Frequently Asked Questions
It is assumed that input/output data represent a senior bond and the 5 year CDS value/estimate of an issuer. Consult our FAQ for a more advanced use of Bond Calc.
1. What is a CDS and why it may represent an indication of an issuer default possibility?
A credit default swap (CDS) is a financial contract that offers protection against a bond going into default. In other words, it may be considered an “insurance” against the default of a bond’s issuer – although, in technical terms, CDS contracts differ from an insurance policy for several reasons.
Most CDSs are written using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), are issued in the $10–$20 million range, with maturities between one and 10 years (with 5 years being the most common), and are not available to private investors.
For the purpose of this application (help investors evaluate the risk associated with some issuers), we will consider the CDS value of a company as a key indicator of the market perceived risk of the issuer, at a certain time:
>>Since the CDS is a “bet” on the institution’s strength (or weakness), its price reflects the probability that the LFI [large financial institutions] debt will not be repaid. Such CDSs, in essence, indicate the risk that a large financial institution will fail.
To regulate finance, try the market – By Oliver Hart and Luigi Zingales
2. How can I calculate the fair pricing (expected market price) of the BTP 4% , maturity date February 1st 2037, a bond issued by the Italian Republic that now has a CDS value of 300 points?
After selecting the first calculator (Fair Price from CDS Value), you are requested the following information:
Coupon rate (annualized) = 4%
Maturity date = February 1st 2037
CDS value = 300
You may now also select the advanced fields to add:
Coupon frequency = semiannualy
Face Value = 100
Yield curve = ECB 3A gov (as the most similar to the German Bund)
You may now select the “Calculate” field, at the top right
Results depends on the time of the selection, however, as an example, you could get a clean price of 76.12 (the expected market price), with a dirty price (including accrued interests since last coupon date) of 76.44.
YTM (Yield to Maturity), assuming the issuer is capable of repaying the bond at maturity in full, would be around 5.94%.
3. How can I estimate the CDS value for an issuer?
We will run two different examples to show how to estimate the CDS Spread for an issuer.
After selecting the second calculator (CDS Estimate from Market Price), you are requested the following information:
Coupon rate (annualized ) % = 5.625 (GE bond)
Maturity Date = 15 September 2017
Clean Price 115.14
You may now also select the advanced fields to add:
Coupon frequency = semiannualy
Face Value = 100
Yield curve = US Treasury
You may now select the “Calculate” field, at the top right.
You will get a CDS estimate of 154 (example as of April 11, 2012). The previous day Bloomberg was advertising a CDS value around 160 for this issuer – small differences are possible, for several reasons, including the fact that the calculation is made on a specific bond price at a certain time of trading, while the CDS values that are usually known to investors (especially for non sovereign issuers) are averages calculated over the whole trading day. We should also consider that a few points represent a very low difference, in percentage, on the expected issuer default risk over a 5 year period. Using several bonds (from the same issuer) with different maturity and making an average of the result can also help getting a more accurate number.
Sovereign issuer – Italy
An interesting aspect of sovereign issuers is that CDS values are relatively easier to find even for the average investor, as the sovereign debt crisis underlined the importance of CDSs as risks indicators for European issuers.
Let’s run the same exercise for an Italian bond.
After selecting the second calculator (CDS estimate from Market Price), you are requested the following information:
Coupon rate (annualized ) = 4.75% (BTP)
Maturity Date = 01 May 2017
Clean Price 100.4
You may now also select the advanced fields to add:
Coupon frequency = semiannualy
Face Value = 100
Yield curve = ECB 3A Gov
You may now select the “Calculate” field, at the top right.
On April 11, 2012, you would get an estimated CDS of about 371. Here is what was advertised by two providers of that information, in the same time frame:
It should also be underlined that these numbers refer to a 10 year CDS value, which is slightly different form the 5 year CDS value.
4. Can the bond calculator also be used in connection with bonds linked to an index + spread?
Yes, you can still use this application, but you will need to convert the coupon into a fixed value – i.e., in case of a bond paying quarterly interests linked to the LIBOR (1 month) index plus a spread of 5.25%, you will need to consider the current coupon as 5.51%.
As the LIBOR is variable, the estimate will be closer to actual results for bonds with a relatively close maturity date, and less accurate for bonds with a long maturity date.
5. When should I use the US Treasury or the ECB 3A Gov Yield curve?
We suggest to use the US Treasury Yield curve in connection with $-denominated issuers and bonds, and the ECB 3A Yield curve for €-denominated issuers and bonds.
6. Can Bond Calc be used in connection with convertible bonds?
No. For their own nature, convertible bonds incorporate a value which can not allow them to be treated as normal bonds.
7. I am primarily investing in common/preferred shares of a company, is this calculator of any help?
Yes, indirectly. By looking at the price of the company’s senior bonds, you may calculate the estimated (implied) default expectations for the company, which is an interesting datum when evaluating an investment in common shares.
Corporate bond pricing, along with other indicators like stock-option pricing, etc. also seem to be indicative of where equity prices are going. The sum of all these information (default risk, momentum, management incentives) may represent additional diligence useful in your stock picking.
