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
-
Why Trustpilot is a stock to watch for e-commerce exposureTrustpilot has built a defensible position in one of the most critical areas of the internet: the infrastructure of trust, says Jamie Ward
-
Tetragon Financial: An investment trust with stellar returnsTetragon Financial has performed very well, but it won't appeal to most investors – there are clear reasons for the huge discount, says Rupert Hargreaves
