MEASURING RISK WITH CDS
The Credit Default Swap or CDS has been gaining popularity and significance as a financial instrument since the 2008 crisis, not only as a protection against default but also as an indicator of risk perception for companies and countries. In this column, we will explain the logic behind its functioning in simple terms and then analyze its performance over the past five years for Brazil, Chile, Colombia, and Mexico.
WHAT IS A CREDIT DEFAULT SWAP?
A good starting point to explain how CDS work is recalling the main characteristics of their underlying assets, bonds. A bond is a debt instrument issued by companies or governments in which the issuer commits to pay periodic interest payments called coupons. In addition, upon the bond’s maturity, the issuer repays the principal amount borrowed. Investors can trade this type of securities in the secondary market, which typically exposes them to two types of risks: the market or interest rate risk, and the credit or default risk.
Chart 1. Own elaboration.
The Credit Default Swap or CDS is a financial instrument that hedges against the default risk linked to the bond issuer. As seen in chart 1, in a CDS, the parties agree that if a default takes place, the counterparty will purchase the bond, allowing the original bondholder to control their associate loss. On the other hand, the counterparty receives a periodic payment for each million covered, known as the CDS Spread. This spread represents the risk premium associated with the bond, replicating the functioning of an insurance.
As this premium daily changes due to the CDS market’s supply and demand forces, a follow-up allows us to observe the counterparties’ risk perception behavior regarding specific bonds and how expensive or cheap it is to hedge against their default risk.
HOW IS THE REGION PERCEIVED?
Charts 2 and 3 show Brazil, Chile, Colombia, and Mexico series to hedge bonds with a 10-year maturity for the last five years. These four countries were selected as they tend to be relevant destinations for foreign investment in the region, particularly regarding their public bonds market. For this reason, comparing them becomes pertinent to understand their respective levels of risk for investors, a factor that affects the demand for their securities and the costs of financing their fiscal deficit. The associate risk perception when choosing between public bonds derives from many elements related to the issuing governments, such as macroeconomic data, monetary policy decisions, and the domestic political climate, among others. That is, these are the fundamental guidelines that investors consider within this market.
In an overall review, both charts show that the region was strongly impacted in terms of risk perception during the 2020 pandemic. Except for Mexico, none of these countries has been able to go back to their 2018 or 2019 levels. It is worth mentioning that October 2 elections in Brazil were particularly polarized, and Lula da Silva’s victory completed a regional turn to the left. This, combined with an increasingly complex economic situation in China, and the 75 basis points hike by the US Federal Reserve, has resulted in an increase in the risk perception of the four countries, as can be seen in the peaks displayed in the charts by the end of 2022.
Chart 2. Own elaboration. Bloomberg data
Mexico and Brazil have had a calm start to 2023, with reductions in their CDS of 2.7% and 5.8%, respectively. This reflects that investors evaluate the political situations in these countries as more stable, along with decreasing inflation figures and a renewed global optimism facing the Chinese opening.
For Chile and Colombia, the chart shows how the associated risk perception has increased due to the political uncertainty stemming from protests and the Constituent process in the former and the first left-wing government in the latter. Chart 3 clearly shows that, even though the risk perception level has been increasing since 2021, it is from May 2022 – when the protests broke out against the Chilean president Gabriel Boric – when significant volatility starts to accompany this trend. This indicator reached a historic high of nearly 238 basis points in October following the rejection of the new Constitution and the increased uncertainty.
Chart 3. Own elaboration. Bloomberg data
For Colombia, the trend and volatility are similar to those seen in Chile. It started in May 2022 with the surprising first-round election that resulted in Gustavo Petro for the left and Rodolfo Hernandez for the right as the presidential candidates, leaving the traditional parties as the main losers, and culminated in June with Petro’s definitive victory and the establishment of the first government of this political orientation in the country’s history.
It is also worth noting that over the past five years, both countries have experienced a notable change in their CDS, with Colombia’s escalating from 182 to 392 basis points, representing a 115% boost, and Chile’s rising from 91 to 175 basis points, a 91% escalation. However, so far this year, their levels seem to be diverging due to higher uncertainty centered on the different structural reforms of Gustavo Petro’s government in Colombia, which has caused this indicator to increase by 9.3%. At the same time, Chile’s increasing rate has slowed to 1.8%. This leaves Colombia as the riskiest country of the group since August 2022, a position traditionally held by Brazil, which shows a shift in investors’ risk perception.
Finally, even though closely monitoring the CDS behavior favors a quick adaptation to the market conditions and provides an insight into investors’ perception of risk, we cannot overlook other factors that complement this view, such as the credit rating of issuers, either companies or governments, as they allow for a better understanding of the risk scenario.