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As I know a CDS is defined w.r.t. some unique Reference bond with a given maturity from a given issuer. Now, an issuer can issue bonds with different maturities and notionals. So, how are the Notional values of the underlying bonds normalized, if at all, in order to construct a term structure of CDS spread from an issuer?

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This assumption:

CDS is defined w.r.t. some unique Reference bond

is not quite true. The term sheet mentions a reference obligation (sometimes more than one), but the swap references the entire tier of debt - all the obligations that are pari passu with the reference obligation(s) on the term sheet, usually all senior unsecured hard-currency bonds. Or bonds and loans if the term sheet says so.

If a credit event happens with some other obligation, then it (probably) triggers the CDS.

If physical settlement is chosen, which is unusual these days, then the protection buyer can deliver (almost) any other obligation.

The maturities of the swaps do not need to align with the maturities of any obligations. A standard swap matures on one of the "IMM Dates" (do not be confused - not the 3rd Wednesday of a month, like some other products "IMM Dates", but the 20th of some months). Typically, the reference obligation is chosen to have a longer matirity than the swap. You may, of course, try to trade an OTC swap with any maturity, including matching some bond or loan maturity, but then it won't be a standard contract.

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They are basically not normalized. If you buy 100mm of a CDS on an issuer, it gives you the right (in the event of default) to deliver 100mm of an eligible bond of any maturity and any coupon. This can sometimes create unusual pricing effects if an issuer is close to default. For example bonds of different coupons can trade at very similar prices if those bonds are both being sought for delivery into Cds contracts.

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  • $\begingroup$ Good answer, but I don't think that the phenomenon of the prices of all bonds converging to the recovery assumption as default approaches only started with the poularity of CDSs in the 1990s. Bonds behaved the same way long before. $\endgroup$ Dec 3, 2022 at 20:29
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    $\begingroup$ Fair point , cheers $\endgroup$
    – dm63
    Dec 3, 2022 at 23:46

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