Why corporate borrowers need to track credit default swap rates

These determine capital costs by offering a market view of risks that goes beyond agency ratings

- MADAN SABNAVIS

Discussions on sovereign ratings usually focus on how rating agencies view the creditworthiness of a country, as broadly judged by its government's management of fiscal and other balances, among other factors. This is an issue of prestige even for governments—like India's—that do not need to borrow in the international market. Ratings, however, matter more to Indian companies that borrow from abroad, given that India's sovereign rating serves as a ceiling on their own rating. A company can get a rating up to two notches higher than the sovereign in case its global operations justify it.

One way to view the impact of sovereign ratings on companies is to look at the interest rates they are asked to pay on their borrowings. Here, sovereign credit default swaps (CDS) are the key, as all private borrowing is benchmarked against these swap rates. A CDS is essentially a form of insurance taken by an investor while investing in a security where the CDS seller provides cover in case of a default. The swap rate, which is denoted in basis points, is the premium to be paid for the cover. Sovereigns are not usually expected to default, but sovereign CDS rates serve as anchors to assess the probability of a default by any entity operating in that country. These rates are based on actual transactions and hence reveal the market's view.