Feels like déjà vu all over again. Credit default swaps (CDS) are back in the front of finance chatter. CDS were one of the financial instruments at the centre of the 2008 financial crisis.
When interest rates rose sharply in 2007, a wave of defaults resulted across the chain of US subprime mortgage securities rendering billions of dollars in these securities worthless.
Subsequently, this triggered hefty CDS payouts for banks such as Lehman Brothers and Bear Stearns which served as counterparties.
Fast forward to 2023. Credit risk indicators are flashing red once again. Following several rounds of aggressive rate hiking, CDS markets are in turmoil again with notable names such as Credit Suisse going belly-up (and defaulting on its debt at the same time).
Fear of exposure to financial problems at counterparties — market players on either side of derivatives — could eventually lead investors to pull back from the CDS market. Is this something frontier markets should be concerned about?
First let's understand credit default swaps.
These are derivatives offering insurance against the risk of a bond issuer — such as a company, a bank or a sovereign government — not paying their creditors or in cases involving debt restructuring.
In other words, one side pays an annual fee to buy protection against default, while the other promises to cover losses in the event of default.
A shifting of default risk between two investors. It is material to note that the premiums paid for the protection offered are commonly used as market indicators of credit risk.
Quoted as a credit spread, which is the number of basis points that the seller of the derivative charges the buyer for providing protection, the greater the perceived risk of a credit event, the wider that spread becomes.
With that said, here's the big issue. The cost of buying insurance against defaults on Africa’s frontier market sovereign debt as spreads have been widening according to a recent African Development Bank’s report; mispricing of sovereign risk.
Now, whether these securities are mispriced or not, investors are demanding an increasing premium to hold them as they believe that the worst may still not be over for the struggling asset class.
Adding the strain of rising key interest rates to this, it's likely the impact of the current turmoil on CDS spreads will force them to grind even higher.
All this does not paint a healthy picture.
Worse, if the current contagion fears persists, then even the underlying debt markets will also be affected where liquidity could run thin.
No doubt, the increase in CDS spreads highlights the deep-seated pessimism investors have regarding emerging and frontier markets right now.
But the current banking crisis exacerbates the issue. Emerging market asset classes will particularly face serious headwinds — everything from higher CDS spreads to further currency depreciation.
If investors are unable to buy protection with credit derivatives to offset their exposures, it would not be smooth sailing.
Mwanyasi is MD, Canaan Capital.