Credit Default Swap Explained: How to Read a CDS Spread

Key takeaways

• A credit default swap (CDS) is a contract that works like insurance on a borrower's debt. The buyer pays a yearly premium, and the seller covers the loss if the borrower defaults or suffers another defined credit event.
• The premium is the CDS spread, quoted in basis points (bps) per year on the amount insured. One basis point is 0.01%, so a 115 bps spread on $10 million costs about $115,000 a year.
• A rough rule links the spread to default risk: annual default probability ≈ spread ÷ (1 − recovery rate). At 115 bps and a 40% recovery assumption, that is about 1.9% a year. This is a market-implied figure that includes a risk premium, not a forecast.
• Whether a credit event has happened is decided by ISDA's Credit Derivatives Determinations Committees. Payouts are then set by an auction. Greece's 2012 auction set a final price of 21.5% of face value.
• CDS are back in the news because Big Tech is borrowing heavily for AI. Meta's five-year CDS hit a record 114.79 bps on 22 October 2026, according to Reuters.

Credit default swap explained: what a CDS is

A credit default swap, explained simply, is a contract that works like insurance on a borrower's debt: the buyer pays a yearly premium, the CDS spread, and the seller pays out if the borrower defaults or suffers another credit event.

The borrower whose debt is covered is called the reference entity. It can be a company, such as Meta, or a government, such as Greece or the United States. The reference entity is not a party to the contract and does not need to know it exists.

There are two sides to every trade:

• The protection buyer pays a regular premium, usually every quarter. Banks and bond investors buy protection to hedge debt they hold. Others buy it to bet that a borrower's credit will get worse.
• The protection seller collects the premium. In return, it must pay the buyer if a credit event occurs, roughly the face value of the debt minus what the debt is still worth after the event.

Unlike ordinary insurance, the buyer does not have to own the underlying bonds. That is why CDS can be used both to hedge and to speculate. Cornell Law School's Legal Information Institute describes a CDS as a derivative in which two parties exchange the risk that a credit instrument will default. It also notes that the Dodd-Frank Act gave US regulators, the SEC and the CFTC, authority over the swaps market that includes CDS.

The market is large but small next to the whole derivatives world. The Bank for International Settlements (BIS) reported total over-the-counter derivatives notional outstanding of about $846 trillion at end-June 2025, its latest commentary, published on 8 December 2025. It said credit derivatives grew fastest among the smaller risk categories, up 23% from a year earlier in notional terms.

How to read a CDS spread in basis points

The spread is the annual cost of protection as a percentage of the notional, the amount of debt insured. Five years is the most quoted maturity, which is why news reports usually refer to "five-year CDS".

A worked example

Take the Meta quote that Reuters, citing Markit data, reported on 22 October 2026: 114.79 bps, rounded here to 115 bps.

1. Convert to a percentage. 115 bps = 1.15% a year.
2. Apply it to the notional. Protection on $10 million of debt costs 1.15% × $10,000,000 = $115,000 a year, or about $28,750 a quarter.
3. Compare with before. Reuters said the spread rose 7.6 bps that day. On $10 million, that is about $7,600 a year more for the same protection.

In practice, most contracts are not paid at the exact market spread. Since the 2009 "Big Bang" changes to ISDA documentation, single-name contracts in North America pay a standard fixed coupon, commonly 100 bps for investment-grade names and 500 bps for high-yield names. The BIS Quarterly Review of December 2010 explains that an upfront payment makes up the difference between that fixed coupon and the market spread. In the example, a buyer paying a 100 bps coupon on a name quoted at 115 bps would also pay an upfront amount covering the extra 15 bps a year over the life of the contract. The exact amount depends on discounting and default risk, so it is somewhat less than 15 bps times five years.

What makes a spread move

Spreads widen when the market sees more credit risk or wants more pay for taking it. Common triggers include weak earnings or cash flow, new borrowing, rating changes, and wider risk-off moves in markets. Spreads also move when demand for hedging rises, even if nothing has changed at the company. That is one reason a wider spread is a signal to investigate, not a verdict.

What CDS spreads say about default probability

The spread is what the seller demands for expected losses plus a margin for bearing the risk. A widely used shortcut, often called the "credit triangle", connects three numbers:

Spread ≈ annual default probability × (1 − recovery rate)

The recovery rate is the share of face value that creditors get back after a default. Rearranged, annual default probability ≈ spread ÷ (1 − recovery). The table below uses a 40% recovery assumption to show how the arithmetic works. It is illustrative and is not a quote for any borrower.

Bullquill calculation using the formula above. Cumulative probability = 1 − (1 − annual probability)⁵. Figures ignore discounting and accrued premium.

Two cautions matter when reading these numbers.

• Recovery assumptions change the answer. At a 20% recovery assumption, a 115 bps spread implies about 1.4% a year instead of 1.9%. The lower the expected recovery, the lower the implied default probability for the same spread.
• Market-implied is not the same as real-world. Spreads include a risk premium, so implied probabilities are usually higher than actual default rates. In BIS Working Paper 173, Berndt, Douglas, Duffie, Ferguson and Schranz compared default swap rates with estimated default frequencies for US firms. They found a strong link between the two, but default risk premia that varied widely over time.

Analysts use the same method on governments. A 2023 Federal Reserve Bank of Chicago working paper, "What does the CDS market imply for a U.S. default?", estimated that the market-implied probability of a US default rose from about 0.3–0.4% in 2022 to around 4% in April 2023, during the debt ceiling standoff. The authors said part of the higher spreads reflected the cheapening of Treasuries that could be delivered into the contracts, which shows how technical factors can push a spread away from pure default risk.

