The cost of insuring Oracle's debt against the risk of default has shot up after its latest earnings reignited worries about how much the broader corporate sector is spending on AI and the borrowing surge to fund it.
A growing debt pile, at just over $100 billion, means Oracle has become a bellwether for sentiment towards AI as concern about a bubble in the sector grows with surging tech shares.
Trading in Oracle credit default swaps (CDS), which has exploded in the last year and are near their most expensive on record, tell a less upbeat story than its shares.
WHAT IS A CDS ANYWAY?
Essentially derivatives that offer insurance against the risk of a bond issuer - such as a company or a government - not paying creditors.
Bond investors hope to receive interest on their bonds and their money back when the bond matures. But they have no guarantee either of these things will happen and so bear the risk of holding that debt.
CDS help to mitigate the risk through a form of insurance.
IS THIS A BIG MARKET?
The market for single name CDS, covering one issuer's bonds, is worth around $9 trillion, according to the International Swaps and Derivatives Association (ISDA).
This is a small part of global bond markets, home to more than $150 trillion in total debt securities outstanding, according to the Bank for International Settlements.
The biggest CDS market is for governments. In the third quarter, Saudi Arabia topped the charts, with a daily notional average of $500 million trades each day, based on Depositary Trust & Clearing Corporation (DTCC) data.
Banks are the most widely traded corporate CDS. But Oracle ranks in the top 20, with a daily notional average of $75 million each day in the third quarter, up 650% from the daily average at this point last year, according to DTCC data.
CDS trading can be thin, with the number of average daily CDS trades, even for large companies, sometimes in single digits, DTCC data suggests.
This makes the market tricky to navigate and creates a situation where even a small CDS trade can have an outsized price impact.
WHO BUYS CDS?
Bond investors typically buy CDS via an intermediary, often an investment bank, which finds a financial firm to issue an insurance policy on the bonds. These are "over-the-counter" deals that do not go through a central clearing house.
The buyer of the CDS pays a fee, called a premium like in the insurance business, on a regular basis to their counterparty, which then takes on the risk. In return, the seller of the CDS pays out a certain amount if something goes wrong, just like an insurance payout.
CDS are quoted as a credit spread, which is the number of basis points (bps) that the seller of the derivative charges the buyer for providing protection. The greater the perceived risk of a credit event, the wider the spread.
The owner of a CDS quoted at 100 bps would have to pay $1 to insure every $100 of bonds that they hold.
Oracle CDS trade around 126 bps, according to data from S&P Global Market Intelligence, well above other AI-linked companies such as Nvidia, trading around 37 bps, or Meta, which trades close to 50 bps, LSEG data shows.
Boaz Weinstein's Saba Capital Management has sold credit derivatives recently to lenders seeking protection on big tech names like Oracle, a source told Reuters last month.
WHAT TRIGGERS A CDS PAYOUT?
A credit event, which can include a bankruptcy of a debt issuer, or a failure to make a payment on bonds.
Like any financial asset, CDS are actively traded. If the perception of risk increases around a debt issuer, demand for its CDS rises, widening the spread.
A REMINDER OF 2008 CRISIS
CDS were one of the financial instruments at the centre of the 2008 financial crisis.
Bear Stearns and Lehman Brothers were among the many banks that issued CDS to investors on mortgage-backed securities (MBS) - mortgages bundled into one package - among other types of derivatives.
When U.S. rates rose sharply throughout 2007, triggering a wave of mortgage defaults, billions of dollars in MBS and other bundled securities were rendered worthless. This sparked hefty CDS payouts for banks such as Lehman and Bear Stearns.
https://finance.yahoo.com/news/explainer-credit-default-swaps-why-181141919.html
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