8. The process of estimating the issuer default rates implied by the current spread of a bond is a bit opaque, can you shed some light?
Our bond calculator has the ambition to draw investors attention to the risks involved in choosing bonds trading at distressed pricing – as they are often underestimated.
It is in our nature of human beings that relatively simple indications are more effective in our decision making than very complicated calculations – and obviously more useful than no data at all.
The round number we estimate for an issuer CDS may be “translated” in a risk neutral probability that the company/country will default, assuming a 40% recovery rate.
This number (say 10% possibility over 5 years, each year) is certainly easier to understand than a CDS Spread number, and more useful in our decision making.
However, risk neutral probabilities are not real probabilities. If we assumed different recovery rates, we would get different indications – in the example quoted, for a 20% to 60% recovery rate, the default probability would be in the 7.7% to 15.5% range (there are less possibilities of a default with very low recovery rates and higher possibilities for a default with higher recovery rates).
40% recovery rate is an average assumption accepted by most financial firms, and puts a decent floor on the investment (loss).
We believe that while the indication of a (potential) issuer default probability over 5 years, expressed by a single number, may be technically criticized, it remains of value for the average investor when evaluating a position in a company’s security.
9. I obtained a negative number for CDS and YTM - how is it possible?
It is possible that, by mistake, an unrealistic price (too high) for the bond was inserted. Combined with the proper data relative to maturity date and coupon, you might get an output number which is not correct.
10. Is it possible to convert a CDS value into a relatively simple-to-understand default rate possibility for the issuer?
It is, but it is also necessary to explain that there are several assumptions built into such a conversion.
A CDS value gives investors a rough number that needs, at least, to be correlated with the same datum from other issuers to gain some meaning (Greece is much riskier than Spain or Italy), and still leaves an unanswered question: what does it mean in terms of real default possibility?
As we mentioned, an issuer CDS may be “translated” in a risk neutral probability that the company/country will default, assuming a certain recovery rate.
This number (say 10% possibility over the next 5 years, each year) is certainly easier to understand than a CDS number alone, and more useful in our decision making – however, risk neutral probabilities are not real probabilities, and there may be false signals, such as very high expectations of default that never materialize, which can also be translated as “successful turnaround stories”.
Real-world default possibilities are usually less than CDS calculated default probabilities, as bond prices incorporate an extra return to compensate for the risks investors are bearing. The purpose of this application is mainly to highlight to investors the potential risks associated with investing in securities with a high YTM, through a relatively easy-to-understand metric.
Deutsche Bank is running an interesting exercise of translating sovereign issuers CDS values into real world numbers (default expectations).
You may relate to this study for further technical explanations of how this information is obtained.
Annual probability of default from 5 Year CDS values for the major countries are available at this link – it is interesting to note that even “safe” countries like USA and Germany have a default percentage around 1% over a 5 year period (0.5% and 1.1% respectively, as we write). There’s no “risk free” asset in the world, using CDSs as an indicator.
Using the same recovery rate (40%) as Deutsche Bank, and for information purposes only, here is a quick “back on the envelope” calculation of how CDSs may translate into default possibilities, over a 5 year period (please note that Deutsche Bank uses CDS Spread to mean the value of the CDS):
A similar exercise may be done for CDS spreads over 1.300 – however, for the purpose of this application we would only underline that you should expect to get into a very high risk/reward area that probably isn’t safe for the average investor.
The probability of default can also be calculated as a “cumulative probability of default” (CPD). This number has often been quoted, recently, by the press related to Greece and its default possibility. Here is a summary of the estimated CPD related to CDS values:
11. I found different CDS Spreads numbers for the same issuer, apparently at the same date, from different sources - how is this possible?
The CDS market is a bit obscure in pricing, and it is no surprise that such a thing might happen. While we usually have official closing prices for securities, the CDS value may be calculated in slightly different ways by different companies – see Markit for their policy on end of the day pricing.
12. Why do I get different CDS estimates using as input bonds with different maturities?
It’s partly linked to the fact that CDS values are calculated over a 5 year period, and longer or lower bond maturities may generate a result slightly different from the correct value – however, when translated into risk neutral default probabilities, these differences should usually represent well below 1% per year. We always suggest to use several bonds for estimating CDS numbers, and make an average.
13. How to use Bond Calc in a creative way
The first calculator allows investors to estimate the fair pricing and YTM of a bond, assuming a certain CDS Spread – however, the spread may also be forecasted, as in the following example:
During the sovereign debt crisis, investor X decides to check what YTM a certain country could deliver, assuming its CDS Spread reaches a critical point. Through the help of the calculator, he is capable of forecasting an estimated price and YTM for several bonds, at different maturities, and decide a strategy, as expressed by an open order at a certain price level for a chosen security.
14. Where can I get some updated CDS numbers on the internet?
Markit discloses some selected companies at this link (registration required).
