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Aon Retirement and Investment Blog

Credit Default Swaps – Improving their Effectiveness for Investors

Introduction
2014 saw the introduction of new terms and conditions relating to the mechanics of Credit Default Swaps (“CDS”) on financial reference entities and sovereigns in non-US jurisdictions.  These changes seek to:

  • improve the transparency of which negative events will and won’t trigger a payout on the contracts; and
  • better align outcomes between those investors holding physical bonds and those holding CDS contracts.
Additionally, further enhancements have been made to the European High Yield CDS Index to reflect recent developments in the European High Yield bond market. It is hoped these changes will improve confidence and transparency in the global credit derivative markets and further enhance the role CDS can perform in clients’ portfolios where CDS are used for non-US exposures.
 
What are CDS?
CDS are a commonly used financial derivative that allows the transfer of credit risk between two parties. A CDS contract can be viewed as an insurance contract which offers protection against default and other detrimental credit events. The purchaser of a CDS contract (known as buyer of protection) will earn a profit or protection against stipulated negative credit events in exchange for offering the seller (known as seller of protection) a periodic fee. CDS contracts exist in respect of single issuers and on baskets of multiple issuers. The higher the perceived risk of the underlying issuer(s) the greater the periodic fee a buyer must pay to the seller of protection for the insurance.
 
How can Credit Default Swaps be used in a portfolio?
CDS have two main uses in portfolios:
  • Hedging – CDS allow an investor to reduce some or all credit risk they are exposed to without having to trade in the underlying security outright.
  • Establishing active (positive or negative) positions – the CDS market is large and liquid and can enable an investor to establish positions more easily than trading in the underlying security would permit. CDS also allow investors to take a “short” or outright negative view.
Historic flaws implicit in Credit Default Swaps
Events in recent years, including the debt restructuring debates in Greece and the Dutch government’s seizure of lender SNS Reaal’s bonds, have prompted changes to the terms and conditions associated with CDS contracts. In the summer of 2014 a Portuguese bank, Banco Espirito Santo (“BES”), received a bailout from Portugal’s central bank and split into two banks; one an ongoing bank which kept the functioning business and a “bad bank” to keep its toxic assets. Those investors who held junior bonds issued by BES were effectively wiped out but buyers of protection on the CDS related to BES were not paid and instead saw their contracts referred to a new entity, meaning those who held CDS as a hedge against their bond holdings or to establish an outright negative stance on BES did not benefit. This highlighted the need for reforms in the CDS market.

In addition, investors have raised concern that the European High Yield CDS Index basket does not provide an adequate representation of those underlying sectors of the bond market.

What has changed?
The International Swaps & Derivatives Association (“ISDA”) introduced new definitions governing CDS contracts that took effect on October 6th 2014. This has been the first major update since 2003 and seeks to fix the flaws which have prevented some contracts from paying out as expected in the aftermath of the global financial crisis.
 
Most significantly, the list of events triggering payouts for buyers of CDS protection has been expanded to include bail-ins, where investors are forced by governments and/or regulatory authorities to contribute to providing financial assistance to that entity (non U.S. jurisdictions only) in trouble. The new conditions also explicitly now insure against debt write-downs, bond exchanges and conversion of debt to equity. The lack of these conditions being included previously led to investors suffering significant write-downs on bonds, whilst buyers of protection did not benefit.
 
2014 saw the convergence of the iTraxx Crossover CDS Index, which represents European High Yield, expanded twice. In February of 2014, the number of issuers in the index increased from 50 to 60 and has recently (as of the September 2014 roll) increased to 75 issuers. This means that this CDS Index now better reflects the underlying dynamics that have seen the number of European High Yield bond issuers grow materially over the last 18-months as many smaller companies have turned to the bond market for financing, as shown in the chart below.
 

 
Conclusion
As a result of the developments to the CDS market we would highlight the following for investors:
  • Investors should take more comfort that their managers who utilise CDS for hedging and/or active positioning receive outcomes aligned with that of bondholders going forwards, especially in the case of junior financial and sovereign CDS.
  • Investors looking to gain exposure to European High Yield now have a more diverse CDS Index available which has less idiosyncratic risk than previously due to an increased number of issuers and should provide a closer match to the performance of high yield bond indices.
If you would like to discuss this topic with us please contact your usual Aon Hewitt consultant or contact.

Paul Whelan is a Principal in the Fixed Income Manager Research team located in London.

The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.


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