What is a Credit Default Swap & How Does it Work?

Credit default swaps (CDS) are financial derivatives that operate much like insurance for bonds or loans. They allow one party to transfer the credit risk of a borrower—typically a corporation or government entity—to another party. In a CDS agreement, the buyer makes regular premium payments to the seller, who in turn agrees to compensate the buyer in the event of a credit event, such as a default, bankruptcy, or restructuring. While the CDS buyer does not hold the underlying bond, the contract reflects market sentiment around the borrower’s creditworthiness.

CDS contracts fall within the broader category of credit derivatives, which are used to manage or trade credit exposure. More generally, swaps are bilateral agreements in which two parties exchange cash flows or financial risks tied to specific instruments. Common examples include interest rate swaps, currency swaps, and credit default swaps—each serving distinct roles in risk management and market positioning.

CDS gained significant attention during the 2008 financial crisis, when they were widely used to hedge or speculate on subprime mortgage debt. Today, they remain an integral part of the fixed income and credit markets, employed by banks, hedge funds, and institutional investors to manage credit exposure or express views on changing credit conditions.

At their core, credit default swaps are about managing risk—specifically, the risk that a borrower won’t pay back their debt. For investors holding corporate or sovereign bonds, that risk can be significant. Credit default swaps (CDS) offer a way to protect against that possibility by allowing investors to effectively “insure” themselves against a default. But CDS can also be used by traders looking to profit from changes in perceived credit risk, without ever owning the underlying bond.

In a typical CDS agreement, one party agrees to pay regular premiums in exchange for protection against a credit event—such as a missed payment, bankruptcy, or debt restructuring—affecting a specific issuer. The party providing that protection receives those premiums, but if the issuer defaults during the life of the contract, they must compensate the buyer for the loss. That payout is usually calculated as the difference between the bond’s face value and its market value after default.

To illustrate: imagine a fund owns $10 million worth of corporate bonds from a company with shaky finances. To hedge that exposure, the fund enters into a CDS contract, paying annual premiums to a protection seller. If the company defaults and the bonds fall to 40 cents on the dollar, the CDS seller pays the fund $6 million—the difference between the original value and the current market price—helping to offset the loss.

CDS contracts don’t require the buyer to own the underlying bond, which makes them a versatile instrument. But that same flexibility also means they can be used for speculation, not just insurance—raising both opportunities and risks for market participants.

Credit default swaps (CDS) come in several forms, each tailored to different credit instruments, portfolio strategies, and risk exposures. While all CDS contracts revolve around protecting against credit events—such as default, bankruptcy, or restructuring—the structure of the underlying reference asset or basket can vary. Some are linked to a single issuer, while others reflect a group of names, or even a specific layer/category of risk.

Outlined below are some of the most common types of CDS and how they are sometimes used. 

Credit default swaps (CDSs) serve multiple purposes in modern finance, from risk management to active trading strategies. While they were originally designed to hedge against credit losses, CDS contracts have evolved into a flexible tool for expressing views on credit risk—without needing to own the underlying bond or loan. Their versatility makes them essential instruments for investors, banks, hedge funds, and asset managers operating in fixed income or credit-sensitive portfolios.

Some of the primary ways that CDS are used today are highlighted below. 

Hedging

The most traditional use of a CDS is to hedge credit exposure. Investors who hold corporate or sovereign bonds can buy CDS protection to guard against the risk of default or restructuring. If the borrower fails to meet its obligations, the CDS payout helps offset losses on the bond position. This type of credit insurance is especially useful in volatile markets, or when managing concentrated positions.

Speculation

CDS can also be used to take directional views on credit risk. A trader who believes a company’s creditworthiness will deteriorate can buy CDS protection, betting that the cost of insuring that risk (the spread) will rise. If they’re right, the CDS increases in value. Conversely, selling CDS protection is a way to bet that credit conditions will improve and collect premium income. 