What happens in a credit event: Determinations Committees and auctions

A CDS pays out only after a credit event as defined in ISDA documentation. The main types are failure to pay, bankruptcy and, for many contracts, restructuring of the debt. Since the 2009 changes, the BIS notes, ISDA's Credit Derivatives Determinations Committees decide whether a credit event has occurred, and the settlement price is set by an auction so that all protection sellers pay the same amount.

Greece is the best-known sovereign case. On 9 March 2012, ISDA's EMEA Determinations Committee ruled unanimously that a restructuring credit event had occurred, after Greece used collective action clauses to impose losses on holders of Greek-law bonds. The auction followed on 19 March 2012. Markit and Creditex, the ICE unit that ran it, announced a final price of 21.5% of face value. ISDA's FAQ explains that the cash payout equals the CDS face amount minus that auction value. So protection sellers paid buyers about 78.5% of the notional.

Corporate vs sovereign CDS

Corporate CDS cover a company's debt. Spreads are driven by cash flow, leverage, ratings and the outlook for the business. They let investors hedge one issuer without selling its bonds, and they react quickly to earnings because they trade on a single standard contract rather than many separate bonds.

Sovereign CDS cover a government's debt. They are shaped by politics, budgets, debt ceilings and, in the euro area, the risk that a country's debt is restructured. Governments do not go bankrupt the way companies do, so a payout usually follows a missed payment or a restructuring, as in Greece. Technical terms matter too: the Chicago Fed paper on US CDS found that the value of the Treasuries that could be delivered into the contracts affected the spread.

For euro-area governments, many readers watch the bond spread over German Bunds instead of CDS, because those bond markets are deeper. Our report on the French 10-year yield rising above 5% follows the OAT-Bund spread, which widened to about 157 bps on 21 October 2026. A bond spread and a CDS spread measure related things, but they are not the same number. The gap between them is called the CDS-bond basis.

Why AI borrowing has put Big Tech CDS in the news

For most of the past decade, the largest US tech companies had so much cash that their CDS hardly traded. That is changing as they borrow to build AI data centres. Meta sold $25 billion of bonds in April 2026, and its long-term debt rose to $80.92 billion by 30 September, according to its SEC filings. Its third-quarter free cash flow was negative, which we cover in our report on Meta's record CDS spread. Reuters also reported that credit protection costs rose that day for Oracle and Amazon.

Two points help put the move in context. First, Meta is still rated Aa3 by Moody's and AA- by S&P, so the spread signals that investors want more compensation, not that a default is expected. Second, more trading in a name's CDS can widen spreads on its own, as lenders and bondholders hedge. The same theme runs through our coverage of Meta's non-voting share class, the chip-stock slump over AI costs and OpenAI's $30 billion fundraising: the market is asking who pays for the AI build-out, and on what terms.

Limits of CDS as a risk signal

• Liquidity. Many single-name contracts trade rarely. Quoted spreads can then reflect a few trades or dealer estimates, and different data providers can show different levels for the same day.
• Counterparty risk. Protection is only as good as the seller's ability to pay. Collateral and central clearing reduce this risk, but they do not remove it.
• Contract terms. What counts as a credit event, which bonds can be delivered and which currency is used all affect the price, as the Chicago Fed paper on US CDS shows.
• Risk premium. Spreads mix default expectations with the price of risk. When markets are stressed, premia rise for everyone, even borrowers whose finances have not changed.

What it means

A CDS spread is the market's price for carrying a borrower's credit risk. Read it in three steps: convert basis points into an annual cost on the notional, turn it into a rough default probability with an explicit recovery assumption, and then ask what changed, such as earnings, new debt, ratings or demand for hedging. Direction and speed of change often say more than the level, especially for names that trade thinly.

For readers following the AI-debt story, CDS offer a view the stock price does not. Shareholders ask whether AI spending will pay off. Credit investors ask whether cash flows will cover the obligations if it pays off late or not at all. When spreads on highly rated borrowers such as Meta reach records, the second question is being asked more loudly. The spread does not answer it on its own.

Sources

• ISDA: EMEA Determinations Committee rules a restructuring credit event has occurred with respect to the Hellenic Republic (9 Mar 2012)
• ISDA: Greek Sovereign CDS Credit Event Frequently Asked Questions (Mar 2012)
• Markit and IntercontinentalExchange: results of the Hellenic Republic credit event auction (19 Mar 2012), via Mondo Visione
• ISDA: Big Bang Protocol (2009)
• BIS Quarterly Review, December 2010: The "Big Bang" in the CDS market
• BIS: OTC derivatives statistics at end-June 2025 (8 Dec 2025)
• BIS Working Paper 173: Measuring default risk premia from default swap rates and EDFs (2005)
• Federal Reserve Bank of Chicago WP 2023-17: What does the CDS market imply for a U.S. default?
• Reuters via AOL: Meta's credit risk indicator hits record high on increased AI spending plan (22 Oct 2026)
• Meta Platforms: Third Quarter 2026 Results, Form 8-K Exhibit 99.1 (SEC EDGAR)
• Meta Platforms: Free writing prospectus for $25 billion senior notes, 30 Apr 2026 (SEC EDGAR)
• Cornell Law School Legal Information Institute: credit default swap

This article is for information only and is not investment advice.