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Credit Default Swap Primer
Figure 1. Estimated Growth in Single-Name CDS Notional
21 18 $ Trillions
Additional Authors: Jeffrey A. Rosenberg
15 12 9 6 3 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Sources: British Bankers Association; ISDA; Banc of America Securities LLC estimates.
The credit crisis has changed the credit default swap (CDS) landscape. Riskier credits trade in points upfront, similar to a discount bond. Higher funding costs make it more expensive to take a leveraged position in cash bonds, increasing the attractiveness of unfunded assets such as CDS. The CDS market has taken steps to reduce the risks associated with rapid growth. Protocols have helped investors to cash settle contracts following recent bankruptcies. Most CDS trades are processed electronically. Counterparties exchange mark-to-market profit daily, and may use initial margin to further reduce exposure. Credit default swaps have moved into the mainstream of credit portfolio management. Hedge funds, banks and dealers, and insurers are the most active participants. We discuss practical trading considerations, such as liquidity, trade unwinds, and CDS rolls. Corporate bond investors and issuers are paying more attention to the CDS market. CDS spreads provide a benchmark for new issue pricing. The CDS markets influences—and is influenced by—corporate finance decisions such as tender offer, guarantees, and spinoffs.
The author of this report is not acting in the capacity of an attorney, and the information contained herein is not intended to constitute legal advice. You should consult with your legal adviser as to any issues of law relating to the subject matter of this report.
This report has been prepared by Banc of America Securities LLC (BAS), member FINRA, NYSE and SIPC. BAS is a subsidiary of Bank of America Corporation. This report is intended for sophisticated institutional investors and equivalent professionals in the fixed income market only. Please see the analyst certification and important disclosures on page 194 of this report. BAS and its affiliates do and seek to do business with companies mentioned in their research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Should investors consider this report as a factor in making an investment decision, it must be considered as a single factor only.
Credit Strategy Research
May 27, 2008
Table of Contents
This primer is organized by importance. Readers who want a basic overview of CDS may prefer to skip appendices. Introduction............................................................................................................................................................................. 4 Chapter I – The Basics of Credit Default Swaps.................................................................................................................. 8 What Is a Credit Default Swap? ........................................................................................................................................ 8 The Credit Derivatives Market.......................................................................................................................................... 9 Beginners Guide to CDS Contract Jargon....................................................................................................................... 15 Appendix I – The Basics of Credit Default Swaps ............................................................................................................. 17 Details around CDS Contract Terminology .................................................................................................................... 17 Risk of a Short Squeeze .................................................................................................................................................. 22 CDS and Corporate Bond Market Surveys ..................................................................................................................... 23 Chapter II – Differences Between the CDS and Corporate Bond Markets..................................................................... 26 Pricing in the CDS Market .............................................................................................................................................. 26 The ABCs of Credit Spreads ........................................................................................................................................... 26 The Credit Default Swap Basis ....................................................................................................................................... 30 Appendix II – Differences Between the CDS and Corporate Bond Markets...................................................................... 34 More on The ABCs of Credit Spreads ............................................................................................................................ 34 Factors Driving the Basis ................................................................................................................................................ 43 Chapter III – CDX and iTraxx Indices............................................................................................................................... 48 Key Features of CDX Indices ......................................................................................................................................... 48 Basis Between Intrinsics and the Index........................................................................................................................... 51 Hedging Between Indices................................................................................................................................................ 53 Appendix III – CDX and iTraxx Indices............................................................................................................................. 53 DV01 Neutral Index Arbitrage........................................................................................................................................ 53 CDX Index Rolls............................................................................................................................................................. 57 Events and Reference Entities in the CDX Indices ......................................................................................................... 60 Chapter IV – CDS Operations Management...................................................................................................................... 65 CDS Operations............................................................................................................................................................... 65 Goals for CDS Operations Management......................................................................................................................... 67 Counterparty Risk and Leverage..................................................................................................................................... 68 Appendix IV – CDS Operations Management.................................................................................................................... 75 Sample Confirmations and Trade Recaps ....................................................................................................................... 75 Sample Credit Event Documentation .............................................................................................................................. 86 Chapter V – CDS Trading Management ............................................................................................................................ 90 Sample Trader Runs ........................................................................................................................................................ 90 CDS Rolls........................................................................................................................................................................ 94 Sample P&L Calculation................................................................................................................................................. 96 Implied Probability of Default ...................................................................................................................................... 