Risk in bonds & loans

A bond holder takes on multiple levels of risk.  In the first place. there is the possibility that the amount you loaned the bond issuer, and the interest payments you expect, will never be paid back (i.e. credit risk).  Second is the possibility, explained in great detail in a previous post, that the interest rates will move in a direction that reduces the value of your bond (i.e. interest rate risk).  Furthermore, given that some bonds may be bought in a foreign currency, there is the risk that the foreign currency will lose value, bringing the value of your bond down with it (i.e. curency risk.)  Lastly, a bond or loan always leaves open the risk of having an unexpected interruption in how much money you are earning compared to how much you owe (i.e. funding risk).

Investors in bonds and loans therefore look for ways to mitigate each or all of these risks.  Two mechanisms of hedging this exposure to risk are interest rate swaps and credit default swaps.

Interest rate swaps

At its purest, an interest rate swap is exactly as it sounds: a trade of interest rates on two separate assets between two separate parties.

For example, let’s say Nina has a bank account with Homecrest Savings Bank that accrues a fixed rate of 2% interest each year on her unemployment benefits.  Meanwhile, Homecrest Savings has loaned money to Amos to fund the purchase of his Master’s degree at Touro College at some variable rate of interest that follows a standard bank rate, such as LIBOR, or the federal funds rate.

Since the interest Amos is paying to Homecrest Savings is variable, while the interest the bank pays Nina is fixed, there remains a risk of some kind of asset/liability mismatch, or other complications for the bank as a result of having different interest rates on the various activities.  It would be better for Homecrest Savings to have better matched interest rates on its assets and liabilities, so it can be sure that payments from Amos will sufficiently cover the obligations it has to Nina.

So the bank may decide to trade the variable interest it receives from Amos for a roughly equivalent stream of fixed rate payments coming from some other financial instituttion, let’s call it Midwood Pension Partners.  The two banks will swap interest rates, thereby creating a fixed-for-floating interest rate swap.  Thus Homecrest Savings is assured of being able to always cover payments to Nina, while Midwood Pension Partners takes on the risk, and thereby the opportunity, inherent in a variable rate interest loan.

In other words,Homecrest Savings has traded away its interest rate risk.  Now if Amos defaults on his loan, it is Midwood Pension Partners that suffers the loss.  Homecrest Savings is still assured its fixed stream of payments from Midwood Pension Partners.

Credit default swaps

The interest rate swap example above showed how a bank can isolate and remove the interest rate risk from the other risks of an asset, thereby leaving only the credit and funding risks.  A credit default swap goes one step further and allows a financial institution to also remove the funding aspect of an investment, thereby leaving only the credit risk.

Let’s say Daniel A has a 20 year $10,000 bond issued by the Iraqi Treasury back when Bush was President.  Daniel isn’t so confident anymore that the Iraqi Treasury will actually be able to pay back the interest and principal on that bond, given that Obama keeps talking about withdrawing troops.  In other words, Daniel sees a lot of credit risk there.

Amos is an opportunist, and thinks that either Obama will never truly commit on his promise to pull the troops, or that by the time he actually does, the Iraqi Treasury will be secure and the oil will flow.  So he’s willing to take on a little bet with Daniel: if Daniel pays him a fixed fee every quarter, he’ll insure Daniel against the potential default of the Iraqi Treasury on its bonds.  This is a credit default swap:  a fixed stream of payments in return for an insurance policy that covers the losses incurred if (and only if) the debt issuer defaults.

Ramon hears about this deal, and thinks that both his brothers are fools.  But he smells free money.  So, although he doesn’t actually hold any Iraqi Treasury bonds, he too agrees to pay Amos a fixed fee in return for insurance against the default of the Iraqi Treasury.  Ramon pays a small fee every quarter to Amos and if the Iraqi Treasury defaults on its bonds, he has the potential to win up to $10,000.  Ramon has no funding risk because he hasn’t ever bought an Iraqi bond, so he has almost nothing to lose.

In other words, the protection buyer of a credit default swap does not actually have to own or trade the underlying reference asset.  A totally  unrelated party will still get a full insurance payout if the bond issuer defaults. The protection seller must be pretty sure that the bond issuer will not default, or else they are on the hook for a lot of money in payouts.

Bond issuers, be they corporations or countries, have credit ratings, issued by independent organizations like Moodys and Standard & Poors.  These purportedly indicate the general creditworthiness, and therefore the credit risk, involved in any issuer’s bonds.  The price of a credit default swap depends highly on the rating of the issuer of the underlying bond.

There is an active secondary market for credit default swaps.  If the bond issuer’s credit rating becomes worse, the price of credit default swaps referenced to that issuer’s bonds will increase.  This is because the chance of that issuer defaulting, and therefore the chance of the holder of a credit default swap being the recipient of a huge insurance policy payout, goes up if the reference entity looks like it’s on the way down.

The more the issuer’s credit rating drops, the higher the price of a credit default swap on the secondary market.  And conversely, the more an issuer’s credit ratings increase, the lower the price of the credit default swaps referencing that issuer.

So with every successful suicide attack of Al Qaeda in Mesopotamia against the Iraqi government, the price of credit default swaps referencing Iraqi Treasury bonds go up in value.