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?