100 Mind the Discount Factor.............................................................................................................................................. 102 CDS Duration and Curve Trades................................................................................................................................... 102 The Transition from Spread to Points Upfront.............................................................................................................. 108 Assignments, Unwinds, and Jump Risk ........................................................................................................................ 109 Interest Rate Sensitivity ................................................................................................................................................ 111 Appendix V – CDS Trading Management........................................................................................................................ 113 More on Single-Name CDS Rolls ................................................................................................................................. 113 More on Points Upfront................................................................................................................................................. 115 More on Jump to Default Risk – Take CDS Profit in Small Chunks ............................................................................ 123
Credit Default Swap Primer Glen Taksler 646.855.7559
Credit Strategy Research
May 27, 2008
Chapter VI – CDS Case Studies and Legal Issues ........................................................................................................... 129 Case Studies .................................................................................................................................................................. 129 Succession—How Corporate Finance Affects Credit Derivatives................................................................................ 132 Operational Issues Surrounding Succession Events...................................................................................................... 142 CDS Settlement Protocols............................................................................................................................................. 143 Details Around Modified Restructuring........................................................................................................................ 152 Special Issues Pertaining to CDS on Monoline Insurers............................................................................................... 158 Chapter VII – Other Credit Derivatives Products........................................................................................................... 166 The Synthetic CDO Market........................................................................................................................................... 166 Leveraged Loan CDS (“LCDS”)................................................................................................................................... 167 Secured CDS ................................................................................................................................................................. 169 Recovery Locks............................................................................................................................................................. 170 CDS on ABS ................................................................................................................................................................. 172 CDS on CLOs ............................................................................................................................................................... 177 Preferred CDS (“PCDS”) .............................................................................................................................................. 177 Accounts Receivable CDS ............................................................................................................................................ 178 Private Institutional CDS .............................................................................................................................................. 179 Appendix VII – Other Credit Derivatives Products .......................................................................................................... 179 Structured Credit Market Basics ................................................................................................................................... 179 Chapter VIII – Glossary..................................................................................................................................................... 188
Credit Default Swap Primer Glen Taksler 646.855.7559
In cash market terminology. CDS market surveys focus on gross. who buys $10 million protection from Bank B. please see “The $62 Trillion Question” on page 11. and a different trader at Bank A sells $10 million protection to Bank B.50. the institution will record two separate trades. Both banks have zero net default exposure ($10 million – $10 million = zero). CDS Market Size Considerable concern has been raised over rapid growth in the credit derivatives market. causing CDS market size to increase. Through the ISDA trade association. the majority 1 2 For more details.855.7559 . Throughout this Credit Default Swap Primer. In this light. typically. along with the current state of the market. A week later. under many circumstances. approximately $20 trillion is single-name CDS (globally). even though net credit exposure will be unchanged. the size of the CDS market may grow without any change in overall risk. if trades were implemented at $100. we address these topics in more detail. Consequently. CDS operational efficiency has improved substantially in recent years. headline market size estimates are drastically larger than the overall economic impact of the CDS market. if an investor buys protection in an index and sells protection in each of the underlying constituents. particularly in a volatile trading environment. to $62 trillion. For more details. Below. The CDS market’s $62 trillion headline size is drastically larger than its overall economic impact Yet. with a total notional of $20 million. credit exposure. that suggests a current gross market value in credit 2 derivatives of $3 trillion. Since that time. and high yield 1. Consider a trader at Bank A. Second. gross market value would increase. the CDS market is subject to double-counting of risk. the systemic risk of credit derivatives is far less than the headline $62 trillion notional. spreads widen. CDS Operational Concerns CDS operational efficiency has improved substantially in recent years With rapid market growth comes increased attention to making sure that trades are confirmed shortly after execution. regardless of the reason. Inc. that error should be quickly discovered and corrected. we comment on some “hot topic” issues. To be clear. please see “The Credit Derivatives Market” on page 9. But. The International Swaps and Derivatives Association. As of December 2007. There are two issues. Roughly speaking. credit derivatives have become a subject of significant market and regulatory attention. In 2005. compared 1 with about $14 trillion in corporate bond notional. their market value as of December 2007 was $96. investment grade credit has lost about 1. the industry is developing netting proposals to more accurately reflect net credit exposure. this is a back-of-the-envelope estimate: If spreads were to widen further.5%. reported CDS notional will grow. Similarly. 4 Credit Default Swap Primer Glen Taksler 646. the Bank of International Settlements (BIS) estimates that the gross market value of credit derivatives contracts was 3. not net. if an institution makes a mistake on a trade. because two different traders transacted.Credit Strategy Research May 27.5%. For example.’s (ISDA) 2007 yearend market survey estimates that credit derivatives notional grew 81% in 2007.2% in total return. 2008 35 Introduction As this publication goes to press. Of this. First. although the exact impact is unclear. The goal is that. The main theme is that rapid growth involves risks.
