How Do You Use Credit Default Swaps (CDS) To Create "Synthetic Debt"?

There's been a lot of talk in recent months about "synthetic debt". I just read a pretty good explanation of synthetics in Felix Salmon's column, so I thought I'd give a brief summary of what it is, how it's used, and why.

First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of similarities to an insurance policy on a bond (it's different in that the holder of the CDS needn't own the underlying bond or even suffer a loss if the bond goes into default).

The buyer (holder) of a CDS will make yearly payments (called the "premium"), which is stated in terms of basis points (a basis point is 1/100 of one percent of the notional amount of the underlying bond). The holder of the CDS gets paid if the bond underlying the CDS goes into default or if other stated events occur (like bankruptcy or a restructuring).

So, how do you use a CDS to create a synthetic bond? here's the example from Salmon's column:

Let's assume that IBM 5-year bonds were yielding 150 basis points over treasuries. In addition, Let' s assume an individual (or portfolio manager) wanted to get exposure to these bonds, but didn't think it was a feasible to buy the bonds in the open market (either there weren't any available, or the market was so thin that he's have to pay too high a bid-ask spread). Here's how he could use CDS to accomplish the same thing:

• First, buy $100,000 of 5-year treasuries and hold them as collateral
• Next, write a 5-year, $100,000 CDS contract
• he's receive the interest on the treasuries, and would get a 150 basis point annual premium on the CDS
  

So, what does he get from the Treasury plus writing the CDS? If there's no default, the coupons on the Treasury plus the CDS premium will give him the same yearly amount as he would have gotten if he's bought the 5-year IBM bond, And if the IBM bond goes into default, his portfolio value would be the value of the Treasury less what he would have to pay on the CDS (this amount would be the default losses on the IBM bond). So in either case (default or no default), his payoff from the portfolio would be the same payments as if he owned the IBM bond.

So why go through all this trouble? One reason might be that there's not enough liquidity in the market for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there might not be any bonds available in the maturity you want. The CDS market, on the other hand, is very flexible and extremely liquid.

One thing that's interesting about CDS is that (as I mentioned above), you don't have to hold the underlying asset to either buy or write a CDS. As a result, the notional value of CDS written on a particular security can be multiple times the actual amount of the security available.

I know of at least one hedge fund group that bought CDS as a way of betting against housing-sector stocks (particularly home builders). From what i know, they made a ton of money. But CDS can also be used to hedge default risk on securities you already hold in a portfolio.

To read Salmon's column, click here, and to read more about CDS, click here.