Credit Default Swap (CDS)

A Credit Default Swap, or CDS, is a financial agreement that functions much like an insurance policy on debt. In simple terms, the buyer of a CDS pays a series of regular fees (similar to an insurance premium) to a seller. In return, the seller agrees to pay the buyer a lump sum if a specific company or government (the “reference entity”) defaults on its loans or bonds—an event known as a “credit event.” This arrangement allows an investor who owns, say, a company's bond, to protect themselves against the risk of that company going bankrupt. These instruments are a type of credit derivative and gained notoriety for their role in amplifying the 2008 financial crisis. While they can be used for legitimate hedging, they can also be used for pure speculation, which is where the trouble often begins.

Imagine you've lent money to a local business, “Captain Ahab's Whale Watching Inc.,” by buying one of their bonds. You're confident in their business, but there's always a small chance they could run into trouble and be unable to pay you back. To sleep better at night, you can buy a CDS.

You approach a large financial institution, “Goliath National Bank,” and agree to pay them a quarterly fee. This fee is the price, or “spread,” of the CDS. In exchange for these payments, Goliath Bank agrees that if Captain Ahab's defaults on its debt, the bank will pay you the full amount you lost on your bond. There are two potential outcomes:

• No Default: Captain Ahab's business sails smoothly. You never get a payout from the bank, but you've paid the fees for the peace of mind. It's just like paying for car insurance and never having an accident.
• Default: A rogue wave of competition sinks Captain Ahab's business, and it defaults. Goliath National Bank now pays you the face value of the bond, protecting you from the loss.

• Protection Buyer: The investor who wants to hedge against default risk.
• Protection Seller: The entity (usually a bank or insurance company) that collects the premiums and takes on the risk of having to pay out if a default occurs.
• Reference Entity: The company or sovereign government whose debt is the subject of the CDS (e.g., Ford Motor Company, the government of Greece).

For the typical value investor, a CDS is not a tool you will ever buy or sell. However, understanding what they are and, more importantly, what their prices tell you, can be a powerful piece of your analytical toolkit.

The price of a CDS (the spread) is a live, market-driven indicator of a company's perceived riskiness. If the cost to insure a company's debt suddenly skyrockets, it's a massive red flag. It means that sophisticated institutional investors are getting very nervous about that company's ability to pay its bills. This can be an invaluable piece of information during your due diligence. If you find a stock that looks cheap, but its CDS spread is widening dramatically, the market may be screaming that the company's foundation is cracking. For a value investor obsessed with a margin of safety, this is a signal to proceed with extreme caution or, more likely, to walk away.

The most controversial use of this instrument is the “naked” CDS. This is when someone buys a CDS to protect against a default on a bond they do not own. Think about it: this is the equivalent of buying fire insurance on your neighbor's house. You have no interest in the house's well-being; in fact, you now have a direct financial incentive for it to burn down so you can collect the insurance money. This is not investing; it is pure speculation. This practice, which was rampant during the subprime mortgage crisis, creates immense systemic risk. It's what legendary investor Warren Buffett was referring to when he called complex derivatives like these “financial weapons of mass destruction.” A value investor's philosophy is rooted in owning a piece of a productive business, not in placing a side bet on its failure.

While CDSs are complex instruments for large institutions, the lesson for the ordinary investor is simple.

• Use CDS spreads as a market “fear gauge.” A rising spread on a company you're researching is a signal to dig deeper into its financial health, especially its balance sheet.
• Avoid complexity. The existence of naked CDSs is a stark reminder of the dangers of speculation versus investing. Your goal is to find wonderful businesses, not to make complex bets on financial catastrophe. If a company's finances are so shaky that you're tempted to insure your investment, you probably shouldn't be making that investment in the first place.