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I've always been so puzzled by these "synthetic" financial products. If someone wants to "insure" a corporate bond, why don't they just swap it with a bank for

by tome 9y ago

I've always been so puzzled by these "synthetic" financial products. If someone wants to "insure" a corporate bond, why don't they just swap it with a bank for a cash flow stream guaranteed by the bank, minus some premium?

Godel_unicode 9y ago
... which guarantee would then be hedged by the bank with a CDS.
- tome 9y ago
  Who would take the other side of that trade ... ?
jeffwass 9y ago
That's basically the same thing as selling the corporate bond and buying a government bond of similar maturity and coupon frequency in the same currency. Though I don't get why you're puzzled on synthetic derivatives, since what you've proposed is a synthetic instrument itself. It's an exchange of upfront payment for an annuity stream. And it's basically the opposite sign of the off-market swaps people in this HN community have already criticised banks for providing as a means of off-balance-sheet funding to some clients. (Eg, Greece and Italy entering into off-market swaps with banks, which is what your proposed contract is, except receiving upfront cash in exchange for the liability of a stream of future payments). Separately, the bank could wrap your annuity stream as into structured note to make it seem more like a cash bond. But then you're back into something even more bespoke and financially complex than a standard contract CDS.
chollida1 9y ago
> I've always been so puzzled by these "synthetic" financial products. Well what you are describing with your swap scenario is the very definition of a synthetic product, so your question as posed doesn't really make any sense:) The real answer probably has a few reasons 1) There are more benefits to owing a bond than just the coupon and principle payments, why give those up by handing ownership of the bond to the bank? With a CDS you still own the bond and the insurance in the case of a default, and remember a default doesn't mean the bonds go to zero. What if the bond doesn't default but goes way up in value, you've handed that value over to the bank rather than getting it yourself. What if you want to sell the bond before the expiry date. All of these are answerable on their own but you can see how this actually rapidly complicates things. 2) and this is probably alot more important, What if I don't have the bond itself but still want default insurance on the bond? I might be a large counterpart to the company, htey could be my largest client or supplier.
- marshray 9y ago
  Also, sometimes there can also be tax advantages to not selling something (realizing gains) and instead buying insurance on it (possibly deductible expense).
yellowstuff 9y ago
Uniformity is a major advantage of CDSs. Bonds are idiosyncratic- every one will has its own maturity date, coupon payments, and lots of minor details in the bond covenants. That makes bonds hard to trade. CDS are far more uniform- they trade with standard terms and maturities. Bonds are primarily a way to provide companies with funding, CDS are primarily an instrument for financial companies to trade. Could a company "insure" a bond by writing a swap with a bank? Sure, a bank would be happy to write a bespoke swap with you, but they're going to charge more than a CDS would cost, and you're not going to be able to trade the swap to someone else. CDS actually make it easier for companies to raise money. If you can hedge your weird, illiquid bond with a nice liquid CDS you're more likely to buy the bond in the first place. FWIW I'm not a specialist in fixed income, so don't take this as gospel, but I think the general point is right.
- whatok 9y ago
  Not sure I necessarily agree with the point about making it easier for companies to raise money. I agree with it at face value but not based on what usually happens in the market. Chances are, if there's liquid CDS for an issuer, they're not going to be issuing weird, illiquid bonds. On the other side, if all an issuer has are weird, illiquid bonds outstanding and without knowing anything about the issuer, I would say it is negative to have a liquid CDS market as that's probably a negative creditworthy signal. I'm sure some academic has done a study about how CDS has shaved a few bps off borrowing costs for large IG issuers though. Agree with everything else in there.
  - yellowstuff 9y ago
    Thanks for the info!
tome 9y ago
To answer several instances of the same question at once: Regardless of whether you think "pay me $COUPON every 6 months until date D when you pay me $PRINCPIAL" might be considered "synthetic" surely you must all admit it's far less synthetic than "Pay me $X if and when CORPORATION defaults"!

by tome 9y ago

Godel_unicode 9y ago

... which guarantee would then be hedged by the bank with a CDS.

tome 9y ago
Who would take the other side of that trade ... ?

jeffwass 9y ago

That's basically the same thing as selling the corporate bond and buying a government bond of similar maturity and coupon frequency in the same currency. Though I don't get why you're puzzled on synthetic derivatives, since what you've proposed is a synthetic instrument itself. It's an exchange of upfront payment for an annuity stream. And it's basically the opposite sign of the off-market swaps people in this HN community have already criticised banks for providing as a means of off-balance-sheet funding to some clients. (Eg, Greece and Italy entering into off-market swaps with banks, which is what your proposed contract is, except receiving upfront cash in exchange for the liability of a stream of future payments). Separately, the bank could wrap your annuity stream as into structured note to make it seem more like a cash bond. But then you're back into something even more bespoke and financially complex than a standard contract CDS.

chollida1 9y ago

> I've always been so puzzled by these "synthetic" financial products. Well what you are describing with your swap scenario is the very definition of a synthetic product, so your question as posed doesn't really make any sense:) The real answer probably has a few reasons 1) There are more benefits to owing a bond than just the coupon and principle payments, why give those up by handing ownership of the bond to the bank? With a CDS you still own the bond and the insurance in the case of a default, and remember a default doesn't mean the bonds go to zero. What if the bond doesn't default but goes way up in value, you've handed that value over to the bank rather than getting it yourself. What if you want to sell the bond before the expiry date. All of these are answerable on their own but you can see how this actually rapidly complicates things. 2) and this is probably alot more important, What if I don't have the bond itself but still want default insurance on the bond? I might be a large counterpart to the company, htey could be my largest client or supplier.

marshray 9y ago
Also, sometimes there can also be tax advantages to not selling something (realizing gains) and instead buying insurance on it (possibly deductible expense).

yellowstuff 9y ago

Uniformity is a major advantage of CDSs. Bonds are idiosyncratic- every one will has its own maturity date, coupon payments, and lots of minor details in the bond covenants. That makes bonds hard to trade. CDS are far more uniform- they trade with standard terms and maturities. Bonds are primarily a way to provide companies with funding, CDS are primarily an instrument for financial companies to trade. Could a company "insure" a bond by writing a swap with a bank? Sure, a bank would be happy to write a bespoke swap with you, but they're going to charge more than a CDS would cost, and you're not going to be able to trade the swap to someone else. CDS actually make it easier for companies to raise money. If you can hedge your weird, illiquid bond with a nice liquid CDS you're more likely to buy the bond in the first place. FWIW I'm not a specialist in fixed income, so don't take this as gospel, but I think the general point is right.

whatok 9y ago
Not sure I necessarily agree with the point about making it easier for companies to raise money. I agree with it at face value but not based on what usually happens in the market. Chances are, if there's liquid CDS for an issuer, they're not going to be issuing weird, illiquid bonds. On the other side, if all an issuer has are weird, illiquid bonds outstanding and without knowing anything about the issuer, I would say it is negative to have a liquid CDS market as that's probably a negative creditworthy signal. I'm sure some academic has done a study about how CDS has shaved a few bps off borrowing costs for large IG issuers though. Agree with everything else in there.
- yellowstuff 9y ago
  Thanks for the info!

tome 9y ago

To answer several instances of the same question at once: Regardless of whether you think "pay me $COUPON every 6 months until date D when you pay me $PRINCPIAL" might be considered "synthetic" surely you must all admit it's far less synthetic than "Pay me $X if and when CORPORATION defaults"!