This blog post examines what the CDS premium on government bonds signifies and why it is used as a key indicator for gauging national economic stability.
The CDS premium on bonds issued by national governments overseas is one of the economic indicators we frequently encounter in the media. To understand this indicator, we need to examine the concepts of a bond’s ‘credit risk’ and ‘credit default swap (CDS)’.
Bonds are issued by governments or corporations to raise funds, and their price is determined in the bond market where they are traded. The bond issuer promises to pay investors a fixed interest and principal on a specified date. Investors who purchase the bond can resell it or earn profits by receiving the interest. However, bond investment carries credit risk—the possibility that interest and principal payments may not be made due to reasons such as the issuer’s inability to pay. Accordingly, countries have introduced credit rating systems to assess bond credit risk and disclose it through credit ratings, thereby protecting investors.
For example, under Korea’s credit rating system, bonds promising interest and principal payments in Korean won are assigned the highest credit rating of AAA if the issuer’s payment capacity is rated as the highest grade. Bonds that default, meaning principal and interest are not paid, receive the lowest credit rating, D. Other bonds are rated in descending order of increasing credit risk within categories such as AA, A, BBB, and BB. Within each rating category, bonds may be further subdivided into three sub-grades based on the relative magnitude of credit risk, sometimes indicated by adding ‘-’ or ‘+’. A bond’s credit rating can be adjusted based on changes in its credit risk. If credit risk increases while other conditions remain constant, the bond’s price falls in the bond market.
Trading in the bond market is not solely aimed at earning interest income. Investors utilize bonds as part of their asset allocation strategy, seeking to enhance portfolio stability. Bond price fluctuations are influenced by various factors, including market interest rates, economic indicators, and changes in credit ratings. Specifically, when a bond’s credit rating declines, its yield tends to increase while its price tends to decrease. This occurs because investors demand higher returns to compensate for assuming greater risk.
CDS is a derivative financial instrument used by bond investors to hedge against credit risk. CDS transactions occur between a ‘protection buyer’ and a ‘protection seller’. Here, ‘protection’ refers to safeguarding against credit risk. The protection seller compensates the protection buyer for losses incurred if the bonds held by the protection buyer default. Through CDS transactions, the credit risk of the bonds is transferred from the protection buyer to the protection seller. The asset subject to this transfer of credit risk in a CDS transaction is called the ‘underlying asset’. For example, Bank A, while purchasing bonds issued by Company B, may enter into a CDS contract with Insurance Company C to avoid the credit risk of those bonds. In this case, the underlying asset is the bond issued by Company B.
The protection seller receives a type of insurance premium from the protection buyer as compensation for bearing the credit risk of the underlying asset; the rate of this premium is the CDS premium. The CDS premium is influenced by various factors, such as the credit risk of the underlying asset and the creditworthiness of the protection seller. All other factors being equal, a higher credit risk of the underlying asset leads to a higher CDS premium. Conversely, the stronger the creditworthiness of the protection seller, the more confident the protection buyer is that losses will be covered in the event of default, making them willing to pay a higher CDS premium. If the protection seller has issued bonds, their credit rating can be used to assess the seller’s payment capacity. Accordingly, all other factors being equal, a higher credit rating on bonds issued by the protection seller results in a larger CDS premium.
The CDS premium on government bonds is a crucial indicator reflecting the overall credit risk of the economy, allowing investors to assess the economic stability of the country. A rise in the CDS premium indicates increased credit risk for that country, while a decline suggests reduced credit risk. For this reason, the CDS premium serves as a crucial reference indicator for financial market participants.
Finally, the bond market and the CDS market are interrelated, meaning fluctuations in one market can affect the other. For example, if a country’s economic conditions deteriorate, causing bond prices to fall, the country’s CDS premium may rise. This occurs because investors purchase more CDS contracts to hedge against the credit risk of the bonds. Conversely, if economic conditions improve, bond prices may rise and the CDS premium may fall. This interaction plays a crucial role in enabling investors to comprehensively analyze market conditions and make investment decisions.
