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.
Watch Tim Bennett's video tutorial: Credit default swaps - should investors be worried?
MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
-
LVMH is set to prosper as the wealthy start shopping againAfter two years of uncertainty, the outlook for LVMH is starting to improve. Is now a good time to add the luxury-goods purveyor to your portfolio?
-
Japan is still rising to new highs – here's how to investOpinion Political ructions in Japan are no obstacle to gains, and the return of inflation may even benefit stocks, says Max King. What is Japan doing right?
