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. 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

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

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

MoneyWeek is written by a team of experienced and award-winning journalists, plus expert columnists. As well as daily digital news and features, MoneyWeek also publishes a weekly magazine, covering investing and personal finance. From share tips, pensions, gold to practical investment tips - we provide a round-up to help you make money and keep it.