How CDS Indices Track Corporate Bond Credit Risk
Summary
The note explains why credit default swap indices are often used to gauge corporate bond markets. It separates a risky bond’s yield into a risk-free government yield and a credit spread, the extra return investors demand for default risk. A CDS protection buyer pays a premium, while the seller compensates for losses after a covered default, making protection resemble insurance on the bond.
Under idealized matching and perfect protection, the CDS rate approximates the bond’s credit spread; subtracting it from the risky bond yield gives an estimate of the risk-free rate. This explains why a broad bond index can move with both interest rates and credit conditions, whereas a CDS index mainly reflects changes in default risk. The explanation is conceptual rather than a precise pricing recipe: CDS and bond terms may not match, and CDS indices are not weighted like conventional bond or equity indices. No empirical comparison or specific global bond benchmark is provided.
Key ideas
- A corporate bond yield can be viewed as a risk-free yield plus compensation for credit risk.
- A CDS premium pays for protection against losses from a covered bond default.
- With ideal matching, the CDS rate can approximate the risky bond’s credit spread.
- Bond indices reflect interest-rate and credit-spread changes, while CDS indices mostly reflect credit risk.
- CDS index construction differs from conventional weighted bond indices.
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Full text
# Why can CDS indices be used as a bond market index?
# Why can CDS indices be used as a bond market index?
I don't understand why the iTraxx indices family, which are credit default swap indices, are in practice often used to gauge the bond market. How are CDS prices related to bonds prices? And what other index would be a good one for the global bond market ?
Thank you for your help
## Answer by rhaskett (score 10, accepted)
https://quant.stackexchange.com/a/17865
It is helpful to think of the yield $r_b$ of a risky bond (say a corporate) in your country as the yield of the risk-free government bond $r_f$ plus a "spread" $r_s$ ($r_b = r_f + r_s$). This extra spread is the extra yield that the market needs to be paid to purchase the corporate bond instead of buying an equivalent amount of risk-less bonds. In other words $r_s$ the (annualized) rate needed to pay someone to take the risk on losing their money if that particular bond defaults.
In a credit default swap the protection buyer generally pays a annualized rate $r_{cds}$ to the protection seller and the protection seller pays the buyer if a bond (like the corporate bond above) defaults. In particular the amount the seller pays is designed to be fairly close to what an owner of the corporate bond would lose if the bond were to default. So, buying protection using CDS is like having insurance on a bond.
Now, if you had perfect insurance on a domestic corporate bond then it is a risk-free bond. So, the risk-free rate should be the bond rate minus the cost of insurance ($r_f \approx r_b - r_{cds}$) or spread due to risk should be approximately the cds rate ($r_s \approx r_{cds}$).
There are a metric ton of messy details here, especially for cds indices which are not weighted indices like a stock/bond index, but this gets the main relationship across. Essentially, a risky bond index like Barclays Bond Indicies will change both if the risk-free rate changes and also when the "average" default risk changes for those bonds. A CDS index changes (mostly) on just that default risk part.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.