Credit Default Swaps as Market Signals
Credit default swaps (CDS) function as the bond market's real-time stress detector. When Credit Suisse CDS spreads jumped 36 bps in a single day to hit 453 bps in March 2023, the derivatives market was pricing a 23% five-year default probability three days before the Swiss National Bank's emergency intervention. In research covering 18 defaulting corporates, CDS spreads widened progressively relative to high-yield peers starting 18 months before credit events (Fitch Ratings, 2010). The practical application: CDS spreads tell you what sophisticated credit traders are willing to pay for protection right now (not what rating agencies concluded six months ago).
What CDS Spreads Actually Measure (The Pricing Mechanism)
A credit default swap is an insurance contract on corporate debt. You pay a premium (the "spread") to a protection seller; if the company defaults, you get compensated.
The mechanics:
- Protection buyer pays periodic premiums (quoted in basis points per year)
- Protection seller pays face value minus recovery if credit event occurs
- Standard coupons: Investment-grade contracts trade at 100 bps fixed; high-yield at 500 bps fixed
- Most liquid maturity: 5-year (where price discovery concentrates)
The spread you observe isn't just expected loss. It contains three components:
Spread = Default Risk + Liquidity Premium + Risk Appetite Premium
Why this matters: A spread of 300 bps doesn't mean the market expects a 3% default. Assuming 40% recovery rate, the implied annual default probability is closer to 5% (300 / 60 = 5%). But even that overstates real-world default risk because CDS prices embed risk premium beyond actuarial expectations.
The CDS-Bond Basis (Where the Arbitrage Lives)
The CDS-bond basis is the difference between CDS spread and bond credit spread for the same issuer and maturity.
The formula: Basis = CDS Spread - Bond Spread (typically measured against Z-spread or asset swap spread)
| Basis Type | Definition | What It Signals |
|---|---|---|
| Positive basis | CDS wider than bond spread | Informed traders buying protection; bonds potentially mispriced |
| Negative basis | CDS tighter than bond spread | Arbitrage opportunity (buy bond + buy CDS protection) |
The practical signal: In March 2024, European corporate CDS-bond basis dipped below zero for the first time in nearly four years. Arbitrageurs who could execute negative basis trades (buying bonds while buying CDS protection) locked in risk-free spread.
Why basis trades are hard to execute:
- Matching maturities on CDS and bonds is expensive
- Balance sheet constraints consume arbitrage profit
- Liquidity differs between markets (harder to exit one leg)
The point is: Widening positive basis (CDS spreads expanding faster than bond spreads) signals that informed traders are buying protection. This often precedes bond price declines by days or weeks.
CDS as Leading Indicators (The Research Evidence)
Academic research confirms what credit traders have long observed: CDS markets price information faster than bond markets.
The evidence base:
| Study | Key Finding |
|---|---|
| Blanco, Brennan & Marsh (2005) | CDS spreads lead bond spreads by 1-3 trading days in price discovery |
| Acharya & Johnson (2007) | CDS spreads widen before negative credit events, especially for firms with more bank relationships |
| Journal of Banking & Finance (2022) | Five-year CDS spread predicts corporate default for horizons up to 12 months |
| Fitch Ratings (2010) | Defaulting corporates showed CDS spread divergence 18 months before credit events |
The mechanism: Banks with private information from lending relationships trade CDS before public announcements (Acharya & Johnson, 2007). The CDS market aggregates this informed trading into observable spreads.
The caveat (why it's not perfect): Post-crisis regulation has reduced CDS market informativeness. Central clearing requirements and position reporting reduced speculative trading that contributed to price discovery. Credit ratings have become relatively more important information sources since 2010 (OFR Working Paper, 2024).
When CDS Signaled Stress Before the Crowd (Historical Cases)
Lehman Brothers (September 2008)
The timeline:
- Weeks before bankruptcy: One-year CDS climbed to 950 bps
- Credit rating: Remained investment-grade until days before collapse
- September 15, 2008: Chapter 11 filing; largest bankruptcy in U.S. history
What CDS told you that bonds didn't: While Lehman bonds still traded near par, CDS spreads implied severe distress. The market for protection knew what the rating agencies hadn't yet acknowledged.
The controversy: Critics argued CDS spread widening itself contributed to Lehman's collapse by eroding confidence. Defenders argued CDS merely reflected underlying reality. Either way, the CDS market was right about the outcome.
