A credit event is a type of financial event in which a borrower’s financial situation changes negatively, affecting their creditworthiness. Credit events can include bankruptcy, default, obligation acceleration, or failure to pay interest or principal in a timely manner.
Keep reading to better understand what a credit event is, how it occurs, and how it can trigger a credit default swap (CDS).
Definition and Example of Credit Event
A credit event is a financial event that changes a borrower’s creditworthiness, or perceived capacity to repay their debt, in a negative way. It can trigger the settlement or protections of a credit default swap, which is a type of credit derivative or financial contract used for hedging.
Credit events include financial events such as:
- Failure to pay
- Debt restructuring
- Obligation acceleration or obligation default
Read about these credit event examples in more detail below.
The buyer and seller of a CDS agreement may disagree as to whether or not a credit event actually happened. They may also disagree as to what the payout should be, which can lead to litigation.
How Credit Events Work
When a credit event occurs, it triggers a CDS, which is the most highly utilized type of credit derivative. A credit derivative is a type of financial contract that allows market participants to either reduce, transfer, or take the credit exposure on a sovereign or corporate entity.
You can think of a CDS as being like an insurance contract because it provides the buyer with protection for certain risks related to credit events. Investors may buy a CDS to protect against a default of high-risk municipal or corporate bonds, but they can serve a variety of other protection purposes in the credit market, like managing the risks of mortgage-backed securities or junk bonds.
To arrange a CDS, one party will sell a credit event risk to another party. A CDS transfers a risk from one party to another, but it doesn’t transfer the underlying bond or other credit asset.
The seller of the credit risk (usually the owner of the underlying credit asset) will pay a periodic fee to the buyer. In return for that periodic fee, the buyer of the risk agrees to pay the seller a predetermined amount if an agreed-upon credit event does occur. A CDS can be used to protect against a variety of credit risks such as bankruptcies, defaults, and credit rating downgrades.
If a credit event doesn’t end up occurring, the seller simply gets their regular income from the bond, and the buyer will lose the money they make in recurring payments.
Types of Credit Events
There are multiple ways for credit events to occur. The following credit events are among the most common and can trigger a CDS settlement.
- Bankruptcy: Companies (or individuals) file for bankruptcy when they become insolvent or are unable to pay debts. A bankruptcy is a legal process designed to give companies a fresh start as they liquidate their assets. There are several types of bankruptcy, but the end goal is to discharge debts.
- Failure to pay: Failing to make interest or principal repayments when they are due is considered a payment default. Too many defaults can lead to bankruptcy.
- Debt restructuring: Debt restructuring is essentially changes in the terms to the debt to allow the borrower to more easily repay it. Reconfigurations may include a longer repayment term, a lower principal, or deferred payment obligations, for example.
- Obligation acceleration or obligation default: Obligation acceleration/default occurs when the debt obligations of the issuer become due before the original maturity date.
- Repudiation/moratorium: If the issuer of the underlying bond rejects their debt, they effectively refuse to make interest and principal payments.
- A credit event relates to events in the credit space, such as bankruptcy, default, or the restructuring of a debt obligation.
- Credit events trigger credit default swaps (CDS), which are the most commonly used type of credit derivative.
- A CDS acts as a form of insurance that protects the buyer financially against certain risks in the credit market.
- The buyer and seller of a credit default swap agreement may disagree as to whether or not a credit event occurred.