3: CDS Swap of Two Floating Bonds

Mini Chapter Three

CDS is a swap of two floating rate bonds

CDS cash flows work like fixed coupon interest rate swaps i.e. the payments made by the CDS buyer to the seller in practice are valued at a fixed coupon of 1% for investment-grade debt and 5% for high-yield debt. You can further break down the cash flows (assuming Investment Grade debt) as an exchange of two floating rate bonds. One, a Credit linked Floating Rate Note (CLN), (bearing a coupon of risk free floating rate + credit spread of 1%) sold by the protection buyer at a premium or discount to par depending on the reference obligation’s yield and the other sold by the protection seller (to the buyer) bearing just a risk free floating rate (zero credit spread) coupon. In other words, an exchange of a risky floating rate bond with a risk-free floating rate bond.

• At the start of the swap, the protection seller would pay the buyer the present value of the purchased CLN obtained by discounting it by its YTM (reference obligation’s yield). The Protection seller in turn would sell a risk-free floating rate bond which would be purchased by the buyer at par (cash flows discounted at the risk-free floating rate always). Net, the counterparties exchange the premium/discount of the CLN upfront (at the start of the swap) as par values on the respective bonds cancel out (discount paid to the protection seller if CDS spread >1% or premium received from the seller if CDS spread < 1%).

• During the tenor of the swap the protection buyer pays a coupon of floating rate + 1% while the Protection seller pays Floating rate. Effectively the protection buyer is paying only the net cash flow of 1% annualised.

• In case of a default of the underlying reference entity/obligation (as defined by the CDS contract) the protection buyer would only need to pay back the recovery value of the CLN in return for par value that the seller would pay back on the risk-free floating bond. Net, amounting to the protection buyer receiving par minus recovery value in case of a default.

• For instance, the price of 5 year CDS trading at 50bps would be equivalent to a 5y CLN bearing a coupon of SOFR + 1% sold by the protection buyer (with the CLN’s credit linked to the underlying reference entity) at a YTM equal to SOFR + 50bps to the seller. For the sake of simplicity (ignoring discounting effects) the protection seller would pay 2.5% upfront against receiving 1% per annum from the protection buyer.

• Valuing the CDS prices and cash flows in the above manner tries to mimic exactly how floating rate bonds of the reference issuer/ obligor would trade based on the current market.

Connecting the Dots. Extending the risky and risk-less floating rate bonds analogy you can now tie up the economics of an asset swap trade and that of a CDS. Going long a credit by selling its CDS in principle should yield similar to (it isn’t exactly the same as discussed in cash-bond basis below) putting on an asset-swap or a total return swap trade. The TRS or an asset swap buyer is going long a floating rate risky bond and being short a floating rate risk-free bond (akin to paying funding cost) net yielding the credit-linked return on the underlying bond.