Impact of credit default swaps

The recent introduction of credit default swaps (CDS) is widely expected to have a positive impact on the growth and development of the Indian bond market by providing a risk management tool to investors.

By providing bond buyers with protection against credit deterioration and credit losses on their investments, CDS is also expected to increase investments in higher yield bonds and provide investors with access to additional investment avenues. At present, users can purchase CDS only for hedging their existing investments in corporate bonds and not for trading purposes.

MITIGATE RISK

While the ability to mitigate credit risk using CDS is undoubted, the impact that positions in CDS will have on the financial results of the CDS users is not widely known. In general, an exposure to CDS is expected to increase profit or loss volatility and have an adverse impact on the financial results of investors. We need to have an understanding of the accounting principles that will apply to the underlying investment in the bond and the related CDS exposure to analyse their impact on results.

A CDS is a credit derivative instrument since its value changes in response to the changes in the credit quality of the underlying corporate bond.

The currently notified Indian accounting standards do not provide any guidance on accounting for derivatives (other than forward exchange contracts).

However, an ICAI notification in 2008 provides two accounting policy choices, i.e. (a) recognise unrealised mark to market losses on derivative contracts based on a principle of prudence or (b) apply the principles of Accounting Standard 30 (AS 30 is a yet to be notified accounting standard on financial instruments) to recognise all unrealised mark to market gains and losses unless hedge accounting principles can be applied to certain qualifying derivative contracts.

If an investor selects an accounting policy based on (a) above, to recognise only unrealised losses on its CDS contracts, there will be an adverse impact on earnings when there is an improvement in the credit quality of the underlying bond.

The CDS value will generally reduce when the credit quality of the underlying bond improves. Although there will be a corresponding increase in the value of the bond over its cost, the investor will not be able to recognise this unrealised gain in its profit or loss account. Hence, the overall impact on financial results will be negative in this scenario.

UNREALISED GAINS

Conversely, when there is deterioration in the credit quality of the underlying bond, the CDS value will generally increase, but this gain will not be recognised in the profit or loss account. The investor may however be required to recognise the losses on the bond, resulting in an overall reduction in earnings.

The other alternative in (b) above, is for an investor to recognise all unrealised fair value gains and losses on the CDS based on the principles of AS 30. This will allow the investor to recognise unrealised gains due to an increase in the CDS value when the underlying bond prices decline. Hence, an unrealised loss on the underlying investment may be offset to the extent of an increase in the value of the CDS.

The change in the value of the CDS may not be equal to the change in the value of the bond since the bond value is affected by overall changes in the spread (including consideration of illiquidity, etc.) whereas the CDS value will be affected by changes in the bond's credit quality as well as the credit risk of the CDS counterparty.

However, when bond prices increase above cost, the unrealised gain on the investment cannot be recognised in the profit or loss account, whereas the unrealised loss on the CDS will have to be taken to earnings.

The hedge accounting principles in AS 30 referred to above, will permit recognition of unrealised fair value gains and losses in the bond (due to changes in credit risk only) in the profit or loss account, to match the impact arising from changes in the value of the CDS. However, these principles can be applied only if certain stringent criteria are met to demonstrate the high degree of offset in fair value between CDS and the underlying bond. It is unlikely that this high degree of offset or effectiveness can be demonstrated since the change in the bond value due to changes in credit risk only is difficult to isolate and quantify.

Further, the current accounting guidance on investments does not permit recognition of unrealised gains on investments, even if they are in an economic hedging relationship. In addition, the value of the CDS does not always mirror the value changes in the underlying bond due to different triggers relating to the payment of the CDS versus diminution in the value of the bond. An investor that transacts in CDS for mitigating the credit risk on its corporate bond investments may experience an increase in volatility and an overall adverse impact on earnings as a result of its exposure to CDS.