A sovereign credit default swap is a type of credit protection available to an individual or entity that owns a debt instrument issued by national government. If a government defaults on its debt obligation, the debt payments are made by the entity that issued the credit default swap. While these instruments work similarly to insurance products, there are regulations in many countries that impact insurance firms, while swap issuers are often unregulated.
National governments sell debt securities known as bonds in order to raise money for short-term projects. In most instances, government agencies use tax revenues to pay off these debts. During periods of recession governments, like other borrowers, sometimes run short of money and in some instances end up defaulting on debt payments. Consequently, investors are often reluctant to buy securities issued by nations with poor credit ratings and during periods of recession, some investors even refuse to invest in financially stable nations.
Financial companies including banks make it easier for governments to borrow money by issuing sovereign credit default swap contracts. These entities agree to insure government bonds in return for regular premium payments that bondholders must pay. If the bond issuer misses a single payment, the swap issuer covers the missed payment. In a worst-case scenario, the swap issuer covers the bondholder’s entire losses if a government chooses to default on the debt.
While insurance companies have to keep a certain amount to cash on hand to cover outstanding obligations, firms that issue sovereign credit default swap contracts are typically not required to keep any cash on hand to cover possible payouts. Credit defaults involving wealthy nations are historically unusual; this means that many swap issuers regard sovereign credit default swap contracts as an easy way to generate revenue while assuming minimal levels of risk. Firms that sell swaps on debt instruments issued by poor nations assume a much higher level of risk. These firms typically charge much higher premiums and keep substantial cash on hand to cover possible payouts. Many swap issuers reduce risk by selling on these swaps to other investment firms such as hedge fund companies or mutual funds.
Within the global economy, a debt default involving a particular nation may have a knock-on effect as lenders may become reluctant to buy bonds issued by neighboring countries. Many nations such as those within the European Union have close economic and political ties. Therefore, national governments often lend money to struggling nations to prevent bonds defaults. This means that the interests of bondholders are often protected by both political pressure and credit default swap contracts.