Another benefit is that bond funds spread out their positions over many individual issues, and this can reduce credit (default) risk.
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Credit derivatives have made it easier to separate the credit risk (the danger of default) of bonds from the interest rate risk.
As I explain in this paper, credit derivatives are merely a financial tool that can be used by those exposed to credit risk, say a default by the Greek government or General Electric, to share that risk with others.
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Commercial banks are continuing to shed corporate-credit risk using default swaps.
In fact, according to CreditSights, credit default swaps (CDS) which measure the risk of default actually tightened (showing the market sees reduced default risk) 15-50 basis points, or from 0.15-0.50%.
The higher the cost of a credit default swap, the higher the implied risk.
Lenders say they need to charge higher rates partly because buyers of manufactured homes often have low incomes, imperfect credit and carry a higher risk of default.
Easy credit could put corporate borrowers at greater risk of default, but even now, distressed debt investors are recouping far more than they have in previous years.
Essentially, this money machine used extreme diversity and interlinking of transactions plus the insurance (credit default swaps) to give the appearance of reducing risk such that there could be a AAA rating.
This is one reason why credit default swaps suggest India is already a bigger investment risk than emerging markets such as Vietnam and more than double the risk of Brazil, Russia, China and South Africa.
The Budget Control Act was the result of a failure by Congress to agree to a balanced approach to deficit reduction, and it was the result of Republicans willing to play chicken with the full faith and credit of the United States, willing to risk default, some of them even seemed to anticipate with glee the prospect of default.
In addition, third parties with no exposure to the particular credit risk can bet on whether the Greeks will default.
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To be fair, none of the central banks realized that even the saving grace of spreading the risk of new products and innovations (like credit default swaps) would not of themselves prevent those who had been too optimistic from suddenly turning pessimistic.
One of the ways the market measures credit risks is by looking at the spreds of credit default swaps, a default insurance derivatives market that measures the risk of buying foreign bonds as compared to buying a comparable maturity from the US Treasury.
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Instead, investors should seek more timely measures of sovereign risk, preferably through price signals from competitive debt and credit default swap markets, and whenever those are unavailable, from more objective and transparent models.
World Acceptance funds itself through lines of credit from Wells Fargo and Bank of America, so those banks already have exposure to consumers with lower credit scores, who pay higher interest and pose a greater risk of default.
Taxpayers already bear the default risk on these loans, which are made without regard to credit history.
But given the implication of higher risk of default, it ought to follow that a lower credit rating would also mean a higher interest rate.
Additionally lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
In recent weeks there has been a rise in both LIBOR (a gauge of banks' borrowing costs) and the credit-default-swap spreads on bank bonds (the cost of insuring against default risk).
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Sustained deflation, Credit Suisse says, would put strains on public finances, increasing the risk of sovereign default, and making longer-term bonds less attractive.
Actions such as selling credit default swaps based on rotten loans, money laundering, interest rate manipulation, and excessive risk-taking can be as objectively determined as financial restatements.
To diffuse this risk Partridge assembles a broad mix that includes foreign and domestic stock indexes, credit-default swaps and futures on commodities like crude oil, cattle, hogs and corn.
Their inexperience might increase counterparty risk the danger that a seller of credit protection cannot pay in the event of a default.
It isn't enough to compare the spread to its average, Mr. Fridson says, because the average doesn't reflect the current level of default risk, the strength of the economy, the yield on government bonds or the availability of credit.
Layering of risk means the borrowers courted by these lenders had multiple characteristics that would put them at high risk for default, including no down payment, no documentation of income or assets, low credit scores and second mortgage in lieu of a down payment.
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