The mechanics of Credit Default Swaps

Credit Default Swaps (CDS) are derivatives that enable an investor to swap or offset their credit risk (the risk that a borrower defaults on meeting its repayment obligations). It allows the transfer of credit risk from one counterparty to another.

That might sound intimidating but at its heart a CDS is essentially a form of insurance against a borrower failing to repay its debt.

What is credit risk?

Whenever someone lends money there is a risk that the borrower might default, i.e. not pay back the lender. For a bondholder a default would mean not receiving either the coupon (the regular interest payment on the bond) or the principal (the par value of the bond at maturity). This risk is called credit risk.

Differing views on credit risk is something that investors can potentially exploit, either by identifying bonds where the yields on offer either over or under-compensate for the risk.

One way to do that is by owning the physical bonds an investor likes and avoiding those they do not. Another way is by expressing a view on the creditworthiness of a bond issuer through a derivative such as a CDS.

CDS usage among investors – especially professional and institutional investors – is very common. In fact, during the first nine months of 2025 the combined European and US CDS traded notional value was US$24.6 trillion.1 This massive figure demonstrates just how widely used CDS are as both a risk management and investment tool.

¹Source: ISDA (International Swaps and Derivatives Association), Credit Derivative Trading Activity Reported in EU, UK and US Markets: Third Quarter of 2025 and Year-to-September 30, 2025, January 2026. Traded notional is the total value of the underlying asset represented in a contract.

CDS: The basics

So how does an investor use CDS?

A CDS is a contract between two parties:

• The protection buyer who wants insurance against default
• The protection seller who agrees to compensate the buyer if default occurs

In exchange for this protection, the buyer pays a regular fee, known as the CDS premium or spread.

Buying protection is equivalent to taking a short position. The protection buyer (the CDS buyer) has effectively gone “short” the bond and will benefit when the reference entity’s credit quality deteriorates. Essentially, a buyer of CDS believes that the cost of insuring debt against default will rise. The buyer pays a premium (akin to an insurance premium and typically paid quarterly or semi-annually) to the seller.

Selling protection is equivalent to taking a long position. The seller receives the premium but is obligated to make the buyer whole again if the bond defaults. From a risk perspective, selling a corporate bond CDS means selling protection (and receiving premiums) and is equivalent to owning or being “long” the bond. This position will generate positive mark-to-market present value changes if the reference entity’s credit quality improves and credit spreads narrow during the life of the position.

CDS can therefore be useful in fund management as it allows the fund manager to express either a positive or negative view on a bond.

It is not necessary to own the bond to hold a CDS

Unlike traditional insurance (say on a house or car) you do not need to own the bond to buy a CDS on it. An investor can buy a CDS purely as a bet that a company’s creditworthiness will deteriorate. If they are wrong, then they have lost out as they have paid premiums for nothing.

For the CDS seller, they can sell CDS and collect the premiums in the hope that they will not have to pay out on the bond. CDS are unaffected by a bond being called early because unlike bondholders who when repaid need to identify another bond to invest in (reinvestment risk), the CDS seller continues to receive the premium from the counterparty to the end of the CDS contract.

CDS Indices

As well as CDS for individual issuers, there are also CDS indices which operate in a similar manner but allow an investor to express a view on a basket of companies or the wider corporate bond market.

Standardised contracts

The market has steadily moved towards standardised CDS contracts, typically these trade to 20 June and 20 December standardised maturity dates, and the contracts have a 100 basis points (bps) spread for investment grade bonds and 500bps for high yield (aligned with the CDS indices). This standardisation is useful because it makes valuation and trading much easier. It means buyers and sellers of CDS can open and close positions with multiple counterparties who can then enter into netting arrangements with each other. This is typically done at a Clearing House, which is essentially an intermediary that deals with both sellers and buyers of CDS.

The contract will include key terms such as

• Reference entity: the company whose credit risk is being traded.
• Notional amount: The total face value of the debt being protected.
• Maturity date: The period over which the contract runs, e.g. 3 or 5 years.

How is a CDS priced?

The price of a CDS will reflect a large number of factors, from the outlook for the specific company to the macroeconomic environment. Rising CDS spreads signal increasing default risk, while falling CDS spreads suggest improving credit quality. When there is heavy demand for protection, spreads rise. When there is heavy selling of protection, spreads fall. CDS spreads are constantly changing, reflecting the view of the creditworthiness of the borrower and the market environment.

Often when there has been a default, the lender can recover some value. The percentage that might be recovered is known as the recovery rate so the market value of a bond may be higher than zero after default. An average recovery rate might be 40% but the range can vary significantly.

In a very simplified formula:

Probability of default x loss given default = CDS spread

Taking the example above and assuming annual default probability is 2% and the loss given default is 60% (100-40% recovery) then CDS spread would be:

2% x 60% = 1.2% or 120 basis point spread

The buyer of protection would pay 120 basis points or 1.2% of the notional value of the contract each year to the seller for the length of the contract. For example, if a 5-year CDS is quoted at 120 basis points, and the notional value of the contract is $1 million, the buyer would pay $12,000 per annum (= $1 million x 1.2%) in return for the credit protection.

So how does that square with the standardised contracts? If an investment grade company’s CDS should be priced at 120 basis points, the seller does not want to be receiving only 100 basis points. To resolve this, the buyer of protection would pay an upfront payment to the seller that would make up the difference. The opposite would be true if the spread was lower than 100 basis points; the seller would need to make an upfront payment at the inception of the contract to the buyer to reflect the fact that the cashflows to be received each year are too generous.

Cash flows on CDS contracts

Source: Janus Henderson Investors. Simplified example for illustrative purposes only.

What happens if a bond defaults?

A CDS payout is triggered by specific events, called credit events, which are defined in the contract. Common examples include:

• Failure to pay interest or the principal
• Bankruptcy or insolvency
• Debt restructuring that is harmful to the lender

The exact definition of what counts as a default matters, so the legal wording has to be precise. Contracts are generally based on ISDA (International Swaps and Derivatives Association) Master Agreements, which dictate the terms for settlement.

When a credit event occurs, the CDS contract is settled in one of two ways:

• Cash settlement: The seller pays the buyer the difference between the bond’s face value and its market value after default.
• Physical settlement: The buyer delivers the defaulted bond to the seller and receives its full face value.

In practice, a CDS seller would a) aim to avoid holding exposure to an issuer that defaults and b) seek to go the other way on the contract if they began to lose conviction in the position and in so doing seek to limit the loss.

CDS contacts are mark-to-market. If perceived credit risk rises, credit spreads widen and the seller’s position may show a mark-to-market loss. They must post collateral (margin) even though no default has happened. The seller will of course receive the collateral back if the default does not occur.

Many of the risks facing a CDS buyer and seller are not much different to those facing any fixed income investor. For a CDS seller the biggest risk is that the borrower defaults and they have to pay the CDS buyer. Both sides face potential counterparty risk – the risk that the other side fails to honour the contract – however, with the move to central counterparty clearing, this risk is very much diminished.

Summary

In summary, CDS are commonly used in investment management to express views on the creditworthiness of borrowers. For buyers of CDS, they can help to mitigate risk, while sellers of CDS can earn a premium. Both buyers and sellers can also trade CDS, hoping to exploit movements in spread during the course of a contract. CDS have become an increasingly important tool in investment management and we anticipate the market to continue to grow over the coming years.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Derivatives

can be more volatile and sensitive to economic or market changes than other investments, which could result in losses exceeding the original investment and magnified by leverage.