Credit default swaps: Is your fund at risk?
Complex financial instruments called credit default swaps have roiled the financial markets for months. They’re at the heart of bond insurers’ woes and were a reason why insurance giant AIG just added billions to a planned writedown.
By TNN |
Complex financial instruments called credit default swaps have roiled the financial markets for months. They���re at the heart of bond insurers��� woes and were a reason why insurance giant AIG just added billions to a planned writedown. But if you think exposure to these derivative securities is limited only to insurers and investment banks, take a good look at your seemingly bland, conservative bond fund.
On the surface, a credit default swap isn���t so complicated. A buyer and a seller with differing views on whether a company���s credit rating will get better or worse place bets with each other in a private contract. For the buyer, the contract acts as an insurance policy against a company defaulting on its bonds. For the seller, the swap delivers a payment stream over a certain time for providing that protection.
Many fund managers see swaps as a way to create a sort of synthetic bond that yields more than the bond the CDS protects. In one basic form, they marry a treasury bond with the swap. The result is a higher yield than funds could get on a treasury, or even by holding the corporate bond that the swap transaction insures.
Some managers, such as Bob Auwaerter of the $19.8-billion Vanguard Short-Term Investment Grade Bond Fund, which has a 1.5% CDS position, are very conservative and cover their credit default swap positions with liquid, highly-rated collateral. Gross says his own fund���s swap positions are fully backed by cash.
The problem is that, in many instances, you can���t tell how much of a swap position is covered by liquid assets such as treasury bonds or cash. The amount of highly-liquid collateral only needs to be the difference between the bond���s par value and where it currently trades.
Shareholders looking for clarity on a fund���s derivative holdings won���t find it in fund reports. Better disclosure won���t help with one fundamental problem, the difficulty of valuing some swaps. If a fund had to sell its swap positions because of redemptions or a market crisis, it could be hard to know what they���d fetch in a potentially illiquid market. In many cases, funds apply what is called ���fair value��� to a swap���s price using complex algorithms.
Default swaps also mean judging the creditworthiness of the institution on the other side of the deal ��� counterparty. Still, it���s hard to find an institution whose capital hasn���t been affected by the credit crunch.
Gross says counterparty risk is ���part of my concern about credit default swaps in general.��� He argues that Pimco screens counterparties much as it does its corporate credits. ���If you selectively choose your counterparties, a credit default swap is tantamount to a regular corporate bond,��� he says. The fund currently has five counter-parties, he notes. Who are they? Gross wouldn���t name them.
On the surface, a credit default swap isn���t so complicated. A buyer and a seller with differing views on whether a company���s credit rating will get better or worse place bets with each other in a private contract. For the buyer, the contract acts as an insurance policy against a company defaulting on its bonds. For the seller, the swap delivers a payment stream over a certain time for providing that protection.
Many fund managers see swaps as a way to create a sort of synthetic bond that yields more than the bond the CDS protects. In one basic form, they marry a treasury bond with the swap. The result is a higher yield than funds could get on a treasury, or even by holding the corporate bond that the swap transaction insures.
Some managers, such as Bob Auwaerter of the $19.8-billion Vanguard Short-Term Investment Grade Bond Fund, which has a 1.5% CDS position, are very conservative and cover their credit default swap positions with liquid, highly-rated collateral. Gross says his own fund���s swap positions are fully backed by cash.
The problem is that, in many instances, you can���t tell how much of a swap position is covered by liquid assets such as treasury bonds or cash. The amount of highly-liquid collateral only needs to be the difference between the bond���s par value and where it currently trades.
Shareholders looking for clarity on a fund���s derivative holdings won���t find it in fund reports. Better disclosure won���t help with one fundamental problem, the difficulty of valuing some swaps. If a fund had to sell its swap positions because of redemptions or a market crisis, it could be hard to know what they���d fetch in a potentially illiquid market. In many cases, funds apply what is called ���fair value��� to a swap���s price using complex algorithms.
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Default swaps also mean judging the creditworthiness of the institution on the other side of the deal ��� counterparty. Still, it���s hard to find an institution whose capital hasn���t been affected by the credit crunch.
Gross says counterparty risk is ���part of my concern about credit default swaps in general.��� He argues that Pimco screens counterparties much as it does its corporate credits. ���If you selectively choose your counterparties, a credit default swap is tantamount to a regular corporate bond,��� he says. The fund currently has five counter-parties, he notes. Who are they? Gross wouldn���t name them.
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