Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Family Offices Use Credit Default Swaps to Hedge Risk
Transcript
- Lucas: So Luna, we've spent a lot of episodes on taxes and estate planning, but today I want to take a sharp left turn into something that sounds scary to most people but is actually one of the most elegant tools in a family office's kit: credit default swaps. Luna: Credit default swaps. The instrument that nearly blew up the global economy in 2008. That's what we're talking about? Lucas: Exactly the one. And look, I get it — the phrase alone triggers a certain amount of PTSD for anyone who lived through that period. But the reality is, since then the market has been completely rebuilt. Today, if a family office uses credit default swaps the right way, it's not speculative gambling. It's insurance. Luna: Insurance. I like that framing. So let's break that down. What exactly is a credit default swap? Lucas: So the simplest way to think about it is like this: you own a bond. Maybe it's a corporate bond from a company you like, paying you six percent. But there's always the risk that the company defaults and you lose your principal. A credit default swap lets you pay a periodic premium — think of it like an insurance premium — to a counterparty who agrees to cover your losses if the company defaults. Luna: So it's literally insurance on a bond. Lucas: Literally. And the premium you pay is quoted in basis points, a hundred basis points being one percent. If a bond is considered risky, the CDS premium might be three hundred basis points, meaning you pay three percent per year to protect against default. Luna: That sounds like a no-brainer for a concentrated bond portfolio. But I assume there's a catch — otherwise everyone would do it. Lucas: The catch historically was counter-party risk. You're buying protection from someone, but what if that someone goes bust when you need them most? That's what happened in 2008 with AIG. They sold tons of CDS protection and couldn't pay out. Luna: Right, so if the insurer fails, your insurance is worthless. Lucas: Exactly. But here's the thing — after the crisis, regulators forced most CDS trades through central clearinghouses. Now, the clearinghouse sits in the middle of every trade, so your counterparty is effectively the clearinghouse itself, and it's backed by margin requirements and a default fund. That systemic risk is largely gone. Luna: So it's safer now. But I still wonder — why would a family office use CDS instead of just selling the bond or diversifying? Lucas: Great question. Because sometimes you can't sell. Let me give you a concrete example. Say a family office holds a significant position in a private credit fund — these have become hugely popular lately, you know, the direct lending funds that have replaced bank loans for mid-sized companies. Those positions are illiquid. You can't just sell them on a moment's notice. Luna: Right, because the underlying loans aren't traded on an exchange. Lucas: Exactly. So the family office wants to maintain that yield, but they're worried about a downturn. They can go into the CDS market — if there's a liquid market for that specific company's credit — and buy protection on a basket of similar credits. You're essentially hedging without selling the underlying asset. Luna: So it's a way to keep the income while shielding against the downside. That's clever. Lucas: And that's the 'if it was worth it' angle. The premium you pay is the cost of that sleep-at-night factor. And for a family office managing, say, half a billion dollars in credit exposure, spending a few million a year to protect against a potential hundred million dollar loss is a rational trade. Luna: But how do they actually decide which credits to hedge? Do they just pick the riskiest ones? Lucas: Usually, it's a portfolio-level decision. They'll look at their entire fixed-income sleeve and identify concentrations. Maybe they're overweight in energy bonds, or they have a big exposure to a single issuer. Then they'll buy CDS on that specific name or on a basket that mirrors their exposure. Luna: And the pricing of that protection — the premium — is that based on the market's view of default risk? Lucas: Yes. And that's where it gets interesting. The CDS market often leads the bond market. It's more liquid and reacts faster to news. So the premium you pay is basically the market's collective view of how likely that company is to default. Luna: So you're paying for someone else's opinion on default risk, and you're hoping they're wrong, but you're protected if they're right. Lucas: Exactly. And there's a nuance here. You can also use CDS to express a view. Some family offices, usually the more aggressive ones, will actually sell protection on companies they think are undervalued. They're essentially acting like a bond insurer, collecting premiums and hoping nothing happens. Luna: But that's more speculative. Today we're focusing on the hedging side, right? Lucas: Yes, absolutely. And it's important to stress that the overwhelming majority of family office usage is for hedging, not speculation. Remember, these are people