Explainer-What are credit default swaps and why are they spooking AI investors?
AI (Artificial Intelligence) letters and robot hand miniature in this illustration taken, June 23, 2023. REUTERS/Dado Ruvic/Illustration
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July 29 : Shares in companies driving the AI boom have been under pressure for weeks. Now their bonds are coming under strain too, pushing up the cost of insuring debt issued by companies such as Oracle, Nvidia and Apple against default.
The move reflects growing concern among investors about when the billions of dollars being poured into artificial intelligence will generate returns.
Technology companies have raised billions of dollars in debt this year to fund AI investments, with firms including Nvidia tapping bond markets for the first time. But the cost of the AI build-out is so high that even blockbuster earnings have failed to reassure some investors about the durability of future returns.
Demand for AI-linked credit default swaps (CDS), a form of insurance against default that gained prominence during the 2008 financial crisis, has surged.
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WHAT IS A CDS?
A CDS is a derivative that provides protection against the risk that a bond issuer, such as a company or government, fails to meet its debt obligations.
Bond investors expect to receive interest payments and repayment of principal when a bond matures, but they bear the risk that those payments may not be made.
CDS help investors hedge that risk by effectively providing insurance against a default or other credit event.
IS THIS A BIG MARKET?
The market for single-name CDS, which cover the bonds of a single issuer, is worth about $9 trillion, according to the International Swaps and Derivatives Association (ISDA).
That is a small portion of global bond markets, which have more than $150 trillion of debt securities outstanding, according to the Bank for International Settlements.
The biggest CDS market is for government debt. Saudi Arabia’s CDS were the most actively traded in the second quarter, with average daily notional trading of about $500 million, according to Depositary Trust & Clearing Corporation (DTCC) data.
Average daily CDS trading across the market was $16 billion in the second quarter, up from $13 billion a year earlier.
Banks dominate the corporate CDS market, but technology companies are gaining ground. Trading linked to the sector reached nearly $650 million in the second quarter, up 20 per cent from the first quarter and almost 600 per cent from a year earlier, helped by new entrants such as Meta, Nvidia and Alphabet, DTCC data shows.
But CDS trading can be relatively thin. Average daily trades, even for large companies, can sometimes be in the single digits, meaning small transactions can have an outsized impact on prices.
WHO BUYS CDS?
Bond investors typically buy CDS through an intermediary, often an investment bank, which then finds a financial firm to issue an insurance policy on the bonds. These are “over-the-counter” deals that do not go through a central clearing house.
Hedge funds also participate in the market, selling CDS to investors seeking to hedge exposure.
The buyer pays a fee, called a premium, at regular intervals to the seller, which assumes the risk of a credit event.
CDS are quoted as a credit spread, which is the number of basis points (bps) that the seller of the derivative charges the buyer for providing protection. The higher the perceived risk of a credit event, the wider the spread.
A CDS quoted at 100 bps costs $1 annually to insure every $100 of debt.
Oracle CDS trade around 200 bps, according to S&P Global Market Intelligence data, well above those of other AI-linked companies. Nvidia CDS have also risen sharply this week, but trade below Oracle at around 78 bps. Meta trades near 93 bps.
By comparison, an index of investment-grade CDS is trading around 53 bps.
WHAT TRIGGERS A CDS PAYOUT?
A CDS pays out following a credit event, which can include a bankruptcy or a failure by an issuer to make bond payments.
When concerns about an issuer’s creditworthiness increase, demand for protection typically rises, widening CDS spreads.
IF IT’S INSURANCE, WHAT’S THE PROBLEM?
CDS provide a hedge for bondholders. But rising perceived risk pushes up the cost of protection, which can prompt investors to sell bonds and raise borrowing costs for issuers.
That can amplify concerns about creditworthiness and potentially create a self-reinforcing cycle.
Source: Reuters
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