To manage Counterparty risk. the CDS market has increased collateral requirements and is working on a clearinghouse to guarantee selected trades Recognizing this risk. they still face challenges in a growing market. please see the section “Counterparty Risk and Leverage” on page 68.1 trillion in collateral in circulation. In its early stages. as of year-end 2007. To reduce outstanding notional.7559 5 . the market continues to develop a series of voluntary solutions. toward the end of 2008.” When agreeing to a protocol. 7 For more details. ISDA estimates that there was approximately $2. ISDA also estimates that unsigned credit derivatives confirmations rose to 6. Now five years old.9x for interest rate derivatives and 13. this proposal may take effect for a small number of trades. not just credit derivatives.com/information/products/metrics. according to Markit Group Ltd. Credit Default Swap Primer Glen Taksler 646. the CDS market continues to develop a series of voluntary solutions. up from $1.3x for equity derivatives. To preserve the spirit of CDS contracts.e. most investors seem to recognize that. Rather than face banks or broker-dealers as Counterparties. Effectively.isda. Although no one knows exactly how much collateral is required to effectively manage Counterparty risk.6x the daily volume of new trades in 2007. Of those eligible trades. 6 ISDA Margin Survey 2008. 5 For more details. investors would face the clearinghouse. while credit derivatives fare favorably to other product areas from an operations 5 perspective. For year-end 2007. the protection Buyer benefits. As such. through the Depository Trust & Clearing Corporation (DTCC). and ISDA 2007 Operations Benchmarking Survey. available from http://www.html Preliminary results of ISDA 2008 Operations Benchmarking Survey.isda. the CDS market began work on a clearinghouse to guarantee selected trades. if a clearinghouse member were to default. the immediate effect is that one party benefits. Now. if a protocol results in a lower recovery rate. where unsigned confirmations—those trades executed but not yet confirmed—piled up in back and middle offices. Although credit derivatives face challenges. Counterparty Risk As an unfunded market. please see “Goals for CDS Operations Management” on page 67. from 4. 90% of total trades) settle 3 electronically. available from http://www.3 trillion in each of 2006 and 2005.org. they fare favorably to other derivatives produts from an operations perspective However. There are no hard assets set aside to guarantee payment.9x in 2006. for their overall portfolio. Yet. For example.org. called “protocols. called “protocols” 3 4 http://www. the CDS market requires parties to post collateral (margin). CDS Contract Language Standard CDS contracts are governed by the 2003 ISDA Credit Derivatives Definitions. another nearly 95% (i. the benefits of a highly functioning CDS market outweigh potential losses on To mitigate potential risks associated with rapid growth. ISDA estimates that 90% of electronic confirmations are normally sent by T+1. creating an issue of Counterparty risk. among a small number of 7 parties. all remaining members would be responsible for a proportionate share of trades. 2008 35 of CDS trades were confirmed by facsimile. about 95% of credit default swaps are eligible for electronic settlement. 6 These numbers are across all derivatives transactions. This resulted in a trade backlog. Recently.. CDS market participants promise to exchange cash flows following a potential Credit Event.Credit Strategy Research May 27. trades would be netted across parties.markit. these Definitions did not fully anticipate the extent of CDS market expansion and current market conditions. and the other suffers.855. The 2007 estimate 4 compares with 9. with quarterly coupon payments reconciled by the manual exchange of spreadsheets.