preserving wealth across generations. They're not trying to make a killing on credit spreads. Luna: So let's talk about the practicalities. How does a family office actually execute a CDS trade today? Lucas: Well, you need to be an institutional investor. You can't just call your broker and buy a CDS like you would a stock. You'll need to sign an ISDA Master Agreement with a dealer — that's the International Swaps and Derivatives Association. And that agreement sets out the legal terms, the collateral requirements, and the default provisions. Luna: And I imagine that's not something you do overnight. It takes time and legal counsel. Lucas: Absolutely. It's a commitment. That's why you see this more in multi-family offices or family offices with dedicated investment teams. A single-family office that's just managing the family's wealth might not have the infrastructure for this. Luna: But with the rise of private credit, I'd guess more family offices are waking up to the need for this kind of protection. Lucas: That's a great point. The private credit market has exploded over the past decade. Family offices have poured billions into direct lending funds because the yields are so much higher than public markets. But that also means they're taking on credit risk that they might not fully understand. Luna: So CDS becomes the escape hatch when the tide goes out. Lucas: Exactly. But here's the challenge: for many private credits, there's no liquid CDS market. You can't buy protection on a specific middle-market company that's privately held. So family offices have to get creative. Luna: Creative how? Lucas: They might buy protection on a basket of comparable public companies. Or they might use an index CDS, like the CDX index in North America, which tracks a basket of investment-grade or high-yield companies. It's not a perfect hedge, but it gives you broad market protection. Luna: So you're hedging the market, not the specific credit. That makes sense as a portfolio hedge. Lucas: And that's actually the trend I'm seeing. More family offices are using index CDS as a macro hedge rather than trying to match specific issues. It's simpler, more liquid, and cheaper to manage. Luna: That's a smart approach. So before we wrap up, let me ask: has the regulation really changed the game that much? Because I remember reading about the 'too big to fail' concerns. Lucas: Huge change. In 2008, the CDS market was a dark web of bilateral trades. Nobody knew who owed what to whom. Today, most standard CDS trades are cleared through central counterparties. That means every trade is subject to margin calls, so if one party can't pay, the clearinghouse steps in. Luna: So the clearinghouse becomes the ultimate backstop. Lucas: Exactly. And because of that, the systemic risk that plagued the market in 2008 is significantly reduced. The Fed even did a stress test a few years ago showing the CDS market could handle a severe default scenario without cascading failures. Luna: That's reassuring. But I'm sure there are still pitfalls. What should a family office watch out for? Lucas: The biggest pitfall is basis risk. That's when your hedge doesn't perfectly match your exposure. For example, if you're hedging a private credit portfolio with an index CDS, the index might move differently than your specific holdings. If the market drops but your hedge doesn't move, you're not actually protected. Luna: So you need to understand the correlation between your assets and the hedge. Lucas: And that requires sophisticated risk modeling. You can't just buy a CDS and forget about it. You need to monitor the basis and adjust your hedges as market conditions change. Luna: Speaking of monitoring, I've been thinking about our conversation and how much this aligns with the idea of 'if it was worth it.' I mean, if today's episode helped you think about your own portfolio in a new way, that's something. Lucas: Absolutely. And honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It's the smallest of asks, but it helps us keep these conversations ad-free and accessible to everyone. Luna: Yeah, every little bit genuinely helps us keep the lights on and the research flowing. No pressure, just if it feels right. Lucas: So back to that basis risk. The key takeaway is that credit default swaps are a powerful tool, but they're not a set-and-forget solution. They require constant attention and a deep understanding of the underlying credit markets. Luna: And for the family office that's willing to put in that work, it's a way to protect wealth without sacrificing yield. That's a pretty compelling proposition. Lucas: Right. And as we look ahead, I expect to see even more sophistication in this space. With private credit continuing to grow, family offices are going to need creative ways to hedge. The CDS market, for all its bad press, is likely to play a central role. Luna: I think that's a great note to end on. So whether you're managing a billion dollars or just your own 401k, the lesson is the same: understand your risks and use the right tools to manage them. Lucas: Well said. Thanks for joining us, and we'll catch you on the next one.