Corporate Bonds and Credit Default Swaps
Credit risk, the risk that the promised cash flows from an asset will not be paid as promised, is a primary risk when investing in corporate bonds. Say that a corporation sells $100 million principal amount of a bond issue, contracting with bondholders to make coupon payments of 7.50% for 10 years and then to return the $100 million principal amount. There is a risk that the corporation will experience financial difficulties before the bonds mature and default on its contractual agreements. The result might be a reorganization or liquidation in which bondholders not only fail to receive the promised 7.50% interest payments but also fail to recover the full $100 million principal amount.
Because corporate bonds are characterized by credit risk, investors demand a higher promised return on corporate bonds than on safer forms of investments, like U.S. Treasury bonds. While the corporation in the previous paragraph was selling its 7.50% 10-year bonds, the U.S. Treasury might have been selling 10-year bonds at 3.50%. Part of the higher return paid by corporations compensates investors for the expected losses due to default and part is a risk premium for bearing default risk.
Since the late 1990s, corporate credit risk has traded not only through corporate debt, but also through derivative contracts known as Credit Default Swaps or CDS. The exposure to corporate default through CDS is in many ways similar to a cash or direct exposure ...