Why use Credit Default Swap to hedge a high-yield bond?
Example I saw on Wikipedia had an institutional investor buying a high-yield bond, then entering into a CDS to protect himself in case the bond issuer defaults. Of course, the CDS has a cost, which reduces the yield of the bond.
My question is: what is the benefit of this to the investor? Why not just buy a lower-yielding bond from a more credit-worthy issuer?
What am I missing?
Answer:
The institutional investor probably saw something specific about that particular bond that showed that it was undervalued - even with the hedge.
In the world of junk bonds, a thorough analysis of the underlying company is very important, and two junk bonds with similar yields can have widely different outcomes, depending on the company issuing the bonds. Why buy the hedge if you know the company is a good risk? The hedge may be relatively cheap, or the bond may be a relatively large part of the investor's portfolio.
The low-risk bond world is much more efficient, and buyers of these bonds generally take a more "macro" bet on interest rates or yield spreads, since credit risk is less of a factor.
One would do this arrangement if the expected value is higher than the expected value of the safer arrangement. Suppose one is at 5% and 100% chance of being paid back, the other is 10% and 80% chance of being paid back. To maximize income, take the 10%/risky one, but hedge it somehow to average out the risk so a single deal doesn't kill you.
E.g., if I was offered the 10% with risk deal (and felt it was honestly evaluted) I'd take it in a minute for 10% of my funds but would NEVER touch it if required 100% of my funds since a loss would wipe me out.
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