Arbitrage

Credit traders often use CDS in arbitrage strategies, also known as “relative value.” One common approach involves identifying a mispricing between a company’s CDS and its bonds. For example, if the CDS spread implies more credit risk than the bond yield indicates, a trader might buy the bond and buy protection via CDS—locking in a pricing mismatch. This is sometimes called capital structure arbitrage, where investors trade different parts of a company’s capital structure—like debt vs. equity or loans vs. CDS—to profit from perceived mispricings

Portfolio Diversification

CDS contracts give investors a way to get exposure to credit markets without actually owning bonds. Instead of buying dozens of individual corporate or government bonds, investors can use CDS indices—like CDX in the U.S. or iTraxx in Europe—which bundle together many companies into one product. This means an investor can make a single trade and still gain exposure to a wide group of issuers. It’s a simple and efficient way to diversify credit risk, while also keeping the portfolio more liquid and flexible. For asset managers or institutions, it’s a useful tool to either invest in or protect against changes in the credit market—without needing to buy and manage all the underlying bonds directly.

Synthetic Credit Exposure

Sometimes investors want exposure to a particular company or credit sector but can’t access the actual bonds—due to liquidity constraints, regulatory issues, or other reasons. CDS offer a way to create synthetic exposure, allowing traders to express long or short views on credit without owning the underlying asset. This makes CDS especially useful in markets where bonds are thinly traded or hard to source.

Capital and Regulatory Efficiency

Banks and large financial institutions often use CDS to manage regulatory capital requirements. By offloading credit risk to third parties via CDS, a bank can reduce the amount of capital it needs to hold under frameworks like Basel III. This improves balance sheet efficiency while still maintaining economic exposure to the borrower—just through a synthetic rather than physical position.

While credit default swaps can be complex, their core purpose—managing or trading credit risk—can be understood through relatively simple use cases. Below are two straightforward examples that help illustrate how different types of CDS are used in practice, depending on the investor’s outlook and goals.

Credit default swaps offer significant strategic flexibility and can be highly effective in managing credit exposure—but they also carry a distinct set of risks. These risks affect both buyers and sellers and are often less visible than those in traditional credit instruments. The degree of risk depends on several variables, including the structure of the contract, the creditworthiness of the counterparty, and prevailing conditions in the broader credit market.

Key considerations for investors include the financial health of the reference entity, the counterparty’s reliability, and the potential for unintended consequences—such as liquidity disruptions or ineffective hedging. As with all derivatives, CDS contracts demand precise documentation, careful position sizing, and disciplined risk oversight. Without these safeguards, even well-structured trades can lead to disproportionate losses or legal and operational challenges.

Below are some of the most important risks associated with credit default swaps.

For a credit default swap to pay out, a defined credit event must occur. These events are the official “triggers” of a CDS contract, and are set by industry standards—most notably through the International Swaps and Derivatives Association (ISDA). The most common triggers include failure to pay, bankruptcy, or restructuring. In practice, that means if the borrower misses an interest or principal payment, files for bankruptcy, or changes the terms of its debt in a way that disadvantages creditors, the CDS may be activated and compensation could be owed to the buyer of the CDS. 

That said, these triggers aren’t always as straightforward as they sound. A company may delay payments or restructure its debt in a way that skirts technical default—raising questions about whether the event qualifies under the terms of the CDS. In these cases, a determination is made by a committee of market participants (the ISDA Determinations Committee), which evaluates the event and decides whether it meets the threshold for a payout. This introduces a degree of legal and procedural uncertainty to the CDS process. 

Looking at an example, imagine a company is struggling financially, and negotiates with bondholders to extend debt maturities and reduce the principal owed—the type of restructuring that clearly signals distress. But unless that restructuring is deemed “coercive” or “materially adverse” to creditors under ISDA rules, it may not trigger a payout. This scenario underscores the importance of understanding not just the CDS spread, but also how and when the contract is triggered—and what specifically counts as a “qualifying event.”

Credit default swaps played a significant role in the 2008–2009 Financial Crisis, not because they failed to function as designed, but because their widespread use and lack of oversight amplified systemic risk. In the years leading up to the crisis, CDS were heavily used to insure mortgage-backed securities (MBS), including large volumes of subprime debt. Many investors—banks, hedge funds, and insurance companies—used CDS to gain exposure to mortgage markets or to hedge against potential losses. However, the scale of the exposure and the concentration of risk among a few counterparties became a major problem once defaults began to rise.

One of the most high-profile examples was AIG, which had written massive amounts of CDS protection on mortgage-related products without holding enough capital to cover potential payouts. When defaults surged and CDS holders demanded compensation, AIG lacked the liquidity to meet its obligations—threatening a broader financial collapse. The U.S. government stepped in with a bailout, injecting over $180 billion to stabilize the company, and prevent a chain reaction that could have brought down other institutions relying on AIG’s protection.

