The CDS premium on a government bond is the premium associated with the credit risk of the bond and is an important indicator for investors to assess the economic stability of a country. A rising CDS premium indicates an increase in credit risk, while a falling CDS premium indicates a decrease in credit risk, and is correlated with the bond market, which has a significant impact on economic conditions.
The CDS premium of bonds issued by the Korean government abroad is one of the economic indicators we often see in the media. To understand this indicator, we need to look at the concepts of ‘credit risk’ and ‘credit default swap’ (CDS).
Bonds are issued by governments or corporations to raise funds, and their price is determined by the bond market where they are bought and sold. The issuer of a bond promises to pay investors a certain amount of interest and principal on a set date. Investors who buy bonds earn a profit by selling them back or receiving interest. However, investing in bonds involves credit risk, which is the possibility that interest and principal payments will not be made due to the issuer’s insolvency. Therefore, countries have introduced credit rating systems to protect investors by evaluating the credit risk of bonds and publishing them as credit ratings.
In Korea’s credit rating system, the highest credit rating of AAA is given to bonds that promise to pay interest and principal in Korean won and the issuer has the best solvency. The lowest credit rating, D, is given to bonds that have defaulted on their principal and interest payments. Other bonds are rated in decreasing order of credit risk: AA, A, BBB, BB, and BB. Within each of these rating categories, each category may be further subdivided into three levels of credit quality by adding a “-” or “+” to the rating, depending on the relative magnitude of the credit risk. A bond’s credit rating may be adjusted in response to changes in credit risk. If the credit risk increases while other conditions remain constant, the price of the bond falls in the bond market.
Trading in the bond market isn’t just about earning interest. Investors utilize bonds as part of their asset allocation strategy, seeking to increase the stability of their portfolios. The price movements of bonds are influenced by a variety of factors, including market interest rates, economic indicators, and changes in credit ratings. In particular, when a bond’s credit rating is downgraded, its yield tends to increase but its price decreases. This is because investors have to take on more risk and therefore demand a higher return.
CDSs are derivative financial instruments utilized by bond investors to hedge against credit risk. CDS trades take place between a ‘guaranteed buyer’ and a ‘guaranteed seller’. The term “guarantee” refers to protection against credit risk. The seller of the guarantee, the buyer of the guarantee, is responsible for compensating the buyer for losses in the event of default on the bonds they hold. Through a CDS transaction, the credit risk of a bond is transferred from the guaranteed buyer to the guaranteed seller. The target asset against which the credit risk is transferred in a CDS transaction is called the ‘underlying asset’. For example, a bank may enter into a CDS contract with an insurance company to hedge its credit risk while buying a bond issued by a company. The underlying asset is the bond issued by the company.
The seller of the guarantee receives a kind of insurance premium from the buyer of the guarantee as compensation for bearing the credit risk of the underlying asset, which is the CDS premium. The CDS premium is affected by several factors, such as the credit risk of the underlying asset and the guaranteed seller’s ability to pay in the event of a contingency. Other factors being equal, the greater the credit risk of the underlying asset, the greater the CDS premium. On the other hand, the better the solvency of the guaranteed seller, the more the guaranteed buyer is willing to pay a larger CDS premium because it is more certain that its losses will be covered in the event of a contingency. If the guarantor has bonds issued by the guaranteed seller, its credit rating can be used to determine the guarantor’s solvency. Therefore, all other factors being equal, the higher the credit rating of the bond issued by the guarantor, the higher the CDS premium.
The CDS premium on government bonds is an important indicator of the credit risk of the economy as a whole, and investors can use it to assess the economic stability of a country. When the CDS premium rises, it indicates that the credit risk of the country has increased, and conversely, when the premium falls, it suggests that the credit risk has decreased. For this reason, the CDS premium is an important reference indicator for financial market participants.
Finally, the bond market and CDS market are interrelated, meaning that fluctuations in one can affect the other. For example, if a country’s economic situation worsens, causing bond prices to fall, the CDS premium for that country may rise. This is because investors buy more CDS to hedge against the credit risk of the bond. Conversely, if economic conditions improve, bond prices may rise and CDS premiums may fall. These interactions play an important role in helping investors analyze market conditions comprehensively and make investment decisions.
