Credit Default Swap
A financial derivative that acts like insurance against a bond default — the buyer pays periodic premiums to the seller, who in turn compensates the buyer if the reference entity defaults.
The macro regime is unambiguously STAGFLATION DEEPENING. The three-pillar structure remains intact and strengthening: (1) Energy-driven inflation shock — WTI at $104-111, +40% in 1M, flowing through PPI (+0.7% 3M, accelerating) into a CPI/PCE pipeline that has not yet absorbed the full pass-through,…
What Is a Credit Default Swap?
A Credit Default Swap (CDS) is a bilateral agreement in which one party (the protection buyer) pays a regular premium to another party (the protection seller) in exchange for a payment if a specified credit event — typically a default — occurs on a reference entity (a company or sovereign government).
A CDS functions like insurance on a bond. If the reference entity defaults, the protection seller pays the buyer the difference between the bond's face value and its recovery value in the market.
How CDS Spreads Work
CDS spreads are quoted in basis points per year (e.g. "150bps on 5-year Ford CDS"). If Ford's 5-year CDS is trading at 150bps, buying $10 million of protection costs $150,000 per year. When credit conditions deteriorate, CDS spreads widen — reflecting the market's increased probability of default.
CDS Indices
The most important CDS products are indices:
- CDX.NA.HY: North American high-yield CDS index (125 companies)
- CDX.NA.IG: North American investment-grade CDS index
- iTraxx Europe: European equivalent of CDX.NA.IG
These indices are the most liquid way to trade broad credit risk and are watched closely as leading indicators of credit market stress.
CDS and the GFC
CDS became infamous in the 2008 Global Financial Crisis. AIG had sold enormous quantities of CDS protection on CDOs backed by subprime mortgages. When those CDOs defaulted, AIG faced hundreds of billions in payouts it could not make — triggering the US government bailout.
What CDS Spreads Tell You
Rising CDS spreads are an early warning signal of:
- Corporate or sovereign credit stress
- Market pricing in increased default risk
- Tighter credit conditions ahead
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