Understanding Risk in Corporate Bonds and Credit Default Swaps

Introduction

When investors purchase a corporate bond and a credit default swap (CDS) on it, there is often a question about the overall risk profile of the investment. This article will explore whether such a dual position truly eliminates risk and discuss the various types of risk involved in these transactions.

The Complex Nature of Risk Management

The answer to the question is not a simple "yes" or "no." While the investor has exchanged one form of credit risk for another, there are still several factors and considerations that impact the overall risk profile.

Credit Risk

By purchasing a CDS on a corporate bond, the investor has effectively shifted the credit risk from the issuer to the CDS counterparty. However, there is still some risk involved:

The CDS counterparty might default before the issuer does, causing a partial loss.

The investor takes on the risk of dual credit deterioration. If both the bond issuer and counterparty experience a sudden decline in credit quality, the investor might face a loss.

Even with good margin terms, the investor remains exposed to the risk of the counterparty defaulting without a timely termination of the swap.

Liquidity Risk

Investors should also be aware of the liquidity risks associated with these positions. These include:

When the credit of the issuer improves, the investor may have to sell the bond and terminate the CDS, leading to potentially poor pricing.

The investor may be forced to sell their bond at a disadvantageous price, especially if it is a small, illiquid issue and there is high demand for selling.

The investor may not receive a fair price when terminating the CDS due to market conditions, especially if they are trying to sell at an inopportune time.

Interest Rate Risk

In addition to the credit and liquidity risks, investors must also consider the interest rate risk associated with the corporate bond. If interest rates rise, the bond's price will fall, even if the investor holds it to maturity. This risk is separate from the credit risk and must be managed accordingly.

Basis Risk

Another important consideration is the basis risk, which refers to the potential mismatch between the price movements of the bond and those of the CDS. This risk is present even if the bond and CDS have the same maturity, and it requires careful monitoring and management.

Conclusion

While purchasing a corporate bond and a CDS on it does not completely eliminate risk, it does significantly reduce the credit risk associated with the bond. However, investors must be aware of the remaining risks, including interest rate risk, basis risk, and liquidity risk. Adequate risk management strategies are crucial to ensure that the overall risk profile of the investment remains acceptable.