Den of The Lion Investor

An understanding of credit default swaps is essential in order for you to understand the workings of credit-linked notes or structured products.

In this post, I will give a brief introduction to credit default swaps. 

But first, we need to know what a bond is. A bond is simply a debt obligation of a company.

For example, if you use $100,000 to buy a 5-year bond from SPH, you are essentially lending $100,000 to SPH. In return for the loan, SPH agrees to pay you a coupon (or interest rate) of say 4.5% p.a.

In the event that SPH goes bankrupt, you will lose a huge part of your principal. The amount you get back will depend on the recovery rate. If the recovery rate is 40%, you will get back $40,000 of your capital. 

To mitigate the risk of a SPH failure on your SPH bond, you can buy a credit default swap (CDS) on SPH. This is like buying an insurance plan that pays you if SPH defaults on your loan. The cost of this insurance premium might be about a couple of percentage points every year but will depend on a few factors including:

• Credit rating of SPH
• Market conditions
• Government risk free interest rate

Using our earlier example of a SPH failure, the seller of the CDS (which acts as the insurance company), will have to pay you $60,000, which is the amount you lost based on a recovery rate of 40%.

If SPH does not default on their bond for the duration of the CDS, the CDS seller happily pockets the premium.

The thing about CDS is that anyone can purchase it without the need for owning the underlying debt. If I feel that SPH is going to fail soon, I can buy a CDS on their default even though I might not hold any SPH bonds.

Conversely, almost anyone might sell a CDS without the need for showing that they can handle the payouts in the event of a default.

In the search for greater yield, this “free for all” mentality in a largely unregulated environment has led to an explosion in the CDS market. So much so until no one really knows what the size of everyone’s else CDS exposure is. And whether they can pay the liabilities in the event of defaults. Furthermore, it is clear now that some institutions have underpriced the CDS that they sold.

This is also the instrument that single-handedly bought down AIG.

And when someone talks about unwinding a CDS position, it simply means cancelling this “insurance contract”. There’s a cost (or profit) to this of course. This will depend on the market rate of the CDS at the point when the position is unwinded.

Let’s say you sold CDS for SPH at a 2% premium. If the current CDS rate for SPH is at 1%, you can buy your own SPH CDS at 1% and transfer away the risk of SPH defaulting (assuming no counter-party risk). Then, you would have made 1%. However, if the market rate for a SPH CDS is at 4%, you would have lost 2% in order to transfer this risk away.

The mathematics would be similar for the cancellation of any credit default swap between the swap parties.

The cost of CDS has increased significantly since the collapse of Lehman Brothers. Thus, most unwinding of CDS positions would have resulted in losses for the original seller.

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Based on the questions received from my previous post on the OCBC preference shares, I think it will be good for me to elaborate more on what preference shares or preferred shares really are.

Preference shares really behave more like a bond than normal shares. Let’s first look at what a normal share is.

A normal share gives you a certain percentage shareholding of a company. You have an economic interest in all future earnings of the company. If there are 100 shares of a company and you own 1 share, effectively you own 1% of the company. If the company is sold, you get 1% of the value. You also get a 1% voting right.

A preferred share is more like a loan to the company. You do not get normal voting rights and to attend AGMs. In return for your capital, you are promised a dividend amount every year. This dividend is not guaranteed and the frequency of payouts will determine on the strength of the company.

This is where a preference share differs from a normal bond. For a bond, the company has to pay the interest no matter what happens. For preference shares, it is conditional upon the company paying dividends to its normal shareholders first. If the company happens to make a loss for that year and decides not to declare any dividends to its normal shareholders, the company can choose not to pay or to reduce the dividends to the owners of its preference shares.

On the other hand, if a company pays out any dividends to its normal shareholders, then it has to fulfill its obligations to its preference shareholders first.

Based on OCBC’s track record, the frequency of dividend payouts should be pretty consistent.

The other difference is that for a bond, it has a fixed maturity date. Come a certain date, you know that you will get back your capital. For preference shares, the company has the right (but not the obligation) to redeem the shares from you on particular dates. If they don’t and you wish to get back your capital, the only way for you is to sell them on the secondary market. The price you get might be lesser or more that what you paid for.

What then affects the market value of the preference shares?

Here, an understanding of bond pricing is required. Two things have the greatest effect on the pricing of bonds - interest rates and credit risk (A third factor is the accrued interest).

If the credit rating drops, the bond price might drop. This is straightforward.

If interest rates go up, bond prices will go down. And vice versa. To illustrate this concept, let’s look at a simplified example.

Suppose the risk free interest rate is 4% and you have a 2-year bond with a face value of $100 that pays a 4% coupon every year. In this case, your yield is 4%.

Assume the risk free interest rate increases to 6%. Nobody will want to buy your bond at $100 as he can get a better yield leaving his money in the bank. However, if a person can get a yield of close to 6% by buying from you at a reduced price, he might do so.

This price will be about $96. His returns over two years are $4 + $4 + $100 and his cost is $96. That works out (this is not the exact calculation) to be about 6.07% pa.

On the other hand, if the risk free interest rates drops to 2%, people will be more than willing to buy your bond for $100 to get the 4% coupon and yield.

In this case, the price will probably move closer to around $104. His returns over two years are $108 and his cost is $104. This works out to be about 1.9% pa.

For bonds, you can really get into trouble if interest rates spikes up. Imagine if the risk free rate is 20% pa. Your money will be stuck inside earning low yields with no possibility of liquidating it as the market value for the bond would be very low.

That more or less explains how the price of preference shares will be quoted on the secondary market. Very much like a bond price and not much to do with the price of the mother share (As there is no term to maturity, the calculation is slightly different from my earlier example). However, if the mother share collapses due to credit issues, the preference share price will be adversely affected.

This is also one additional thing. Because the preference shares can be redeemed at the option of OCBC after five years and on the occurence of certain events, it puts an artificial cap on the price it can attain. No one will want to pay too high a price for it since there is always a risk that it has to be sold back to OCBC at the face value.

That brings us to the last point. The redemption price.

If OCBC decides to redeem the preference shares (there are a few scenarios given in the prospectus that they can do so), they will have to pay the face value ($100) and any accrued dividends. The latter simply means the prorated amount of dividends owed to you. The market price it is trading at that time is irrelevant.

In the event of a liquidation and winding up of OCBC, bond holders get first priority, followed by owners of preference shares and then ordinary shareholders. If the liquidation assets are not sufficient to cover the obligations of the bonds and preference shares, you will get back less than the face value of your preference shares.