Although the eventual outcome is unclear.7559 . 10 For more details. Similar uncertainty exists surrounding the effect on CDS contracts from a potential split of monoline insurers into separate municipal bond and structured finance businesses. or acquisition. thus reducing short squeezes as protection Buyers no longer have to locate bonds. some protection Buyers have found it difficult to unwind singlename CDS trades and realize profits. there may be wide disparity in the price and liquidity of such obligations. A bank or broker-dealer that accepts this trade must pay the investor 15 points. he may (eventually) forfeit the right to receive par from the protection Seller. For example. please see “Special Issues Pertaining to CDS on Monoline Insurers” on page 158. Currently. For example. Risk of a Short Squeeze Following a Bankruptcy. A debate ensued as to whether this structure would cause some existing Verizon CDS notional to succeed. If a credit default swap were. there are 8 plans to eventually hard-wire such provisions into CDS contracts. the market to potentially cash settle to) any debt obligation directly wrapped by the monoline. standard CDS contracts allow the protection Buyer to deliver (by extension. As part of the transaction. and then hedge the transaction with a new trade at par. causing potential market disintegration. This setup leaves the bank or broker-dealer with “jump risk”: If there is a Credit Event at the underlying Reference Entity immediately after trade inception. Changes in Corporate Finance Structure The development of new. to recover par. please see “Succession—How Corporate Finance Affects Credit Derivatives” on page 132. in 2005.Credit Strategy Research May 27. Monoline Insurers For CDS referencing monoline insurers. in 2006. an ISDA 9 working group has been formed to try to develop a solution. the bank or broker-dealer will lose 15 points: 8 9 For more details. In other words. merger. Corporate finance is becoming increasingly important to CDS investors Trade Unwinds in a Volatile Market Managing risk associated with trade unwinds when spreads gap wider As spreads gap wider.855. However. few investors would be willing to buy protection in the future. say. or change Reference Entity. consider a protection Buyer who looks to profit 15 points. While not guaranteed. tax-efficient corporate finance structures sometimes has created uncertainty as to how CDS contracts should be treated following a spin-off. If the protection Buyer cannot do so. the price of the CDS contract has fallen from par to $85 ($100 – $15). standard CDS contracts require the protection Buyer to deliver a bond or loan to the protection Seller. Verizon spun off its directories business. While not guaranteed. please see “CDS Settlement Protocols” on page 143. As a result. For more details. 6 Credit Default Swap Primer Glen Taksler 646. the vast majority of investors have voluntarily agreed to cash settle CDS contracts following recent bankruptcies. making it particularly difficult to settle CDS contracts should a monoline Credit Event ever occur. 2008 35 individual trades. our best advice is for 10 investors to learn these sometimes overlooked clauses of CDS contract language. some existing Verizon bonds were exchanged for loans in the new directories business (Idearc). there are plans to eventually hard-wire the ability to cash settle CDS contracts Uncertainty around CDS contracts referencing monoline insurers To accommodate these issues. There is some potential that monoline CDS notional could be divided between the two businesses or move entirely to the municipal bond business. with its wider high yield spreads. bond prices started to short squeeze considerably following bankruptcies—the price of Delphi bonds rose from $58 to $72 after the company declared bankruptcy. to Idearc.
and pays 15 points: P&L post-Credit Event = 100 – Recovery – 15 Bank or broker-dealer hedges by selling protection in a new trade: P&L post-Credit Event = – (100 – Recovery) Net P&L post-Credit Event = – 15 As such. such as rolling to on-the-run contracts and taking profits in small chunks. Until the market develops a solution. For more current views on credit derivatives strategy. with appendices on more advanced topics. 2008 35 Bank or broker-dealer buys protection from investor. This primer is organized by chapter.855. “More on Jump to Default Risk – Take CDS Profit in Small Chunks“ on page 123 discusses strategies for managing unwind risk. please see our daily Situation Room and biweekly Credit Market Strategist publications.7559 7 .Credit Strategy Research May 27. Credit Default Swap Primer Glen Taksler 646. buying protection on unwind or assignment becomes less valuable to the bank or broker-dealer.
