In a credit derivative, a credit event is a contractually defined occurrence relating to a reference entity that can activate credit protection, subject to the transaction's conditions. The definition determines whether a loss is covered: a bondholder can suffer a credit-related loss without being entitled to a protection payment.
For a credit default swap, the reference entity is the borrower whose credit is referenced. Its credit event is distinct from a failure by the protection seller to honour the swap. That second problem is counterparty credit risk.
Distress is evidence to examine, not the event definition
A falling bond price, wider credit spread or rating downgrade can signal worsening creditworthiness and change a position's value. Those observations alone do not establish a covered credit event under an ordinary CDS.
Common event categories include bankruptcy, failure to pay and restructuring, when selected in the terms. They answer different questions: an insolvency-related occurrence, a qualifying missed payment, or a qualifying change to debt terms. Their everyday meanings are insufficient. The specified obligations, thresholds and detailed definitions matter. A negotiated debt workout, for example, is not automatically a covered restructuring.
ISDA's disclosure annex, under “Specification of Credit Events,” explains why coverage varies with the reference entity, obligations and transaction terms. Read the confirmation together with the definitions, supplements and other documents it incorporates.
Three elapsed days do not complete five
Consider a wholly fictional contract. Its particular failure-to-pay condition requires a missed payment to remain unpaid after a five-day grace period has expired, as well as satisfying other specified conditions. Stipulate five complete calendar days and assume all prerequisites for starting that clock are satisfied at the missed-payment deadline.
At three elapsed days, the payment is still unpaid. This grace-period condition has not yet been met. Neither the missed deadline nor an alarming headline removes the remaining time. After expiry, the other requirements still need checking; the clock alone does not establish the event or produce a payment. A separate covered event, such as bankruptcy, would require its own assessment.
A stipulated clock for one fictional failure-to-pay condition, not a universal grace period or a determination that no other credit event has occurred.
Five days is an assumption for this example. Actual grace-period rules depend on the relevant documentation. In ISDA's 2019 supplement, §2 replaces the Failure to Pay definition with provisions addressing applicable grace periods, their commencement conditions, payment requirements and qualifying obligations. Where the Credit Deterioration Requirement applies, the specified connection to deteriorating creditworthiness or financial condition must also be satisfied. A generic overdue-payment flag cannot replace that test.
Event, determination and settlement
The occurrence being assessed, its contractual determination and the resulting settlement are distinct parts of the process. The Determinations Committees apply CDS documentation to particular facts. Their role in a transaction depends on its terms; it is not a universal legal declaration of default for every purpose.
Required notices, information and deadlines can affect whether an event takes effect under the transaction. Settlement then follows the applicable physical, cash or auction provisions. Identifying a covered event does not, by itself, fix the settlement amount, date or deliverable debt. Those terms explain how the protection responds; the event definition explains what it responds to.
Sources
- ISDA, Credit Derivatives Disclosure Annex, July 2021, pp. 1–7 and “Settlement Methods”: scope, covered events, obligations, determinations, information, notices and settlement. ISDA-authored text hosted by Deutsche Bank.
- ISDA, 2019 Narrowly Tailored Credit Event Supplement, §2: amended Failure to Pay definition and the conditional Credit Deterioration Requirement.
- Credit Derivatives Determinations Committees, About the DCs: applying contractual definitions to evidence in specific cases.
- John C. Hull, Options, Futures, and Other Derivatives, ninth Global Edition (Pearson, 2018), §25.1, pp. 594–597: CDS structure, credit events and settlement.