A credit default swap (CDS) is a contract that resembles insurance against a bond debtor’s default. The buyer pays an ongoing premium; if default occurs, the protection seller compensates the buyer for the bond’s full value. A CDS can be separated from the original lending relationship, so the protection buyer need not be the lender. section 5.2
For data-driven investors, a CDS is a speculative signal about credit risk rather than a simple yield tool. It can complement bond ratings and market analysis, but it involves complex contracts, uncertain predictions, and potentially severe losses. section 5.2
Detached protection
If A borrows from B, C can buy default protection from D. C pays the premium, and D pays C if B defaults. The arrangement shows how CDS exposure can be detached from the original lender. section 5.2
Table 5.1 Rating of bonds
|
Rating tier
|
Moody’s
|
S&P
|
Fitch
|
Meaning
|
|---|---|---|---|---|
|
Investment Grade
|
||||
|
Highest quality
|
Aaa
|
AAA
|
AAA
|
Prime credit quality, lowest risk
|
|
High quality
|
Aa1, Aa2, Aa3
|
AA+, AA, AA-
|
AA+, AA, AA-
|
Very high credit quality
|
|
Upper medium grade
|
A1, A2, A3
|
A+, A, A-
|
A+, A, A-
|
Strong capacity to meet financial commitments
|
|
Lower medium grade
|
Baa1, Baa2, Baa3
|
BBB+, BBB, BBB-
|
BBB+, BBB, BBB-
|
Adequate capacity, some susceptibility to conditions
|
|
Speculative grade
|
||||
|
Upper speculative
|
Ba, Ba, Ba3
|
BB+, BB, BB-
|
BB+, BB, BB-
|
Higher risk of default, but financial commitment met
|
|
Highly speculative
|
B1, B2, B3
|
B+, B, B-
|
B+, B, B-
|
Material default risk, but financial obligations still met
|
|
Substantial risk
|
Caa1, Caa2, Caa3
|
CCC+, CCC, CCC-
|
CCC+, CCC, CCC-
|
Very high risk, substantial vulnerability to default
|
|
Near default
|
Ca
|
CC, C
|
CC, C
|
Highly vulnerable to default
|
|
Default
|
C
|
D
|
RD, D
|
In default
|
Compare bond-rating tiers before treating CDS pricing or default exposure as evidence of opportunity. section 5.2
