Credit Default Swaps: Is Your Fund at Risk?

By Lewis Braham

Complex financial instruments called credit default swaps have roiled the financial markets for months. They're at the heart of the bond insurers' woes and were a reason why insurance giant AIG (AIG) just added billions to a planned writedown. But if you think exposure to these derivative securities is limited only to insurers and investment banks, take a good look at your seemingly bland, conservative bond fund.

Start with the world's largest, Bill Gross's $120 billion Pimco Total Return fund. Gross railed against credit default swaps (CDS) in his January investor newsletter, calling them securitized weapons of mass destruction. But the latest holdings for his bond fund, as of Sept. 30, show more than 300 CDS positions, some as large as $200 million.

Gross is hardly alone in dabbling in the swaps, which allow managers to get a bump up in yield as well as hedge their bond positions. Of the 30 largest bond funds, 12 have exposure to credit default swaps, including Oppenheimer Strategic Income, T. Rowe Price New Income, Western Asset Core Plus Bond, Vanguard Short-Term Investment-Grade, and four Pimco funds. Unlike some of the troubled CDS of late, the swaps in these mutual funds aren't necessarily related to subprime mortgages.

Just what are these things? And given the disruption they have caused in the financial markets, should you be worried if they're in your fund? The risks are hard to measure, but it's important to keep perspective: Those 300-plus swaps in Gross's fund represent 4%, or $4.8 billion, of the fund's $120 billion in assets. Gross says his "is the safest fund around."

On the surface, a credit default swap isn't so complicated. A buyer and a seller with differing views on whether a company's credit rating will get better or worse place bets with each other in a private contract. For the buyer, the contract acts as an insurance policy against a company defaulting on its bonds. For the seller, the swap delivers a payment stream over a certain time for providing that protection.

Consider a swap in the $14.6 billion Western Asset Core Plus Bond Fund. The fund has a contract with Credit Suisse First Boston to insure $9 million of Eastman Kodak (EK) bonds. If Kodak goes bankrupt, Western Asset will be on the hook for some or all of the $9 million in losses, which it will pay to Credit Suisse. In return for such insurance, Credit Suisse pays Western 1.4% per quarter on the $9 million. Neither side has to actually own the bond, so pretty much any financial player can place a bet on Kodak's credit quality. All of those bets help explain why the credit default swap market tops $43 trillion, larger than the entire bond market.

Many fund managers see swaps as a way to create a sort of synthetic bond that yields more than the bond the CDS protects. In one basic form, they marry a Treasury bond with the swap. The result is a higher yield than funds could get on a Treasury, or even by holding the corporate bond that the swap transaction insures. Some managers, such as Bob Auwaerter of the $19.8 billion Vanguard Short-Term Investment Grade Bond Fund, which has a 1.5% CDS position, are very conservative and cover their credit default swap positions with liquid, highly rated collateral. Gross says his own fund's swap positions are fully backed by cash.

The problem is that, in many instances, you can't tell how much of a swap position is covered by liquid assets such as Treasury bonds or cash. The amount of highly liquid collateral, in more cases than not, only needs to be the difference between the bond's par value and where it currently trades. So if a bond has a par value of $100 and trades at $90, the fund would need to set aside $10 in collateral to sell CDS insurance on the whole $100. Fund managers like this because they have to set aside just $10 per bond in fund assets as collateral, but they get paid to insure the whole $100.