Does Your Mutual Fund Hold Credit Default Swaps?

It is not likely your mutual fund holds credit default swaps (CDS) if you are invested in a conservative fund. The majority of mutual funds are conservative, made up of stocks and bonds. However, some funds will include derivatives, and this is where you may run into the risk of credit default swap exposure. 

What is a Credit Default Swap?

A swap of any financial instrument means Party A trades the income of one of its financial instruments to Party B in exchange for the same. For example, a person holding a bond paying 5 percent over 10 years can trade with a person holding a bond paying 10 percent over 5 years. With a credit default swap, Party B only gets the payment if a "qualifying event" occurs. Typically, this is a default, foreclosure or restructuring of a loan contract. 

What are the Risks of CDS Exposures?

CDS's bet that a loan will go bad. If the loan goes bad, the borrower begins payments to the owner of the swap instead of to the initial lender. The problem is, some of these borrowers are completely unable to make the payments, meaning the debt is forgiven in a bankruptcy court or otherwise worthless. Party B is holding a worthless, toxic asset, while trading out payments of a better asset to Party A.

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