A credit default swap sounds like a complicated thing, but in actuality, it’s just a particular kind of contract. Often abbreviated as a CDS, credit default swaps make it possible to offset their particular credit risk with the risks incurred by a different investor. The contract is also sometimes known as a derivative.
Credit default swaps are a newer kind of investment product. They weren’t introduced until the 1990s. And these kinds of contracts are not without criticism. During the 2008 financial crisis, credit default swaps came under scrutiny. They were used for many mortgage-backed securities. This type of derivative is best used as a type of insurance. It should be understood as offering some peace of mind in the event of something unusual happening. In practice, though, the buyer of the CDS can default on it. This prevents the seller from getting the money they’re expecting based on the stipulations in the contract.
Another issue with credit default swaps is that they’re highly distinctive. These agreements need to be customized because they’re contracts between two parties about very specific risks. Because of this, it’s hard for regulatory agencies to track this type of investment closely. Despite this, credit default swaps remain a popular investment. They can involve mortgage bonds, which caused trouble in 2008. Other CDS contracts are focused on emerging market bonds, municipal bonds, and corporate bonds.
Typically, hedge funds and banks are more likely to trade in credit default swaps than individuals are. Mutual funds and exchange-traded funds are also sometimes invested in credit default swaps. Those are the routes through which most average Americans become exposed to these derivatives. Credit default swaps are great because they help insulate buyers against risks. Investors sometimes worry a specific bond will be downgraded. It can be useful for them to have some insurance against that type of eventuality.
Another reason CDS’s can be a good investment is the nature of the securities they insure. Bonds can have terms of up to 30 years. It’s difficult to estimate the risk of an investment that takes so long to mature. Credit default swaps are one tool that makes it possible for funds to mitigate this risk more effectively for their investors.