Rising rates will affect value of fixed coupon CDS, says Morgan Stanley

In its most recent Credit Derivative Insights report, Morgan Stanley looks at how rises in interest rates would affect credit default swaps written under the new fixed coupon standard. The researchers point out that there is a benefit to the counterparty that receives the upfront payment.

This is for two reasons. First, the value of the cash paid up front increases with a rise in interest rates. Second, higher interest rates increases the discount factor used to value the stream of future payments. This means that the net present value of the coupons falls with an increase in interest rates.

In the US market, says the report, around half of all names trade with the protection seller paying the up front and half have the up-front paid by the protection buyer. The fixed coupon format is new for most credits, and so the interest rate dynamic is something that many CDS counterparties may not have considered fully to date.