Pakistan’s 5-year Credit Default Swap
According to Bloomberg, the price of protecting Pakistan’s debt from default risk has increased recently. The country’s credit-default swaps rose 92 basis points in May, from a two-month low to the highest level in nearly three weeks at roughly 913 basis points. According to a statistics expert, this takes the contracts closer to the 1,068 contracts marked in April as the highest in a decade.
Bonds issued by Pakistan denominated in dollars continued to have higher yields. The fact that the Sukuk is set to maturity on December 5, 2022, indicated that the investors were concerned that the country would fail to meet its duty to repay credit holders $1 billion.
Example: How is the value of the bond determined?
Suppose bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds?
The value of the bond would be,
Suppose everything remains the same but the yield increased to 10% from 8.5%
How does CDS work?
Let’s say that Company X, the issuer of the bond, has a credit rating of BB, leading the bond buyer to believe that it would be wise to look for a credit default swap from Bank XYZ. The written agreement specifies that the bond buyer will give the bank 1% of the bond’s face value each year for the length of the bond’s existence. In exchange, the bank will provide bond payment default insurance for Company X.
The face value of the underlying security is referred to as a CDS’ notional value. The premium, which is paid by the purchaser of the CDS to the seller, is calculated as a percentage of the notional value of the contract, stated in basis points. The total dollar amount of outstanding credit default swaps is referred to as the gross notional value. The Bloomberg terminal can be used to obtain current and past CDS information.
Let’s look at what this Bloomberg report has to say regarding Pakistan’s financial future. In the following paragraphs, we will talk about the financial derivative known as Credit Default Swap (also known as CDS).
Credit Default Swaps (CDS): What Are They?
A financial derivative known as a credit default swap (CDS) enables an investor to exchange or offset their credit risk with that of another investment. The lender purchases a CDS from another investor who agrees to pay them back if the borrower defaults in order to swap the default risk.
Similar to the recurring premium payments required for an insurance policy, the majority of CDS contracts are maintained by an ongoing premium payment. The risk of a borrower failing on a loan is frequently offset or swapped by a lender using a CDS.
There are two parties involved in this transaction; the first is the party that first purchases the debt instrument (let’s say a bond), also known as the bondholder; the second is the party that sells the CDS (seller aka investor).
A CDS can be purchased by the debt buyer (the bondholder) to transfer the risk to another investor, who agrees to compensate them in the event that the debt issuer defaults on its obligations; however, since the probability of default by the debt issuer (in this case, Pakistan) has increased as a result, CDS investors have increased their premium.
On previous Tuesday, November 2022, the yield on the five-year third Pakistan International Sukuk Company Limited jumped by 75bps to 139.74 percent.
The yield on a 10-year Eurobond that would mature on April 15, 2024, increased from 89.58 percent to 92.93 percent. A 10-year Eurobond’s yield climbed to 59.07 percent from 57.63 percent, maturing on September 30, 2025.