Sovereign Credit-Default Swaps:
Bloomberg:(some links may be broken)
Royal Bank of Scotland 5Y CDS
Lloyds TSB Bank PLC Bank 5Y CDS
BNP Paribas SA 5Y CDS
UBS AG 5Y CDS
UniCredit SpA 5Y CDS
Societe Generale SA 5Y CDS
Banco Santander SA 5Y CDS
Credit Agricole 5Y CDS
ING Groep NV 5Y CDS
Banco Popolare SC 5Y CDS
Commerzbank AG 5Y CDS
Bank of Ireland 5Y CDS
Deutsche Bank 5Y CDS
GENERAL ELECTRIC CAPITAL CDS USD 5Y (GECC)
MORGAN STANLEY CDS USD 5Y
GOLDMAN SACHS CDS USD 5Y
JP MORGAN CDS USD 5Y
BANK OF AMERICA CDS USD 5Y
WELLS FARGO CDS USD 5Y
CITIGROUP CDS USD 5Y (CGI)
MERRILL LYNCH CDS USD 5Y
U.S. BANK CDS AVERAGE*
AIG GROUP CDS USD 5Y
US STEEL CDS USD 5Y (X)
BERKSHIRE HATHAWAY CDS USD 5Y
ALCOA CDS USD 5Y
FAIRFAX FINANCIAL HOLDINGS CDS USD 5Y
TATA MOTORS CDS USD 5Y
CEMEX CDS USD 5Y
WOODSIDE PETROLEUM CDS USD 5Y
BOEING CDS USD 5Y (BA)
AT&T CDS USD 5Y (ATT)
ALLSTATE CDS USD 5Y (ALL)
IBM CDS USD 5Y
PFIZER CDS USD 5Y (PFE)
MCDONALDS CDS USD 5Y (MCD)
TARGET CDS USD 5Y (TGT)
ALLY BANK CDS USD 5Y (Formerly GMAC Bank)
FORD CDS USD 5Y (FCO, CFM1U5)
CATERPILLAR CDS USD 5Y (CAT)
WALMART CDS USD 5Y (WMT)
DOW CHEMICAL CDS USD 5Y (DOW)
HEWLETT-PACKARD CDS USD 5Y (CHWP1U5)
GENERAL ELECTRIC CORP CDS USD 5Y (CGEIUM:IND)
HARTFORD CDS USD 5Y
PETROLEOS DE VENEZUELA CDS USD 5Y (PDVSA)
NORINCHUKIN BANK CDS USD 5Y
UST LLC 5Y CDS
SANPAOLO IMI SPA 5Y CDS
BARCLAYS BANK PLC 5Y CDS
HSBC Holdings PLC 5Y CDS
Several CDSs are available at this link.
Additional CDSs are available at DDV (link).
15. I hear that Spain has a CDS Spread of 400 points against Germany, what does this mean?
The CDS Spread can be described as the difference between two country’s CDS values. The Sovereign crisis in Europe has brought this metric to many investors’ attention, as it relates to the difference (in %) that a country is expected to pay when it issues its bonds. You may estimate the CDS Spread between two parties by calculating both country’s CDS numbers, and by difference (say 460 minus 60 = 400).
Here is an example of Euro CDS Spreads – Spain vs Germany, Italy vs Germany, France vs Germany.
16. It would be quite interesting to be able to put several metrics together for the S&P 500 companies, including CDS...
Ploutos, at Seeking Alpha, has an interesting article discussing Credit Default Swap Spreads And S&P 500 Constituents. As the author underlines, there may be special occasions where rising credit default swap spreads may be good news for shareholders and bad news for bond holders: an additional reason to closely check this metric and its development throughout the life of a company, along with the newsflow.
Rating agency Fitch has developed a CDS Implied Ratings (CDS-IR) model that is used as an additional tool to evaluate a company’s default possibility/risk .
A few comments from their research are worth a quote (emphasis added):
>CDS Advantages – Pure, Light, & Liquid: CDS prices are a fairly pure indicator of credit risk because the structure separates the credit risk component from the other asset risks, such as interest rate and currency risk. In addition, they are “light” instruments in that one does not need to fund an entire bond position, for example, to have essentially the identical credit risk exposure. Finally, CDS pricing has become liquid with standardized ISDA2 contracts and exponentially growing markets. Total market size of CDS (notional outstanding) was $17 trillion by broker estimates in April 2006.<
Fitch study dates back to 2007. The company underlines that this additional metric may be different from the rating agencies’ commentary:
>The goal of CDS-IR is to provide a timely and accurate representation of market information. Hence, it is important to note that one should not expect a 100% match of Fitch CDS-IR with agency ratings, but to anticipate that there should be a difference between these two.<
In this study, Fitch also notes that the market seems to anticipate rating agencies’ adjustments – in line with the market perception that rating agencies are often following the market, rather than highlighting, in advance, potential risks to investors:
>Table 4 and Table 5 report the lead-lag analysis for various time intervals prior to agency rating changes for Americas and Oceania and Europe. It is clear from the tables that agency rating adjustments are anticipated by CDS implied rating.<