The crisis revealed several key weaknesses in the CDS market: insufficient transparency, inadequate risk controls, and high counterparty risk. These issues weren’t unique to the CDS market, but the opaque nature of over-the-counter derivatives made it harder to assess who was exposed and by how much. In response, post-crisis policy reforms focused on increased regulation, mandatory clearing for many CDS contracts, and improved transparency—measures aimed at reducing the kind of systemic risk that CDS helped expose during the crisis.

While both credit default swaps (CDS) and loan credit default swaps (LCDS) serve the same fundamental purpose—providing protection against credit events—they are tied to different types of debt instruments. Traditional CDS contracts are typically linked to corporate bonds, whereas LCDS are associated with syndicated secured loans, which are commonly issued by highly leveraged borrowers.

Because loans differ from bonds in structure—often featuring higher recovery rates, more robust collateral arrangements, and different legal frameworks—LCDS contracts are specifically designed to account for these distinctions. Although the basic mechanics remain similar (the buyer pays a premium for protection against default or restructuring), the nuances in contract terms, recovery assumptions, and credit event definitions can differ between the two.

CDS contracts are widely used across corporate and sovereign bond markets, while LCDS are more niche, primarily utilized by banks, collateralized loan obligation (CLO) managers, and institutional investors focused on the leveraged loan space.

Credit default swaps (CDS) are legal, regulated instruments widely used across global financial markets. In the United States, they fall under the oversight of regulatory bodies such as the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). In the wake of the 2008 financial crisis—where CDS played a prominent and controversial role—sweeping regulatory reforms were implemented to strengthen transparency, mitigate systemic risk, and enhance market stability.

One of the key changes has been the increased use of central clearing. Today, many CDS contracts are processed through central counterparties (CCPs), which help reduce counterparty risk and promote market integrity. While CDS have drawn criticism in the past for enabling speculative bets and contributing to market volatility, they remain a vital tool for managing credit risk, hedging portfolios, and facilitating price discovery. When used responsibly, CDS are a legitimate and effective component of modern credit markets—employed by banks, asset managers, insurers, and institutional investors worldwide.

A CDS spread represents the cost of purchasing credit protection on a specific borrower, quoted in basis points (1 basis point = 0.01%). It reflects the market’s assessment of the issuer’s credit risk: the higher the spread, the greater the perceived likelihood of default. For example, a spread of 50 basis points suggests the borrower is viewed as relatively low risk, whereas a spread of 500 basis points indicates elevated credit concerns. Because CDS markets respond in real time, spreads often move ahead of changes in credit ratings or bond prices—making them a forward-looking indicator of creditworthiness.

Beyond individual issuers, CDS spreads also serve as valuable macroeconomic indicators. Broad-based widening in spreads across sectors or regions often signals rising market anxiety about credit conditions—typically in response to events such as economic downturns, financial instability, or tightening monetary policy. Conversely, narrowing spreads tend to reflect improving sentiment and a willingness among investors to take on additional credit risk.

In this way, CDS spreads function not only as a pricing tool for individual credit risk, but also as a real-time barometer of broader market sentiment and systemic stress.

• Credit default swaps (CDS) are financial contracts that allow investors to protect against the risk of a borrower defaulting on their debt.

• A CDS buyer pays a regular premium to a protection seller in exchange for a payout if a credit event—such as default, bankruptcy, or restructuring—occurs.

• CDS can be used for hedging, speculation, arbitrage, or to gain synthetic exposure to credit risk without owning the underlying bond or loan.

• Common types of CDS include single-name CDS, index CDS (like CDX or iTraxx), tranche CDS, loan CDS (LCDS), and sovereign CDS.

• CDS spreads reflect market-perceived credit risk—the higher the spread, the higher the expected chance of default.

• Widespread CDS spread widening can indicate broader credit market stress, while tightening spreads often reflect improved investor confidence.

• CDS contracts are legal and regulated, with reforms after the 2008 financial crisis requiring more transparency and clearing of trades.

• Risks include counterparty risk, liquidity risk, basis risk, documentation issues, and mark-to-market volatility—especially during market disruptions.

• CDS payouts depend on clearly defined credit events, which are sometimes subject to legal interpretation or committee rulings.

• Used properly, CDS can be valuable tools for managing credit exposure—but they require strong risk management and a solid understanding of how the instruments work.