Introduction to Credit Derivatives via SG Investor

In this article, we introduce the very basics of Credit Default Swaps, Total Return Swaps, Credit-Linked Notes and Collateral Debt Obligations. In general, credit derivatives are instruments used by financial institutions to manage their credit risk. Credit risks arise because of the possibility that financial claims, such as loans or bonds, will not be repaid in full.

Credit Default Swaps (CDS)

A Short Introduction to Credit Derivatives

The concept behind credit default swaps is identical to that of insurance where you pay the insurer a fixed sum of money periodically in order to protect a reference entity against future risks. Typically, this would be your car, house or health. In the case of CDS, the reference entity is now a loan or bond which has been made or purchased by a financial institution. To protect against the risk of default, the financial institution similarly pays a fixed periodic sum to an insurer (usually another financial institution) for protection. In a credit event (default), the insurer pays a contingent payment as compensation. Otherwise, the insurer simply earns the periodic fees for incurring part of the credit risk from the loans or bondsWhen there is widespread defaults as in a financial crisis, insurers might lack the liquidity or assets to service all contingent payments and become defaulters themselves.

Total Return Swap

The concept of insurance is applicable to Total Return Swaps as well. However, the method of payment and compensation is slightly different. Here, the protection buyer transfers all returns arising from the reference entity to the protection seller and instead, earns as comparatively riskless return from the protection seller. This is usually a premium above a floating rate such as your U.S government bond yields or fed fund rates.

Credit-Linked Notes (CLN)

Credit-linked notes are essentially bonds embedded with a CDS contract. Investors get interest payments and par value of the CLN upon maturity. The common belief is that returns are simply the reward of incurring risk and hence, are commensurate with the degree of risk. Under certain circumstances, this is debatable – just ask a value investor. However, I believe that even most value investors would agree that this holds true to a greater extent for fixed income instruments as compared to equities. That being said, we can observe from the above diagram that the flow of returns and risk are not identical. The returns cascade from the reference credit down through many layers of investors and with each passing layer, the level of return is reduced. Unfortunately, the risk is simply passed on rather than split, and the investors of such CLN ultimately bear the default risks of the reference credit while receiving arguably the lowest returns.

Collateral Debt Obligations (CDO)

CDO are similar to CLN, but based on a pool of assets and has been resold by the sponsor to other financial institutions or special purpose companies (SPC). These are then sold to investors and can be further divided into different tranches. As with bonds, interest payments to the senior tranches are fulfilled first, followed by the mezzanine and then subordinated tranches. Once again, the investors bear the credit risk of the collateral. CDOs are the fastest growing sector of the asset-backed securities market and were the main instruments responsible for the 2008 Subprime Mortgage Crisis.