as such. seniority. are available. Unlike other financial instruments. In this instance. These cash market limitations are more accentuated when investors seek to express a bearish view. Figure 2 illustrates the mechanics of a credit default swap. In addition. investors in the cash markets who are bullish on an issuer’s credit must fund the investment and express their view among available loans and bonds in whichever maturities.855.Final Price Protection Buyer Protection Seller Protection Seller Physical Settlement Protection Buyer Obligation Par Protection Seller Protection Seller Source: Banc of America Securities LLC estimates. Figure 2. 2008 35 Chapter I – The Basics of Credit Default Swaps What Is a Credit Default Swap? A credit default swap is a bilateral contract for transferring credit risk Credit default swaps are bilateral contracts used to transfer risk among market participants. in exchange for receiving a payment should a third party (the Reference Entity) or its obligations suffer one or more pre-agreed adverse Credit Events. One party (the protection Buyer) agrees to pay another party (the protection Seller) periodic fixed payments. investors’ ability to short cash instruments is constrained by their ability to borrow the cash instruments and by the rollover risk inherent in short-term repos. customized credit risk positions. etc. Traditional cash instruments are inherently funding vehicles and.7559 .Credit Strategy Research May 27. 8 Credit Default Swap Primer Glen Taksler 646. represent inflexibly bundled market and credit risks. credit default swaps allow users to take unfunded. Mechanics of a Credit Default Swap The protection Buyer pays the protection Seller a quarterly premium for protection against adverse Credit Events on a third-party Reference Entity Between trade initiation and the earlier of a Credit Event or maturity. investment in bonds or term loans can subject investors to either undesired interest rate risk or additional expense in hedging out this risk. Flexibility to manage credit risk Limitations of cash instruments for expressing credit views The financial innovation achieved by credit default swaps—and their primary attraction—is flexibility to manage credit risk. For example. the protection Buyer makes regular payments of default swap premium to the protection Seller: Protection Buyer Periodic Fixed Payments Protection Seller Protection Seller Following a Credit Event. one of the following takes place: Cash Settlement Par .
The total cost of funding. credit default swaps allow investors to separate the credit decision from the funding decision. the documentation evidencing the transaction—is based on definitions set forth by the International Swaps and Derivatives Association. a credit default swap allows protection Buyers to fix protection costs for the life of the CDS. Application of credit default swaps for expressing credit views Credit derivatives are not insurance The buyer of an insurance policy is required to own the underlying asset. The sections “Counterparty Risk and Leverage“ (page 68) and “CDS Operations“ (page 65) discuss Counterparty risk and procedures for setting up a new Counterparty to CDS. but precise documentation remains the responsibility of the parties involved. the 2003 ISDA Credit Derivatives Definitions took effect. they are not considered insurance. Since credit derivatives have no such requirement.Credit Strategy Research May 27. so to speak. Figure 3 provides a sense of the growth in notional volume of credit default swaps (CDS) since 1997. These Definitions build on a substantial case history of the CDS market. reflects the credit rating of the particular Counterparty.855. while rollover risk from an alternative cashbased shorting strategy will either become very difficult or costly to execute precisely when an issuer’s credit profile significantly deteriorates. Inc. Credit Default Swap Primer Glen Taksler 646. a house. In May 2003. As unfunded products. Credit default swaps also provide flexibility in expressing credit risk views on maturities. for example. including initial and variation margin. With few exceptions. For details. seniority and Credit Events. The Definitions provide a basic framework for documentation. because it allows the transfer of risk from a single party—for example. a bank lending a large loan facility—to a wide group of investors. among two parties on a third entity—provide more flexibility for expressing investment views on credit risk. without regard to the availability of a physical market instrument. credit default swaps—as side agreements. 2008 35 By contrast. relative to the corporate bond market. because credit default swaps are bilateral contracts. credit default swaps make the credit markets more accessible to investors who have higher funding costs. it is clear that the market has grown and gained significant strength in recent years.7559 9 . This distinction is intentional. As such. The Credit Derivatives Market While the precise size of the credit derivatives market is not known. a trade association. In this sense. expanding and revising the 1999 Definitions and Supplements. please see page 129. (ISDA). the legal framework of CDS—that is.
