Credit Default Insurance: What it Means, How it Works (2024)

What Is Credit Default Insurance?

Credit default insurance is a financial agreement—usually a credit derivative such as a credit default swap (CDS) or a total return swap—to mitigate the risk of loss from default by a borrower or bond issuer.

Credit default insurance allows for the transfer of credit risk without the transfer of an underlying asset.

Understanding Credit Default Insurance

The most widely used type of credit default insurance is a credit default swap (CDS). Credit default swaps transfer credit risk only; they do not transfer interest rate risk. A CDS is a financialderivative that allows an investor to "swap" or offset theircredit riskwith that of another investor.

In effect, a CDS isinsuranceagainst non-payment. Through a CDS, abuyer can reduce the risk of their investment by shifting all or a portion of that risk onto an insurance company, or other CDS seller, in exchange for a periodic fee. For example, if a lender is worried that a borrower is going todefaulton a loan, the lender could use a CDS to offset or swap that risk.

In this way, the buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees thecreditworthinessof the debt security. The buyer of a credit default swap will be entitled to thepar valueof the contract by the seller of the swap, should the issuer default on payments.

If the debt issuer does not default andall goes well, the CDS buyer will end up losing some money, but the buyer stands to lose a much greater proportion of their investment if the issuer defaults, andthey have not bought a CDS. As such, the more the holder of a security thinks its issuer is likely to default, the more desirable a CDS is and the more thepremiummay be considered a worthwhile investment.

History of Credit Default Swaps

Credit default swaps have existed since1994. CDSs are not publicly traded, and theyaren't required to be reported toa government agency.CDS data can be used byfinancial professionals, regulators,and the media to monitor how the market views thecredit riskof any entity on which a CDS is available, which can be compared to that provided by the credit rating agencies, including Moody's Investors Service and Standard & Poor's.

Most CDSs are documented using standard forms drafted by theInternational Swaps and Derivatives Association (ISDA), although there are many variants.In addition to the basic, single-name swaps, there arebasketdefault swaps (BDSs), index CDSs, funded CDSs (also calledcredit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include aspecial purpose vehicleissuingasset-backed securities.

Credit Default Swaps vs. Total Return Swaps

Whereas credit default swaps transfer credit risk only, total return swaps transfer both credit and interest rate risk. A total return swap is aswap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and anycapital gain.

In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, a basket of loans, or bonds. The asset is owned by the party receiving the set rate payment.