A credit event refers to a negative change in the credit standing of a borrower that triggers a contingent payment in a credit default swap (CDS). It occurs when an individual or organization defaults on its debt and is unable to comply with the terms of the contract entered, triggering a credit derivative such as a credit default swap.
The three most common credit events are bankruptcies, payment defaults, and debt restructuring. They are discussed in more detail below.
What is a Credit Default Swap?
A credit default swap (CDS) refers to a credit derivative contract between two parties. In a credit default swap, the buyer makes periodic payments to a seller for protection against credit events such as the ones mentioned above. The CDS is a type of insurance aimed at protecting the buyer by transferring the risk of a credit event to someone else.
Example of a Credit Default Swap
John is a creditor of ABC Company and holds a 10-year bond with a par value of $1,000 and an annual coupon rate of 10%. The company is facing deteriorating market conditions, causing creditors to question the going concern of the company. John decides to enter into a credit default swap with Jane to ensure that he does not lose all of his money if ABC Company defaults. The credit default swap comes with the following terms:
John (the buyer) provides Jane (the seller) with bi-annual payments of $50;
If ABC Company experiences a credit event (bankruptcy, payment default, or a debt restructuring), the credit default swap will trigger, and Jane will pay John the remaining interest on the bond.
What is Bankruptcy?
Bankruptcy is a legal process that ensues when an individual or organization is unable to repay their outstanding debts. It is filed by the debtor (or, less commonly, the creditor). A company that is bankrupt is also insolvent.
Notable companies that have filed for bankruptcy are Apple in 1997, General Motors in 2013, and Marvel Entertainment in 1996.
Example of a Bankruptcy
ABC Company is facing deteriorating market conditions, causing the company to generate revenue that is significantly lower than projections. Due to its inability to generate profits, the company is unable to pay its outstanding debts to creditors and is eventually forced to file for bankruptcy.
What is Payment Default?
A payment default occurs when an individual or organization is unable to make payments on their debts on a timely basis. Continual payment defaults are a precursor to bankruptcy.
Payment default and bankruptcy are often confused with one another: A bankruptcy is telling your creditors that you will not be able to pay them in full, and a payment default is telling your creditors that you will not be able to make a payment when it is due.
Example of a Payment Default
ABC Company is a cyclical business that generates extremely volatile quarterly earnings. In its most recent quarter, ABC Company suffered a steep decrease in revenues due to a trade war between the US and China. It causes ABC Company to default on its periodic interest payments to creditors.
Debt restructuring refers to a change in the terms of the debt, causing the debt to be less favorable to debt holders. Common examples of debt restructuring include a decrease in the principal amount to be paid, a decline in the coupon rate, a postponement of payment obligations, a longer maturity time, or a change in the ranking of priority of payment.
Example of a Debt Restructuring
ABC Company is cash-strapped and decides to restructure its debt to ensure the going concern of the company. In the past, the company issued 20-year bonds with a face value of $1,500 and an annual coupon rate of 5%. The company then restructures the debt to a 20-year bond with a face value of $1,500 and an annual coupon rate of 2%.
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