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 CDS works?
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.