Credit Suisse (March 2023)
The signal sequence:
- March 13, 2023: Five-year CDS jumped 36 bps in single day to 453 bps (record high)
- Implied probability: Market-implied five-year default probability reached 23%
- March 16: Swiss National Bank loaned Credit Suisse $54 billion emergency liquidity
- March 19: Forced acquisition by UBS announced
The lead time: CDS spreads hit distressed levels three days before central bank intervention, six days before the forced sale announcement. Bond holders who monitored CDS had a narrow window to reduce exposure.
Post-Lehman Contagion (September 2008)
How CDS tracked systemic risk:
- Morgan Stanley CDS: Rose to 496.7 bps from 215 bps one week earlier (131% increase)
- Goldman Sachs CDS: Rose to 344.6 bps from 159.3 bps (116% increase)
The durable lesson: CDS spreads on healthy institutions widening simultaneously signals systemic stress (not issuer-specific problems). Compare your issuer's CDS to sector indices before panic selling.
Worked Example: Detecting Credit Stress Early
Your situation: You hold $500,000 in bonds from a BBB-rated industrial company. Here's how CDS monitoring would have flagged deterioration.
Week 0 (baseline):
- CDS spread: 150 bps
- Bond spread: 140 bps (positive 10 bps basis)
- Implied annual default probability: 150 / 60 = 2.5%
- Assessment: Normal levels for BBB credit
Week 1 (first warning):
- CDS widens to 220 bps while bond spread stays at 145 bps
- Basis expands to +75 bps (from +10 bps)
- Implied PD: 3.7%
- Signal: Informed traders buying protection; bonds haven't repriced yet
Week 2 (confirmation):
- CDS hits 350 bps; implied PD now 5.8%
- Bonds finally catch up: spread widens to 280 bps
- Signal: CDS warning validated; consider reducing position
Week 3 (public revelation):
- CDS at 500 bps (8.3% implied default)
- Company announces covenant violation and liquidity concerns
- Your position: If you sold in Week 1, avoided 12% of bond price decline
Week 4 (rating action):
- CDS peaks at 800 bps (13.3% implied default)
- Rating agencies downgrade to BB+ (finally)
- Bond prices down 15% from Week 0
The practical point: CDS gave a two-to-three week early warning signal. The widening positive basis in Week 1 was the clearest actionable signal.
CDS Index Signals (Tracking Market-Wide Stress)
Single-name CDS tells you about individual issuers. CDS indices tell you about entire credit markets.
The major indices:
| Index | Coverage | Normal Spread | Stressed Level |
|---|---|---|---|
| CDX.NA.IG | 125 North American investment-grade names | 50-70 bps | 150+ bps |
| CDX.NA.HY | 100 North American high-yield names | 300-400 bps | 600+ bps |
| iTraxx Europe | 125 European investment-grade names | 50-80 bps | 150+ bps |
| iTraxx Crossover | 75 European sub-investment grade names | 250-350 bps | 500+ bps |
How to use index signals:
- Your issuer CDS widens, index flat: Issuer-specific stress; investigate company fundamentals
- Your issuer CDS widens with index: Systemic stress; likely recovers with market (consider holding)
- Index widens, your issuer flat: Your credit is outperforming; possible relative value opportunity
The 2023 banking stress example: When SVB failed, JPMorgan/Bank of America/Wells Fargo CDS all widened sharply. But comparison to CDX financials sub-index showed this was contagion fear (systemic), not issuer-specific deterioration. CDS normalized within two weeks.
Converting CDS Spreads to Implied Default Probability
The simplified formula:
Annual PD = CDS Spread / (1 - Recovery Rate)
Standard assumptions:
- Investment-grade recovery: 40%
- High-yield recovery: 25-40% (depends on seniority)
Example calculations:
| CDS Spread | Recovery Assumption | Implied Annual PD | Assessment |
|---|---|---|---|
| 100 bps | 40% | 1.7% | Normal IG |
| 300 bps | 40% | 5.0% | Elevated concern |
| 500 bps | 40% | 8.3% | Distressed territory |
| 1,000 bps | 40% | 16.7% | Restructuring expected |
The caveat: These are risk-neutral probabilities (what risk-averse investors price), not real-world probabilities (what actuarially happens). CDS-implied PD typically exceeds historical default rates by 2-3x due to embedded risk premium.
Why this matters: Don't panic if CDS-implied PD seems high. Compare to historical default rates for the rating: BBB historically defaults at 0.2% annually. A CDS-implied 3% PD on a BBB credit means the market is pricing significant risk premium (not necessarily expecting 15x historical default rates).
