Why you should watch credit default swaps

For those not familiar, credit default swaps have become a behemoth in the
derivatives industry. The International Swaps and Derivatives Association
estimated the CDS market was worth over $8 trillion in 2004, and had doubled in
each of the past three years.

If an investor in a bond is worried that the underlying issuer might default,
the investor can try to buy a CDS for that issuer, for which he would pay
periodic payments to a seller. The seller of the CDS would take on the default
risk for the bond, and would have to pay out to the buyer in the event the
issuer actually defaulted on their bond payments.

The investor gets to offset the default risk of their bonds, the seller gets a
steady stream of income from the buyer, and the issuers get a deeper, more
liquid market. The CDS market creates a win-win-win situation.

Until something goes wrong, that is.

This is a relatively new market, yet its growth has been phenomenal. Regulators
have become squeamish lately for several reasons, not the least of which is that
the market has not been tested in a crisis. What happens when a bunch of big
issuers default at the same time? The ripples will likely be felt throughout
equity and bond land.

One of the byproducts of such a rapidly-growing market is that companies try to
hitch a ride like barnacles, creating off-shoot products to serve other niches.
A little over a year ago, Dow Jones created several indexes which track the CDS
market, and it makes the value of those indexes available on several quote
platforms.

My favorite index is the one based on the high-yield CDS market. This one tracks
about 100 high-yield issuers, and the spread that the CDS derivatives are
trading over Treasury securities. When the spread is high, then we know that
investors are getting scared, and are willing to pay up for default insurance;
when the spread is low, then the market is reflecting relative calm – which may
not be a good thing.

In the chart below, we see a derivation of the index that compares the current
reading to that of others in the past few months, with extremes in the indicator
highlighted by arrows on the chart of the S&P 500.

We can see from the chart that when bond investors are too complacent, it has
spelled a rocky time for equities going forward. On the other hand, the two
times that this indicator suggested that bond investors were fearful, equities
rallied strongly afterwards.

Currently, the indicator has begun to reverse from an extremely complacent
reading, suggesting that bond investors had become overly confident of good
conditions, and are now re-thinking that outlook.