A credit default swap (CDS) is a financial contract where the buyer of the contract pays a regular premium to the seller in exchange for the seller agreeing to pay the buyer the face value of a bond if the issuer of the bond defaults.

A CDS is analogous to an insurance policy. If the issuer company defaults on its debt, the seller of the CDS pays the buyer the face value of the debt. In return, the buyer pays a regular premium. This mechanism is similar to an insurance policy.

The CDS spread is like the insurance premium. The CDS spread is the cost of buying protection against the default of a particular bond issuer. It represents the annual premium (expressed in basis points) that the buyer of the CDS must pay to the seller to insure against the risk of the bond issuer defaulting. For example, if a CDS spread is 2% or 200 basis points (bps), then the buyer of the CDS pays 2% of the bond’s face value per year to the seller of the CDS to protect against the risk of default. 

The higher the company’s risk profile, the higher the premium-payable spread to the buyer. Hence, if the CDS spread is high, it signifies that the investors believe that the issuer company is more prone to default. 

Understanding the Relationship Between CDS Spread and Bond Yield Spread

The yield spread of any corporate bond refers to the difference between the yield in the corporate bond and the yield in an equivalent-risk-free bond, like treasury bonds. This spread compensates the investor for the additional risks involved when taking a position in a corporate bond rather than on an equivalent risk-free bond.

Ideally, the spread of the CDS should thus approximate the spread of the yield on the bond since both represent the same credit risk concerning the issuer of the bond. Spread gaps or mismatches that might exist between the CDS and the yield on the bond give rise to arbitrage opportunities where one can generate returns higher than the risk-free rate or borrow at a lower than the risk-free rate.

Examples When CDS Spread ≠ Bond Yield Spread

1. CDS Spread is Lower than Bond Yield Spread

Scenario: A corporate bond has a yield of 7%, while the corresponding risk-free bond yield is 5%, giving a bond yield spread of 2%. However, the CDS spread is only 1.5% (150 bps).

Strategy:
Buy the Corporate Bond: Earn 7% per year.
Buy CDS Protection: Pay 1.5% per year for protection against default.
Net Yield: The investor nets 5.5% (7% – 1.5%).
Result: The net yield of 5.5% is higher than the 5% risk-free rate. In this case, the investor earns more than the risk-free rate by buying the corporate bond and hedging the risk with a CDS. The investor benefits from a net yield higher than the risk-free rate and is protected in case of default by the CDS contract. In the event of a default, the principal is recovered and can be reinvested.

2. CDS Spread is Higher than Bond Yield Spread

Scenario: Suppose the same corporate bond yields 7%, but the risk-free yield is 5%, giving a bond yield spread of 2%. This time, the CDS spread is 2.5% (250 bps).
Strategy:
Short the Corporate Bond: Borrow at 7% by selling the bond
Sell CDS Protection: Earn 2.5% per year by taking on the risk of default.
Net Cost/Yield: The investor needs to pay 7% for shorting the bond but earns 2.5% from selling the CDS.
The net cost is 4.5% (7% – 2.5%).
Result: The net cost of 4.5% is lower than the 5% risk-free rate. Here, the investor effectively borrows money at a rate lower than the risk-free rate by shorting the bond and selling CDS protection. The investor benefits by borrowing at a lower cost than the risk-free rate but assumes the risk of default. If the issuer defaults, the investor (as the CDS seller) is liable to pay the bond’s face value.

The study of the relationship between the spread of CDS and the yield spread of bond can give good insights about the credit risk and any arbitrage opportunities in the $10 trillion CDS markets. Knowledge of the nuances of these two spreads enables investors to better control their risk and opens the way for finding profitable opportunities.