Sources: Bank of International Settlements. 10 Credit Default Swap Primer Glen Taksler 646. for a 32% growth rate.4 trillion in year-end 2006 vs.5 trillion in mid-year 2007. Banc of America Securities LLC estimates. ISDA estimates that CDS notional grew by 81% in 2007. British Bankers Association. Total CDS Notional-Estimates are for total notional of the global credit derivatives market.0 trillion in mid-year 2006. and $34. $45. Estimated Growth in Single-Name and Total CDS Notional. Federal Reserve. Inc. Globally Single-Name CDS Notional-Estimates Total CDS Notional-Estimates Cash Notional-Estimates 64 56 48 40 32 24 16 8 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Single-Name CDS Notional-Estimates are for the single-name notional of the global credit derivatives market. Banc of America Securities LLC estimates.’s (ISDA) 2007 year-end market survey estimates that CDS notional grew 81% in 2007. but non-traditional products have grown rapidly: 11 $62. ISDA.2 trillion in year-end 2007 vs. ISDA estimates that CDS notional grew 37% during the second half of 2007. despite recent market conditions. Single-name CDS has the greatest market share by product. compared with 32% during the second half of 11 2006. to $62 trillion. Moreover. to $62 trillion The International Swaps and Derivatives Association. including synthetic CDOs and index products. for a 37% growth rate. 2008 35 Figure 3. Sources: ISDA. Cash Notional—Estimates are for the total notional of the global corporate bond market. For further details. $26.Credit Strategy Research May 27.7559 $ Trillions .855. please see the Chapter Appendix on page 23.
under many circumstances. from $319 billion in 2003. the institution will record two separate trades. Synthetic CDO volume declined substantially in the second half of 2007. CDS Product Usage.) The $62 Trillion Question Headline market size is drastically larger than the overall economic impact of the CDS market. CDS Product Usage. Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. For example. Banc of America Securities LLC estimates. The single-name CDS market is estimated at $20 trillion for 2007 Based on the overall CDS market size shown in Figure 3. A week later. because two different traders transacted. typically. the CDS market is subject to double-counting of risk. and equity linked products. We emphasize that the 2008 forecast market share was made in 2006. But. the industry is developing netting proposals to more accurately reflect net credit exposure. 2003 Total return swaps 4% Credit linked notes 6% Tranched Index 2% Index (Excl. the size of the single-name CDS market is pegged at $20 trillion for 2007.855. Tranches) 29% Synthetic CDOs 16% Sources: British Bankers Association. First. spreads widen. No survey was released in 2007. with a total notional of $20 million. the Bank of International Settlements (BIS) estimates that the gross market value of credit derivatives contracts was 3. As of December 2007. reported CDS notional will grow. Other includes total return swaps. Forecast 2008 Basket products 1% Options 3% Other 8% Single-name CDS 30% Figure 4. Consider a trader at Bank A. 2008 35 Figure 5. The next release is expected in 2008. To estimate the size of the synthetic CDO market. the size of the CDS market may grow without any change in overall risk. asset swaps. not net. so this forecast is from before the onset of the credit crunch. Both banks have zero net default exposure ($10 million – $10 million = zero). and a different trader at Bank A sells $10 million protection to Bank B. who buys $10 million protection from Bank B. compared to $2 trillion in 2003. as discussed in “The Synthetic CDO Market” on page 166. Similarly. CDS market surveys focus on gross. before the onset of the credit crunch. Banc of America Securities LLC estimates. Through the ISDA trade association. even though net credit exposure will be unchanged. There are two issues. (The CDX credit derivatives indices began trading in October 2003. Synthetic CDO market notional was an estimated $10 trillion in 2007. Second. Sources: British Bankers Association. The index market expanded to an estimated $18 trillion in 2007. up from $570 12 billion in 2003. credit exposure. In cash market 12 Synthetic CDOs are debt obligations representing a pool of credit default swaps. if an investor buys protection in an index and sells protection in each of the underlying constituents.7559 11 .5%. Tranches) 9% Basket Asset swaps 4% products 4% Options 3% Equity linked products 1% Credit linked notes 3% Tranched Index 10% Single-name CDS 51% Synthetic CDOs 16% Index (Excl. we multiply the 2008 forecast market share from Figure 5 by the 2007 total CDS notional from Figure 3. causing CDS market size to increase.
