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How Pension Funds Exploit Credit Default Swaps

Credit Default Swaps give pension funds easy exposure to credit markets, while offering attractive returns.

Credit Default Swaps have received their share of blame for the financial crisis. American International Group’s CDS business not only brought down the insurer but also nearly toppled the financial system. Even George Soros has pronounced CDSs “particularly suspect.”

Credit Default SwapsWhy, then, would pension funds consider venturing into the treacherous world of the CDS? The answer is simple: These swaps allow investors to hedge risk and gain easy exposure to credit markets, while offering attractive returns.

“Every portfolio manager has the obligation to minimize risk and maximize returns, and CDSs can be part of a program to accomplish this, if properly used,” says Viva Hammer, who was responsible for tax regulations governing CDSs while with the U.S. Treasury Department’s Office of Tax Policy. Following the collapse of Lehman Brothers Holdings, she points out, the CDS market behaved in an orderly fashion. “The cause of the crisis wasn’t derivatives; the cause was fraud and misbehavior in the underlying markets,” she argues.

What exactly is a CDS? Like any swap, it involves an exchange of cash flows. Payers buy insurance on their credit holdings (typically bonds); sellers receive a series of payments similar to insurance premiums or bond coupon payments and promise to make good if the bonds default. The parties do not exchange the full cost of an asset up front, as they would with a bond, but merely the difference in cash flows. Thus, a CDS investor can buy a lot of exposure for little money down, making a CDS a highly leveraged — and hardly risk-free — investment.

“A CDS sounds more difficult than it really is,” says Marko Komarynsky, a senior investment consultant in the Chicago office of pension services provider Towers Watson. “The complexity is really in evaluating the risks.” For example, can the seller deliver on the default protection? Are the payments, or premiums, received truly worth the risk?

Given the history of CDSs, it’s not surprising that they spook pension funds. Nevertheless, says Komarynsky, investors grow less wary once they learn what CDSs can do. Take hedging. Suppose a pension fund has heavy exposure to Greek government bonds. CDSs can mitigate the risk of a sovereign default. They also can insure against the hazard of spreads widening when credit quality deteriorates and bond prices fall. “Pension funds are used to hedging against interest rate risk [through swaps], but now everyone is more sensitive to spread exposure,” Komarynsky explains.

CDSs also allow fairly cheap and easy exposure to credit markets. Imagine an investor who believes that high-yield bonds are poised for a comeback — that spreads will narrow and prices rise. Rather than taking the time and trouble to assemble a bond portfolio, “one of the most efficient plays” is to buy a CDS index, Komarynsky says. Financial services firm Markit offers several CDS indexes.

Investors need to understand, however, that when they buy a CDS index, they are buying a “spread” rather than a “price,” as is the case with an equity index. As the risk of default increases (think Greece), the spread widens. The terminology can get a bit confusing: The “buyer” seeks credit exposure to the index but is actually selling protection. The “seller” of the index pays a premium to the buyer. That is, the buyer is paid for assuming the risk. But if there is a default, the tables are turned and the buyer has to pay the seller.

“For pension funds interested in CDSs, indexes provide a moderate profile in risk and return,” says Darrell Duffie, president of the American Finance Association. But he warns that investors must grasp how derivatives work. Most funds invest in CDS indexes through specialized managers. Tax quirks also pose complications. Yet, as Hammer says, “if you restrict or forbid pension funds from the CDS market” — as some legislators would do — “you would be excluding them from an important market and potentially increasing their risks and decreasing their returns.”

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