Practical Thresholds (When to Act)
Investment-Grade Credits
- 50-150 bps: Normal range for single-A and BBB
- 150-300 bps: Elevated; monitor weekly, investigate fundamentals
- 300+ bps: Stressed; prepare contingency plan for position reduction
- 500+ bps: Distressed; market expects potential downgrade to junk
High-Yield Credits
- 300-500 bps: Normal for BB credits
- 500-800 bps: Elevated; deteriorating outlook
- 800-1,000 bps: Distressed trading
- 1,000+ bps: Restructuring or default expected
Basis Signals
- Basis widening 50+ bps in one week: Informed protection buying; bonds may follow
- Negative basis exceeding -50 bps: Potential arbitrage opportunity (if you can execute)
Mitigation Checklist (tiered)
Essential (high ROI)
These 4 actions catch most CDS-signaled stress early:
- Track 5-year CDS spread weekly for all bond holdings exceeding 5% of portfolio
- Flag any single-week widening exceeding 50 bps
- Compare issuer CDS to sector CDS index before attributing stress to issuer-specific factors
- Calculate implied default probability when CDS exceeds 300 bps for IG or 600 bps for HY
High-impact (workflow + automation)
For investors who want systematic monitoring:
- Set Bloomberg/Reuters alerts for CDS spread levels at 2x current spread for each holding
- Track CDS-bond basis weekly; widening positive basis exceeding 50 bps triggers fundamental review
- Monitor CDX.NA.IG and iTraxx Europe for market-wide stress context
- Document CDS readings at purchase; creates reference point for future comparison
Optional (good for active credit managers)
If you're managing concentrated credit exposure:
- Track term structure of CDS (1-year vs 5-year) for curve inversion signals
- Monitor CDS-implied default probability against historical rating default rates
- Review DTCC weekly data for single-name CDS trading volume spikes
Detection Signals (how you know CDS is flashing warnings)
Your credit position may be at risk if:
- CDS spread has widened more than 100 bps in the past month (while bonds barely moved)
- CDS-bond basis has expanded from near-zero to +50 bps or wider
- CDS-implied default probability exceeds 3x historical default rate for the rating
- Sector CDS index is stable but your issuer's CDS is widening (issuer-specific stress)
- CDS curve has inverted (1-year spread higher than 5-year indicates near-term stress)
Related Concepts (Use These to Think Clearly)
Causal chain for CDS signal interpretation:
Private credit information (banks, insiders) -> CDS spread widening -> Basis expansion -> Bond repricing -> Rating agency action
Connected topics:
- Credit spread components: Understanding what portion of spread is default risk vs. liquidity vs. risk appetite
- Investment-grade vs. high-yield characteristics: Different CDS spread ranges and recovery assumptions
- Leverage and coverage ratios: Fundamental drivers that eventually show up in CDS spreads
Next Step (put this into practice)
Pull CDS spread data for your largest corporate bond holding and calculate the implied default probability.
How to do it:
- Find 5-year CDS spread (Bloomberg: CDSI; or search "Ford CDS spread" or similar for your issuer)
- Assume 40% recovery rate for investment-grade, 30% for high-yield
- Calculate: Implied PD = CDS Spread (in decimal) / (1 - Recovery Rate)
Interpretation:
- PD below 2%: Normal for IG credit
- PD between 2-5%: Elevated; compare to rating peers
- PD above 5%: Stressed; investigate fundamentals immediately
Action: If CDS-implied PD exceeds 3x the historical default rate for your credit's rating, schedule a fundamental review this week.
References
- Blanco, R., Brennan, S., & Marsh, I. W. (2005). An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps. Journal of Finance, 60(5), 2255-2281.
- Acharya, V. V., & Johnson, T. C. (2007). Insider Trading in Credit Derivatives. Journal of Financial Economics, 84(1), 110-141.
- Fitch Ratings. (2010). CDS Spreads and Default Risk. Special Report, October 2010.
- OFR Working Paper 24-04. (2024). Do Credit Default Swaps Still Lead? The Effects of Regulation on Price Discovery.
- ISDA. (2024). Key Trends in the Size and Composition of OTC Derivatives Markets.
- Norden, L., & Weber, M. (2009). The Co-movement of Credit Default Swap, Bond and Stock Markets. European Financial Management, 15(3), 529-562.