Explainer-What are credit default swaps and why are they spooking AI investors?
Shares in companies driving the AI boom have been under pressure for weeks. Now their bonds are coming under strain too, pushing up the cost of insuring debt issued by companies such as Oracle, Nvidia and Apple against default.
Intelligence analysis by Llama
The surge in demand for AI-linked credit default swaps (CDS) reflects growing concern among investors about when the billions of dollars being poured into artificial intelligence will generate returns.
Imagine you lend money to a friend to buy a house, but they might not be able to pay you back. A credit default swap is like insurance that helps you protect your money in case your friend can't pay you back. It's like having a safety net to catch you if your friend defaults on the loan.
Analysis
What are Credit Default Swaps (CDS)?
A CDS is a derivative that provides protection against the risk that a bond issuer, such as a company or government, fails to meet its debt obligations. Bond investors expect to receive interest payments and repayment of principal when a bond matures, but they bear the risk that those payments may not be made. CDS help investors hedge that risk by effectively providing insurance against a default or other credit event.
Is this a big market?
The market for single-name CDS, which cover the bonds of a single issuer, is worth about $9 trillion, according to the International Swaps and Derivatives Association (ISDA). That is a small portion of global bond markets, which have more than $150 trillion of debt securities outstanding, according to the Bank for International Settlements. The biggest CDS market is for government debt. Saudi Arabia's CDS were the most actively traded in the second quarter, with average daily notional trading of about $500 million, according to Depositary Trust & Clearing Corporation (DTCC) data.
Who buys CDS?
Bond investors typically buy CDS through an intermediary, often an investment bank, which then finds a financial firm to issue an insurance policy on the bonds. These are "over-the-counter" deals that do not go through a central clearing house. Hedge funds also participate in the market, selling CDS to investors seeking to hedge exposure. The buyer pays a fee, called a premium, at regular intervals to the seller, which assumes the risk of a credit event.
Key points
- The market for single-name CDS is worth about $9 trillion.
- The biggest CDS market is for government debt.
- Saudi Arabia's CDS were the most actively traded in the second quarter.
- Bond investors typically buy CDS through an intermediary, often an investment bank.
- Hedge funds also participate in the market, selling CDS to investors seeking to hedge exposure.
If the AI boom continues to generate returns, the demand for credit default swaps may decrease, and the cost of insuring debt may decrease as well. This could lead to a more stable and predictable market for AI investments.
If the AI boom fails to generate returns, the demand for credit default swaps may increase, and the cost of insuring debt may increase as well. This could lead to a more volatile and unpredictable market for AI investments.
