on bond investments and their principal investment at the maturity of the bond. Still, there is no guarantee that this can happen, so they have to bear the debt-holding risk. This is where CDS can be helpful as they act as some form of insurance to mitigate such risk.
Usually, CDS contracts are maintained through continuous premium payments, comparable to regular premiums required for insurance policies. Therefore, when a lender is concerned about a borrower's potential default on a loan, they can employ CDS to mitigate or swap such a risk.
How Credit Default Swaps Work
A CDS is a contract between two parties that entails the transfer of credit exposure on instruments such as bonds2. A buyer receives compensation for any losses that result from a credit event in a reference instrument.
For instance, if a company sells a $100 bond with a ten-year maturity, the company may enter a contract to pay the face value of the bond after maturity but with periodic interest payments over the bond's term. Since bond issues cannot guarantee repayment of the premium, the investor will assume that risk. Therefore the bond buyer can buy a CDS to swap the risk to another investor that agrees to settle if the bond issuer defaults.
Role Of CDS In Corporate Bonds Markets
Risk Management Tool Through Hedging Against Credit Risk
CDSs serve as a tool for mitigating credit risk associated with Corporate Bonds or asset-backed securities. This safeguard offers capital relief and protects the acquirer from potential credit losses, assuming the CDS contract allows for flawless hedging.
Moreover, CDSs can be utilized to hedge against counterparty exposure. During daily trading, dealers assume unsecured liabilities with other financial institutions. During times of significant market turmoil, credit default swaps are highly sought after by market participants as they provide a means of hedging such counterparty risks. These swaps offer protection by generating gains by widening credit spreads on their counterparties.
Speculation And Trading Opportunities
An investor can purchase a CDS for a particular entity, perceiving it as undervalued or overvalued, to generate profits through trading. Additionally, they can acquire CDS protection to speculate on the likelihood of the company defaulting, as an escalation in CDS spread indicates a deterioration in creditworthiness and vice versa.
If a CDS buyer anticipates an improvement in the seller's creditworthiness, they may opt to sell their protection. In this scenario, the seller is considered to have a long position on the CDS and the credit, while the investor who purchased the protection is seen as having a short position on the CDS and the credit. Many investors argue that a CDS facilitates the evaluation of an entity's creditworthiness.
Impact On Bond Pricing And Yields
CDS considerably impact bond pricing and yields, and their availability offers important information and market signals that can impact the issuer's creditworthiness and demand for their bonds. For instance, there is the spillover effect, where speculation and trading activity can impact bond prices and yields. When a CDS spread considerably widens, it indicates a high perceived credit risk and, as a result, may lead to investors demanding higher yields on corresponding bonds.
Relationship Between CDS And Bond Markets
CDS and Bonds markets are interconnected as each can influence the pricing of the other. Bond markets represent the issuance and trading of debt securities by companies or sovereign governments, and they promise periodic interest payments and return of principal amount at maturity. On the other hand, CDS act as security on the risk of default on instruments such as bonds. With a CDS, the buyer will pay a periodic premium, and the seller assumes the risk of default. Should there be a default, the seller will compensate the buyer for incurred losses.
In terms of risk mitigation, investors in the bond market will employ CDS contracts to hedge against the risk of default. Using CDS enables investors to swap risk on bonds purchased to other parties allowing them to focus on capital preservation and income generation. Another aspect that shows how the two are intertwined is the pricing mechanism where, for instance, when the perceived default risk on a certain bond is high, the price of CDS also increases.
CDS and bond markets demonstrate a symbiotic relationship about market sentiment. Participants in the market pay close attention to CDS spreads as a reliable gauge of credit risk. Broader spreads signify a deterioration in credit conditions and evoke investor concerns, resulting in downward pressure on bond prices
Regulatory Oversight And Reforms On CDS
In India, the CDS market includes sovereign CDS spreads and CDS for banks and corporates, but the availability of sovereign spreads in India is limited. However, investors can access CDS spreads for some Indian banks and corporates, which are somewhat liquid. The Reserve Bank of India (RBI) issued the first CDS guideline in 2011. It paved the way for the introduction of over-the-counter single-name CDS for Corporate Bonds.
Regulations on CDS have evolved, and recently the Securities Exchange Board of India (SEBI) allowed alternative investment funds (AIFs) to take part in the CDS market to protect sellers and buyers3. Under the new guideline, Category I and II AIFs can purchase CDS for hedging. In contrast, Category III AIFs can buy CDS for other reasons besides hedging but within acceptable leverage.
Conclusion
CDS are important instruments that investors can use to hedge against risk when purchasing securities with a longer maturity period. Besides risk mitigation, they can also be used in market speculation because of their close relationship with bond markets. It is worth noting that CDS prices depend on bond market pricing and demand. Indian investors can leverage this instrument for their benefits thanks to a conducive regulatory environment set by the RBI and SEBI.
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References:
- The Economic Times <https://tinyurl.com/mr2vj8ab> (hedge against default)
- Investopedia <https://tinyurl.com/4jjbxped> (the transfer of credit exposure)
- The Economic Times <https://tinyurl.com/nh9s7k9j> (alternative investment funds)
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