Analyzing Credit Default Swaps

Analyzing Credit Default Swaps

Interprets CDS markets with basis analysis, curve dynamics, and credit event monitoring.

When To Use

• Evaluating single-name or index CDS spreads for relative value or directional views
• Monitoring credit events (failure to pay, restructuring, bankruptcy) and their settlement implications
• Analyzing CDS-bond basis to identify mispricing between cash and synthetic credit exposure
• Assessing CDS curve shape (term structure) for credit deterioration or recovery signals
• Building or unwinding CDS positions as part of hedging or speculative strategies

Inputs To Gather

• Reference entity and tier: Identify the reference entity, seniority (senior unsecured, subordinated), and applicable restructuring clause (CR, MR, MM, XR) [VERIFY clause convention by region — CR for North America, MM/MR common in Europe]
• CDS spread data: Current and historical par spreads across standard tenors (1Y, 3Y, 5Y, 7Y, 10Y); source (e.g., Markit, Bloomberg CDSW)
• Cash bond comparables: Comparable bond yields, asset-swap spreads, or Z-spreads for basis analysis
• Recovery rate assumptions: Market-implied recovery vs. historical sector recovery rates
• Credit event triggers: Any pending or recent ISDA Determinations Committee rulings, succession events, or restructuring notices
• Index context: Relevant CDS index series (CDX.NA.IG, CDX.NA.HY, iTraxx Europe) and the entity's index membership/weight

Workflow

1. Establish the reference entity profile

   • Confirm ISDA documentation terms: 2003 or 2014 definitions, applicable restructuring type
   • Note the deliverable obligation characteristics and any cheapest-to-deliver (CTD) considerations
   • Identify sector, rating, and recent rating agency actions

2. Analyze spread levels and curve dynamics

   • Plot the CDS term structure; assess steepness or inversion
   • A steep curve suggests near-term stability with longer-term concern; an inverted curve signals acute near-term stress
   • Compare current spread to 6-month, 1-year, and 3-year percentile ranks
   • Decompose spread moves into systematic (index/sector beta) vs. idiosyncratic components

3. Compute and interpret the CDS-bond basis

   • Basis = CDS spread − asset-swap spread (or Z-spread) of comparable cash bond
   • Negative basis (CDS tighter than cash): may indicate a negative basis trade opportunity (buy bond + buy protection)
   • Positive basis (CDS wider than cash): often driven by funding costs, repo availability, or counterparty risk
   • Evaluate basis stability — transient dislocations vs. structural factors (e.g., illiquid bond, CTD optionality)

4. Monitor credit event risk

   • Track ISDA DC filings and credit event notices at www.cdsdeterminationscommittees.org [VERIFY current URL]
   • For restructuring events, assess whether the event qualifies under the applicable restructuring clause
   • Model auction settlement mechanics: recovery rate scenarios, deliverable basket composition, and potential CTD dynamics
   • Flag succession events that may split or reassign CDS contracts

5. Assess relative value and positioning

   • Compare single-name spread vs. index-implied spread (intrinsic spread) for rich/cheap signals
   • Evaluate curve trades: flatteners (sell long-dated / buy short-dated protection) vs. steepeners
   • For index positions, calculate jump-to-default (JTD) exposure and skew between index and constituent spreads
   • Size positions using DV01 (spread duration × notional) and consider roll-down P&L over the holding period

6. Evaluate counterparty and collateral factors

   • Note CSA terms, margin thresholds, and potential collateral calls under stress scenarios
   • For large notional positions, consider market impact and liquidity (bid-ask spreads widen significantly beyond ~$10M notional in off-the-run names) [VERIFY liquidity thresholds for specific names]

Output

• Spread summary table: Current spreads by tenor, change over 1D/1W/1M/3M, percentile rank
• Basis analysis: Computed basis with explanation of drivers; flag actionable dislocations
• Curve assessment: Shape characterization (steep, flat, inverted) with historical context
• Credit event status: Active or pending ISDA DC determinations; settlement timeline if applicable
• Trade recommendation or risk flag: Directional view, relative value trade, or risk warning with defined entry/exit levels and stop-loss thresholds
• Key risks and limitations: Model assumptions, data staleness, liquidity caveats

Quality Checks

• Confirm restructuring clause matches regional convention and ISDA documentation version
• Verify that spread data source and snapshot time are consistent across tenors
• Cross-check basis calculation inputs — ensure bond and CDS reference the same seniority and maturity bucket
• Validate recovery rate assumptions against both market-implied and historical benchmarks
• Ensure any credit event analysis references the correct ISDA Definitions (2003 vs. 2014) and applicable supplement [VERIFY which supplement applies to the specific event type]
• Flag any data points older than 24 hours as potentially stale in fast-moving credit situations
• Confirm index series is on-the-run and that roll effects are accounted for when comparing to off-the-run data