Credit Default Swaps, Explained: The Market’s Live Price of Default

Foundations

A credit default swap (CDS) is insurance on a borrower. The buyer pays a regular premium; if the borrower defaults, the seller compensates the buyer for the loss on the debt. That premium, quoted in basis points per year, is the market’s live price for the risk that a company or country fails to pay, which makes CDS one of the most information-rich instruments in finance: a default probability you can watch tick by tick.

From a premium to a default probability

The translation is rough but useful. If protecting $100 of a company’s debt costs 200 basis points ($2) a year, and lenders would recover around 40 cents on the dollar in a default, the market is pricing very roughly a 3 to 4 per cent chance of default per year (the premium divided by the expected loss). This “model-implied default probability” is how analysts turn a traded spread into a headline like “the market prices a one-in-five chance of default over five years”. The recovery assumption is doing quiet work in that arithmetic: assume less recovery and the same premium implies less risk of default, and vice versa.

Who uses them, and for what

Lenders and bondholders buy CDS to hedge exposure they already own. Traders use them to bet on creditworthiness in either direction without touching the underlying bonds, which are often illiquid. And everyone else reads them: a widening CDS spread is frequently the first public signal that professional money is worried about a borrower, moving before ratings agencies and sometimes before the bonds themselves. The instrument earned notoriety in 2008, when sellers of protection on mortgage debt, most famously AIG, discovered they had insured far more risk than they could pay for; post-crisis reforms moved most CDS trading through central clearing to contain that danger.

Reading CDS in credit analysis

Two cautions keep the signal honest. First, CDS markets can be thin: for smaller borrowers a handful of trades can move the quoted spread, so a lurch is not always a verdict. Second, the spread prices default and recovery together, so it can widen because expected recoveries fell, not because default became likelier. Used carefully, though, CDS-implied probabilities are the sharpest tool available for questions like whether a heavily indebted company’s borrowing costs are sustainable, which is exactly why they appear in our coverage of leveraged AI infrastructure borrowers and stressed credits.