Thursday, February 11, 2016

What are Credit Default Swaps Telling Us About the Economy?

Credit Default Swaps (aka CDS) are one of those little understood (by Main Street) but highly imaginative products brought to you by the creative minds of Wall Street.  In this posting, I want to give you a brief primer on Credit Default Swaps and then take a look at what they are telling us about the current state of the economy.  While the CDS market has shrunk considerably since the 2008 crisis, they still provide investors with an interesting economic barometer.

Credit Default Swaps, a form of derivative, were first launched in 1997 by JPMorgan Chase as a means for banks to make some easy cash by selling "insurance" to investors who wished to protect themselves from bad loans.  Credit Default Swaps are a contract between two parties that transfers the credit risk of certain types of debt (i.e. corporate, mortgage, emerging market bonds and municipal bonds).  It is easiest to think of Credit Default Swaps as a form of insurance.  If the buyer of the bond/debt is unwilling to take the risk of a potential default or credit rating downgrade, they can offload the risk to a party that assumes the risk that the borrower/creditor will be unable to pay.  Of course, this is done for a price or fee called the "spread" which is paid by the buyer to the seller of the contract.  The CDS contract is not actually tied to a physical bond but references it.  If the bond issuer defaults, the party that has sold the CDS is responsible for paying the full value of the bond plus accrued interest to the party that purchased the CDS.  If the bond issuer's debt remains in good standing, the party that sold the CDS profits from the fees paid by the bond holder.

There are certain credit events that are covered by a CDS:

1.) Bankruptcy

2.) Obligation Acceleration

3.) Obligation Default

4.) Failure to Pay

5.) Repudiation or Moratorium

6.) Restructuring (until 2002)  

On the market, the price of a CDS is referred to as its "spread" which is measured or denominated in basis points or 0.01 percentage points.  Since the value of a CDS contract varies over time based on the increasing or decreasing probability that an entity will default on its debt, CDS can be used by speculators to place a bet for or against the quality of the credit issued by a corporation or other entity.  An investor who thinks that the credit quality of a company is positive can take a position where they buy a position on the protection selling side of the equation and collect a share of the payments that are made by the bondholders.  An investor who thinks that the credit quality of a company is unstable or poor can take a position on the other side and receive their payoff when a company or other entity defaults on its bonds.  With the market for CDS being over the counter (OTC), trades are unregulated, resulting in the possibility that the risk buyer may not have the financial strength to abide by the contract's provisions (i.e. they might not be able to cover the cost of a significant default).  As well, by their very nature, CDS are highly leveraged, meaning that a downturn in the market could cause massive default and make it difficult for risk buyers to cover their obligations.

In case you were curious, according to the Office of the Comptroller of the Currency, in the third quarter of 2015 (the latest data), there were $8.2 trillion worth of credit derivatives outstanding in the U.S. banking sector alone.  Of these, 95.3 percent or $7.815 trillion  were credit default swaps as shown on this pie chart:

To put this into perspective, CDS form a very small portion of $192.2 trillion worth of national derivatives outstanding, most of which are interest rate contracts.

Obviously, the price of Credit Default Swaps will vary as the perception of the health of the economy varies.  A paper, "Credit Default Swaps as Indicators of Bank Financial Stress" by David Avino et al examines how changes in CDS spreads can be used to predict bank failure.  CDS spreads will rise as the risk associated with the debt rises and fall as the risk drops.

Let's get to the "meat" of this posting.  Here is a chart that shows us what has happened to the CDS spread on United States Investment Grade A and Above Bonds over the past three years (rating of A- and above):

The spread is now tied for the highest level that it has been at since early February 2012 and has risen by 34 basis points to 67 basis points (0.67 percent) over the past year.

Let's look at what has happened to the CDS spread on United States Investment Grade BBB Bonds over the past three years (rating from BBB- to BBB+):

The spread is now the highest that it has been for the past three years and has risen by 92 basis points over the past year to 159 basis points (1.59 percent).

Here is a chart that shows what has happened to the U.S. Corporate 120 Credit Spread Index which tracks the credit spreads of the largest investment-grade debt issues in the corporate sector of the S&P 500 over the past three years:

This spread is also at its highest point of the past three years and has risen by 60 basis points to its current level of 119 basis points (1.19 percent). 

While using CDS spreads as a measure of economic strength is somewhat limited, from the current rise in CDS spreads, it certainly appears that there is a growing lack of confidence in the ability of Corporate America to service its debts.  As the economy slows further, this will become even more apparent.


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