2% investment grade return x 70% market share – 1.50. for an estimate of $3 trillion gross market value. and relative value between CDS and cash. we assume a 70% investment-grade and 30% high-yield market share.2% in total return. Since that time. would partially offset these losses. for a total CDS market value of -4. their market value as of December 2007 was $96.5% high yield return x 30% market share).7559 . hedge funds are typically total-return investors. The next release is expected in 2008. investment grade credit has lost about 1. broker-dealers generally try to run more evenly balanced trading books. which are excluded from our analysis. that suggests a current gross market value in credit 13 derivatives of $3 trillion. and as Sellers. and are now the fastest-growing participants in this rapidly expanding market. Multiply the result by $62 trillion notional. the systemic risk of 14 credit derivatives is far less than the headline $62 trillion notional. would widen quotes—and therefore losses—drastically. banks and dealers have been the dominant CDS players as both Buyers and Sellers of credit default protection. Hedge funds are the fastest-growing participants 13 Total return estimates based on the CDX IG and CDX HY indices. Moreover. leading to increased participation as Buyers of protection. Hedge funds also have emerged as large Buyers and Sellers of protection. 2008 ( -1. 2008 35 terminology. with a focus on the 15 riskiest parts of the capital structure. Hedge funds have two main motivations for participating in the CDS market: the opportunity to use higher leverage than other markets allow. 12 Credit Default Swap Primer Glen Taksler 646.5% from December 2007. Their overall position in the CDS market grew from about 15% in 2003 to 30% in 2006. Using these estimates. should such a scenario ever occur. which are discussed in “CDX and iTraxx Indices” on page 48. As market makers. Netting agreements between counterparties. Banks’ prominence as protection Buyers is in part a natural outgrowth of their desire to hedge their substantial credit exposure. 14 We emphasize that this is a back-of-the-envelope estimate.Credit Strategy Research May 27. The total estimated CDS return is -1. contributing to a general perception that CDS has higher volatility than the corporate bond market.5%. but are becoming more active in managing their portfolios of credit risk. Breakdown of Buyers and Sellers of Protection Banks and dealers are both Buyers and Sellers of protection To date. following British Bankers Association estimates from 2006.855. as of May 22. so estimates are not available for 2007. 15 The British Bankers Association releases surveys bi-annually. and high yield 1. out of increased ROE focus and desire to diversify credit exposure.7%. if trades were implemented at $100. A mass unwind of derivatives trades.3%. Roughly speaking. Although the exact figure is unclear. Add the BIS estimate of -3. as discussed in the section “Counterparty Risk and Leverage” on page 68. The CDS market is working to improve netting of trades.
