Investors can limit their exposure to credit risks, including the risk of default by purchasing Credit Default Swaps (CDS) in the credit derivatives market. Credit Default Swaps allow investors to swap credit risk on a company or country, with a different counterparty.
If a lender or investor wants to hedge its fixed income product against the risk of default, they can purchase a CDS contract. Most often times issued by a bank or insurance company. Similar to car insurance, the purchaser of the CDS must pay a premium or spread, until the underlying debt reaches maturity. The spread/premium is based on the riskiness of the loan. The higher the likelihood of default, the higher the spread. It is expressed in basis points (1 basis point = 0.01%).
In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interest that would have been paid until maturity. The contracts are traded over-the-counter (OTC), meaning that they are non-standardized and not verified by an exchange. In essence, a CDS transfers the credit exposure from the buyer (the investor) to the seller (the bank) without transferring the underlying bond or credit asset.
Today, as the narrow-minded and neurotic Russian leader, Vladimir Putin, continues his unjustified onslaught on Ukraine, Russian CDS has rocketed to all-time highs. Indicating that default on government debt may be imminent. Investors’ fears of non-payment were only further exacerbated after a decision by Moscow to authorize payments to foreign bondholders only with rubbles, regardless of the bond currency. Be sure to keep an eye on the chart above.