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Last week we saw Deutsche Bank plunge 15% as credit default swaps on the bank’s bonds surged to 5.10% premiums on unsecured bonds. Because credit default swaps are pure jargon, I will explain them as simply as I can.
A credit default swap is basically insurance for your bonds. They insure you in the case that the bonds can’t be paid back and default.
The way every form of insurance works is you pay a premium for that protection, and the higher the premiums the higher the risk that the event occurs. For instance if you are a bad driver with many insurance claims, your insurance premium will be higher.
In Deutsche Bank’s case the premium bond holders would pay would be 5.1% annually to get coverage. Meaning if you own a 5% 2025 Deutsche Bank bond and wanted your principal protected you would need would net -0.1% return until your bond either defaults or you remove the insurance.
Most of the time this product is used by portfolio managers to hedge investments (which they would use as a way to reduce risk), because the premium is small, other times they are the insurers to the bond holders (in which case they would be looking for extra return).
Like anything the premiums are supply and demand driven. If there are a lot of investors wanting coverage and only so many insurers willing to cover the premiums rise.
In this case there was panic that caused investors to want coverage, yet insurers saw risk and pulled back on insuring the bonds which signals a bad outlook for the bank.
We’ve gotten questions about buying some of these beaten up bank stocks, but our opinion has remained as wait and see. The reason we say that, is this modern banking crisis has proven the speed at which a bank run can occur and swings in volatility (whether in insurance or shares) can cause depositors to take to the web and wire money leaving the bank in the middle of a crisis within 2 days.
Things move slow until they don’t, there will likely be a better (and less risky) entry point in the future and we are keenly watching.
