Idea Generation—Looking at CDS Spread Changes

radio-shackOne of the key identifiers that we look to when attempting to find short ideas is the CDS (or Credit Default Swap) spread for a particular company.

A Credit Default Swap (or CDS) is an arrangement between a buyer (often called protection buyer) and seller (or protection seller) in which the buyer receives credit protection, whereas the seller of the CDS guarantees the credit worthiness of the debt security.

A CDS can often be thought of as a level of insurance since the buyer pays the seller a premium while the seller of the CDS has the obligation to cover the face value of the CDS if the company in question does indeed default.

The spread of a Credit Default Swap is the annual amount the buyer must pay the seller over the length of the contract for the swap. This amount is expressed as a percentage of the notional principal (or face value) of the contract.

For example, if we find that the CDS spread for Arco Widgets is 100 basis points, or 1%, then a buyer who is purchasing $10 million worth of protection from GGG CDS Dealer must pay an amount totalling $100,000. Payments are typically made on a quarterly basis. and will continue until either Arco Widgets defaults or when the contract actually expires.

The higher the spread on the CDS, the higher the expectations are for a company default. Credit Default Swaps became somewhat more mainstream and familiar to the investing public during the financial crisis of 2007-2008. When the ship was getting ready to sink at Lehmann Brothers and Bear Stearns, CDS spreads went wild.

Often the companies with the highest CDS spreads typically have poor balance sheets with signficant debt loads/poor liquidity. It is important to get a gauge of the CDS market, since the credit players often have great insight into the problems faced by companies. Here is a list of companies sorted by largest increase in 5 Year CDS Spread for the past month:

So, how to read the data? The column ’5 Year CDS Spread’ is just the spread or premium as we mentioned above–that a protection buyer is repsonsible for paying to the seller when purchasing protection.

For an example, Radio Shack has very high spreads—1311.69 or 13.11%, meaning that a buyer must pay nearly $1.3 million per year for protection on a $10 million swap.  That’s a pretty high premium, and the credit market is giving us a strong indication that Radio Shack might be nearing the end…especially with its spreads up by 26% in the last month.   Could be a good short, but note that Radio Shack does have a short interest at near 30% of its float.

The prospects for another electronics retailer, Best Buy, are also looking quite grim according to the credit markets.   CDS Spreads are at 5.4%, not as high as Radio Shack, yet up 22% on the month.

Use this as a guide in your short selling research–we recommend finding companies with a noticeable increase in spread for the month, and checking debt levels, cash flows, interest obligations to see if there might be any sense of probabilitiy for upcoming default.  Remember if the short interest is extremely high it might not be worth your costs (to borrow and for the potential for a squeeze).     

Please do let us know if there are any questions or comments on this data.