Who pays and receives in a CDS
| CDS Feature | Detail |
|---|---|
| Buyer pays | CDS spread (e.g., 150 bps/year on notional) |
| Buyer receives | Par − recovery value if default occurs |
| Seller receives | Premium income |
| Seller pays | The loss if default occurs |
| No default needed | CDS trades in secondary market based on spread changes |
The CDS premium formula
Annual CDS Premium = Notional × CDS Spread (bps) / 10,000
Why CDS spreads beat rating grades
CDS spreads are often a better real-time indicator of credit risk than rating agency grades. When CDS spreads spike, the market is pricing in deteriorating creditworthiness — often before the rating agencies downgrade.
Watching spreads widen in credit stress
When spreads move before ratings
How CDS fueled the 2008 crisis
What buying CDS protection actually is
Reading CDS spreads as implied ratings
| CDS Spread | Implied Rating | Market View |
|---|---|---|
| < 50 bps | AA/AAA | Very low default risk |
| 50–150 bps | A/BBB | Investment grade |
| 150–400 bps | BB/B | High yield territory |
| 400–1000 bps | CCC | Distressed |
| > 1000 bps | Default likely | Near-default or restructuring expected |
Estimating default probability from the spread
Fixed-income desks also read a CDS spread as a default-probability estimate: the approximate annual probability of default is the CDS spread divided by (1 minus the recovery rate). A 5-year CDS at 300 bps with an assumed 40% recovery implies roughly 300 / (1 - 0.40) = 5% default probability per year. Related read: the CDS-bond basis -- the CDS spread minus the cash-bond spread -- should theoretically sit near zero; when it turns significantly positive, CDS protection is expensive relative to bonds, a signal of market stress or technical dislocation.
Sit with the ideas.
A company's CDS spread widens from 80 basis points to 350 basis points over three months, but its stock price has barely moved. What should an equity investor conclude?