Credit Default Swaps: What Happens in a Credit Event

When a credit event occurs, the protection seller must compensate the protection buyer for the loss, typically by paying the difference between the bond’s face value and its post-default market value, or by delivering the defaulted bond in exchange for the full notional amount. The exact process depends on the terms of the CDS contract and the type of credit event triggered. This article explains the mechanics, the types of credit events, and what both parties should expect.

Formula

The protection payout is calculated as:

Payout = Notional × (1 – Recovery Rate)

Where:

• Notional (USD) – the face value of the debt covered by the CDS.
• Recovery Rate (%) – the percentage of face value the bondholder expects to recover after default (e.g., 40% means the bond trades at 40 cents on the dollar).

The buyer’s remaining loss is simply Notional × Recovery Rate, because they receive the payout but still lose the recovered amount (which they would have received from the bond itself).

Worked Example

Using the default values: Notional = $1,000,000, Recovery Rate = 40%.

1. Convert recovery rate to decimal: 40 / 100 = 0.4
2. Calculate loss fraction: 1 – 0.4 = 0.6
3. Payout = $1,000,000 × 0.6 = $600,000
4. Buyer’s remaining loss = $1,000,000 × 0.4 = $400,000

The protection seller pays $600,000, and the buyer still loses $400,000 (which they would have recovered from the bond).

What Is a Credit Event?

A credit event is a formal trigger defined in the CDS contract that obligates the protection seller to pay. The International Swaps and Derivatives Association (ISDA) publishes standard definitions, and most contracts reference them. The most common credit events are:

• Bankruptcy – the reference entity (the borrower) files for bankruptcy or is insolvent.
• Failure to Pay – the borrower misses a scheduled interest or principal payment after a grace period.
• Restructuring – the terms of the debt are changed in a way that reduces the creditor’s rights, such as extending maturity or lowering the coupon, often due to financial distress.
• Obligation Acceleration – the debt becomes due earlier than scheduled due to a default clause.
• Obligation Default – a default occurs that allows the creditor to accelerate the debt, even if not yet accelerated.
• Repudiation/Moratorium – a government or entity rejects or suspends its debt obligations.

Not all contracts include all events; for example, restructuring is often excluded in North American corporate CDS.

How Settlement Works

Once a credit event is declared (usually by a committee or via a public notice), settlement occurs in one of two ways:

• Physical Settlement – the protection buyer delivers the defaulted bond (or another eligible obligation) to the seller, who pays the full notional amount. This is the classic method and still common for single-name CDS.
• Cash Settlement – the seller pays the buyer the difference between the notional and the market value of the bond after default. The market value is often determined by an auction process run by ISDA and data providers.

Most modern CDS contracts allow either party to choose physical settlement, but cash settlement has become more common because it avoids the need to deliver physical bonds. The auction process sets a final price (the recovery rate) that is used for cash settlement.

Common Problems and Misconceptions

One frequent misconception is that a CDS is like an insurance policy that pays out immediately upon default. In reality, the payout is based on the loss given default, not the full notional. If the recovery rate is 40%, the buyer only receives 60% of the notional. Another issue is the definition of “credit event� – not every default triggers a payout. For example, a technical default (like a missed covenant) may not be a credit event unless it leads to failure to pay or bankruptcy.

Another problem is the basis risk: the CDS may reference a specific bond, but the buyer might hold a different obligation of the same entity. If the reference obligation is not the one that defaults, the settlement may not match the buyer’s actual loss. Also, the auction process can be illiquid for less-traded names, leading to a recovery price that differs from what a private sale would fetch.

How to Read the Result

The payout calculation above gives the gross compensation from the protection seller. The buyer’s net loss is the notional minus the payout, which equals the recovery amount. In practice, the buyer also pays periodic premiums (the CDS spread) to the seller, so the total cost of protection is the sum of premiums plus any loss not covered by the payout. For a hedger, the goal is to match the payout with the loss on the underlying bond, so the recovery rate used should be close to the actual market recovery.

Costs and Practical Considerations

The cost of a CDS is the premium, quoted as a percentage of the notional per year (e.g., 100 basis points = 1%). The premium is paid quarterly. In addition, there may be upfront payments if the contract is not at par. For the protection seller, the risk is that a credit event occurs and the payout exceeds the premiums collected. Sellers often hedge their exposure or require collateral.

Note that the recovery rate is not known until after the default. The auction process determines it, and it can vary widely – from near zero for distressed credits to 60% or more for senior secured debt. The calculator above uses a user-input recovery rate, which is an estimate.

Alternatives to CDS

Investors seeking credit protection can use other instruments:

• Credit-linked notes – a bond whose principal is reduced if a credit event occurs.
• Total return swaps – one party pays the total return of an asset (including losses) in exchange for a floating rate.
• Short selling the bond – selling borrowed bonds to profit from a price decline, though this carries its own risks.
• Buying put options on the bond or on a credit ETF – a simpler but less precise hedge.

Each alternative has different liquidity, cost, and basis risk characteristics.

Frequently Asked Questions

What exactly triggers a credit event?

The contract defines it, but the most common triggers are bankruptcy, failure to pay after a grace period, and restructuring. The ISDA Credit Derivatives Definitions list the standard events, and parties can choose which ones to include.

How is the recovery rate determined?

For cash settlement, ISDA runs an auction where dealers submit bids and offers for the defaulted bonds. The final price is the recovery rate. For physical settlement, the buyer delivers the bond and receives the full notional, so the recovery rate is effectively the market price of the bond at delivery.

Can a credit event be triggered by a rating downgrade?

No. A rating downgrade is not a credit event under standard ISDA definitions. It may affect the CDS spread, but it does not trigger settlement.

What happens if the protection seller goes bankrupt?

The buyer faces counterparty risk. If the seller defaults before a credit event, the buyer may lose the protection and only recover a fraction of the claim through bankruptcy proceedings. This is why collateral and central clearing are used.

Is a CDS the same as buying insurance?

Superficially similar, but CDS are not regulated as insurance and do not require an insurable interest. You can buy protection on a bond you do not own (a naked CDS), which is often used for speculative purposes.

What is the difference between single-name and index CDS?

A single-name CDS covers one entity, while an index CDS (like the CDX or iTraxx) covers a basket of names. Index CDS settle based on the weighted average recovery of the defaulted names in the index.

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in t | Notional amount (USD) | USD | 1000000 | 0
in r | Recovery rate (%) | % | 40 | 0 | 100
out payout | Protection payout (USD) | USD | t * (1 - r/100) | 2
out loss | Buyer's loss after payout (USD) | USD | t * (r/100) | 2