I don’t understand the purpose of credit default swaps. I understand that they transfer the risk of the underlying asset defaulting from the CDS buyer to the CDS seller. What I do not understand is why an investor would buy a risky bond and then buy a CDS to hedge the default risk associated with the risky bond to neutralize the risk. If the investor wants a bond without having to worry about default risk, why not just buy a risk-free bond instead?
My question, then, is what’s the difference between the following two types of investments:
- A risky bond + a CDS that hedges the default risk of the risky bond.
- A risk-free bond (e.g. a US treasury).
I suppose (1) would still be riskier than a US treasury because of the possibility that the CDS seller defaults on the CDS when the underlying’s credit event occurs? So investment (1) would have a higher yield than investment (2)? Short of this difference, buying a risky bond and then hedging that risk looks like a convoluted way of creating a risk free position (which should yield the risk-free rate).
What am I missing?