A number of Sober Look readers have asked about the meaning of an inverted CDS term structure and how one thinks about the massive short-term spread (which is sometimes over 100%).
An inverted curve with higher spreads for shorter maturities generally means that it's a distressed company. The market is pricing in a credit event in the near term with the expectation that in case the company makes it past the next few months, it is more likely to make it over a longer term. The more likely the near-term event the steeper the curve. As an example, let's take a look at CIT. Below is the CIT CDS term structure, showing a rapid drop with increasing maturities.
But what does it mean to have a CDS with a 9400 basis point (94%) spread (which is the case for a one-year maturity)? This in fact is an implied spread and in practice this CDS trades with 500 bp running and points upfront. The 1-year CDS for example is 66 points upfront, which means if you buy CIT protection for a year on $100, you have to pay $66 immediately. If CIT files for bankruptcy, the dealers will auction off CIT bonds to determine the recovery level. Let's say the bonds trade at 20 cents on the dollar (20% recovery). You as the protection buyer are owed par less the recovery or $80. So you paid $66 in premium and possibly a couple of running spread payments of $1.25 a quarter (500 bp annualized) to get back $80 for an $11.5 in profit. If CIT doesn't file in the first year, you will have paid out $71 (66 + 5) and got back zero.
The curve below shows roughly the points upfront for CIT by maturity.
The way to think about translating 94% "running spread" (no upfront payments and just large ongoing quarterly payments) into 66% points upfront is by considering an effective "duration" for this one-year CDS of about 9 months. Assuming zero interest rates (which is a good approximation these days) the 500 bp running spread will end up paying 3.75% over the 9 months producing a total premium paid of about 70%. Taking the 94% running spread over 9 months would produce about the same amount of premium, thus making 94% running spread and 66% upfront equivalent.
