Advertisement

Credit default swap

Anyone who owns a bond faces two main risks. The first is that the price drops and the second is that the issuer goes bust...

Anyone who owns a bond faces two main risks. The first is that the price drops and the second is that the issuer goes bust. Credit default swaps (CDS) deal with the second problem. So a fund manager holding a risky bond, worried about a default, could buy a CDS and pay a non-refundable premium for it. If the bond issuer subsequently defaults, the fund manager can call in a compensating payment from the CDS issuer. As such, a CDS is just bond insurance. But why not simply sell the bond? That may involve substantial trading costs if the bond is illiquid and possibly trigger a tax obligation too. Also, the fund manager may sacrifice a decent income stream- high 'coupons'- often a feature of risky bonds and difficult to replicate elsewhere.

Advertisement - Article continues below

Watch Tim Bennett's video tutorial: Credit default swaps - should investors be worried?

Advertisement
Advertisement

Recommended

Visit/glossary/bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
Visit/spending-it/glossary/601300/quantitative-investing
Glossary

Quantitative investing

Quantitative investing uses sophisticated computer-based mathematical models to identify and carry out trades.
8 May 2020
Visit/glossary/quantitative-easing-qe
Glossary

Quantitative easing (QE)

Quantitative easing (QE) involves electronically expanding a central bank's balance sheet.
8 May 2020
Visit/glossary/600702/emerging-markets
Glossary

Emerging markets

An emerging market is an economy that is becoming wealthier and more advanced, but is not yet classed as "developed".
24 Jan 2020

Most Popular

Visit/investments/stockmarkets/601423/as-full-lockdown-ends-what-are-the-risks-for-investors
Stockmarkets

As full lockdown ends, what are the risks for investors?

In the UK and elsewhere, people are gradually being let off the leash as the lockdown begins to end. John Stepek looks at what risks remain for invest…
29 May 2020
Visit/economy/global-economy/601420/james-ferguson-the-virus-the-lockdown-and-what-comes-next
Global Economy

The MoneyWeek Podcast: James Ferguson on the virus, the lockdown, and what comes next

Merryn talks to MoneyWeek regular James Ferguson of Macrostrategy Partnership about what's happened so far with the virus; whether the lockdown was th…
28 May 2020
Visit/investments/property/601411/can-the-uk-housing-market-escape-a-slump
Property

Can the UK housing market escape a slump?

The Bank of England is predicting a 16% slump in house prices.
29 May 2020