Credit Default Swap (CDS)

What Is a Credit Default Swap?

Think of a CDS as fire insurance on a loan. You own a company’s bonds and worry it might not repay. You pay a bank a fixed amount every quarter, and if the company goes bust, the bank pays you the money you lost. If nothing happens, you have paid for peace of mind and the bank keeps the premiums.

The contract has three parties in view: the protection buyer, the protection seller, and the reference entity, the company or government whose debt is covered. The reference entity is not part of the deal and usually does not know it exists. This detail matters, because it means anyone can buy protection, whether or not they own the underlying bond.

A team at JPMorgan developed the modern CDS in 1994 to move the credit risk of a large loan off the bank’s books without selling the loan itself. The product spread fast. By 2007 the notional value of CDS contracts outstanding had passed $50 trillion. From here the focus shifts from what a CDS is to how traders price and use it.

How Does a Credit Default Swap Work?

Each contract names a notional amount, a maturity (five years is the most traded tenor), and a list of credit events that trigger payment. The main events are failure to pay, bankruptcy and, for some contracts, a forced restructuring of the debt. Until one of them happens, the buyer pays the spread every quarter.

Suppose a fund owns $10 million of bonds issued by a hypothetical airline. It buys five-year protection at a spread of 200 basis points, so it pays $200,000 a year. Two years later the airline files for bankruptcy, and an auction values its bonds at 40 cents on the dollar.

The seller now pays the fund the difference between face value and recovery value: $10 million × (1 − 0.40) = $6 million. The fund’s bonds are worth $4 million, and the CDS payout restores the rest. It spent $400,000 on premiums to avoid a $6 million loss.

Spreads move every day with the market’s view of default risk. If the airline’s outlook had worsened without a default, the spread might have jumped from 200 to 600 basis points. The fund could then sell its contract for a profit, because new buyers would have to pay three times as much for the same cover.

Types of Credit Default Swaps

Single-name CDS covers one reference entity, such as a single company or country. It is the classic form and the one most quoted in news about a borrower in trouble.

Index CDS covers a basket of names at once. The CDX indices in North America and the iTraxx indices in Europe each bundle around 100 or 125 companies, and traders use them to hedge or bet on credit conditions as a whole.

Sovereign CDS insures government debt. Greece is the best-known case: in March 2012 ISDA ruled that the country’s forced bond exchange was a credit event, and sovereign protection paid out.

Credit Default Swap vs. Insurance

Why Is a Credit Default Swap Important for Traders?

CDS spreads are a live price of default risk. Bond yields mix credit risk with interest-rate moves and supply, but a CDS spread isolates the credit piece. That is why traders watch bank and sovereign CDS during a crisis: a spread that doubles in a week often signals trouble before ratings agencies act or share prices fully adjust.

The instrument also carries its own danger. A CDS buyer swaps the borrower’s risk for the seller’s, so protection is only as good as the firm that wrote it.

AIG is the lesson every credit trader knows. The insurer sold protection on hundreds of billions of dollars of mortgage-linked debt without holding enough collateral. When those securities were downgraded in September 2008, AIG faced collateral calls it could not meet, and the US government stepped in with an $85 billion loan to stop the losses spreading to every bank that had bought protection from it. That episode turned counterparty risk into a household phrase.

After 2008, regulators pushed standard contracts through central clearing houses that collect margin daily. The EU also banned naked sovereign CDS, protection on government debt bought without owning the bonds, from November 2012, arguing that it let speculators push up a country’s borrowing costs. Critics still point out that CDS can create odd incentives, since a holder of both bonds and more protection than bonds may profit if the borrower fails.

For most traders, CDS are an indicator rather than a tool, because the market is over-the-counter and dominated by banks and funds. Watching the spreads still helps with position sizing in shares, bonds and currencies of the same borrower.

Key Takeaways

• A credit default swap transfers the risk of a borrower’s default from the protection buyer to the protection seller in exchange for a regular premium.
• The CDS spread is quoted in basis points per year of notional, and a rising spread means the market sees a higher chance of default.
• If a credit event occurs, the seller pays the gap between face value and the recovery value of the debt, often set by an industry auction.
• Unlike insurance, a CDS can be bought without owning the underlying bond, which makes it a tradable view on credit as well as a hedge.
• The buyer depends on the seller’s ability to pay, a weakness exposed by AIG in 2008 and addressed since through central clearing and margin.