2006 Pension funds Corps.Credit Strategy Research May 27. 2006 Misc. 1% Banks and Dealers (Trading Portfolios) 39% Figure 6. but also trades for other maturities between one and ten years. provides a cushion for potential loss of 16 principal on the credit portfolio. Figure 8 shows a more detailed breakdown of high grade CDS issuer representation by sector: 16 In recent months. Sellers of Protection. According to Moody’s Investors Service. “Credit Derivative Product Companies 2007 Sector Review and 2008 Outlook. The next release is expected in 2008. Moody’s also writes that. Insurers tend to be net Sellers of protection Credit Derivative Product Companies (CDPCs) are a relatively new class of protection Sellers Insurers tend to be net Sellers of protection. the newly launched CDPCs hope to become broadly accepted as trading partners.855. 2008 35 Figure 7.” However. tranched CDS.” Credit Default Swap Primer Glen Taksler 646. CDPCs are triple-A rated investment vehicles that sell protection. Banc of America Securities LLC estimates. The need for yield has led to participation in the credit derivatives market through selling protection on single-name and. “A record number of CDPCs launched in 2007 despite subprime turmoil and the pipeline for 2008 remains strong … When liquidity in the CDS market improves. CDS Issuer Composition High Grade About 63% of high-grade issuers trade actively in the CDS market. Since these issuers are concentrated in the larger. Sources: British Bankers Association. The next release is expected in 2008. 2008. because CDPCs do not post initial margin. CDPCs are exempt from initial margin requirements. to a lesser extent. they represent approximately 87% of the market value of high grade debt. Owing to their high rating. Sources: British Bankers Association. 2% Insurers 6% Mutual funds Pension funds 2% 2% Misc. Equity. Volume is greatest at a five-year maturity. in the form of common stock. more liquid credits. Buyers of Protection. “Caution commensurate with uncertain times has made it more difficult for CDPCs to get prospective counterparties comfortable with understanding and accepting model-based counterparty credit risk and counterparties who do not post collateral.” March 11. 1% Banks and Dealers (Trading Portfolios) 33% Corps.7559 13 . Credit Derivative Product Companies (CDPCs) are a relatively new class of protection Sellers. some Counterparties have expressed concern about trading with CDPCs. accounting for 87% of market debt In high grade. and therefore in principle are able to use leverage to seek high returns. No survey was released in 2007. primarily on investment grade credits. Banc of America Securities LLC estimates. 2% 5% Mutual funds 3% Hedge funds 31% Hedge funds 28% Loan Portfolios 7% Loan Portfolios 20% Insurers 18% No survey was released in 2007. we estimate that there is an active market for credit default swaps referencing about 63% of issuers.
High Grade Cash Issuers Estimate as of April 2008 Count Sector Basic Materials Capital Goods . High Yield About 16% of high-yield issuers trade actively in the CDS market. S&P. and REITs. Figure 9 illustrates this point.7559 .Credit Strategy Research May 27. Lodging & Leisure Health Care Insurance Media Technology Telecommunications Transportation Utilities Total Source: Banc of America Securities LLC Estimates. 14 Credit Default Swap Primer Glen Taksler 646. 2008 35 Figure 8. Finance includes Finance. and Fitch. Banks. While not as large as in high grade. with cash bonds outstanding of at least $250 million. these issuers represent approximately 44% of high yield market value. % Issuer Market Value 64% 64% 85% 86% 66% 43% 80% 76% 44% 84% 61% 80% 77% 64% 63% 70% 76% 95% 97% 86% 87% 96% 89% 71% 95% 65% 97% 94% 88% 87% 44 45 40 43 64 121 5 33 52 19 18 20 13 53 570 Liquid CDS HG Issuers 28 29 34 37 42 52 4 25 23 16 11 16 10 34 361 Includes corporate issuers with investment grade ratings by at least two of Moody’s.Manufacturing Consumer Cyclical Consumer Non-Cyclical Energy Finance Gaming. accounting for 44% of market debt In high yield. Diversified Finance. High Grade Liquid CDS vs. we estimate that there is an active market for credit default swaps referencing approximately 16% of issuers.855.
For a more detailed explanation. Figure 10 outlines the basics around each type of Credit Event. please see the Chapter Appendix on page 17. please see the Chapter Appendix on page 17. There are three types of Credit Events: Bankruptcy. Lodging & Leisure Health Care Insurance Media Technology Telecommunications Transportation Utilities Total Source: Banc of America Securities LLC estimates.Credit Strategy Research May 27. Below. and Fitch. 17 For Reference Entities located in Europe. Modified Restructuring.Manufacturing Consumer Cyclical Consumer Non-Cyclical Energy Finance Gaming. S&P. 17 Failure to Pay. 2008 35 Figure 9. Credit Events A Credit Event is the “default” in “credit default swap” A Credit Event is the “default” in “credit default swap. and for some contracts.7559 15 . % Issuer Market Value 17% 13% 19% 14% 9% 13% 7% 10% 29% 19% 31% 25% 6% 55% 16% 34% 50% 36% 57% 32% 19% 52% 50% 42% 48% 46% 60% 3% 90% 44% 109 92 127 57 85 61 57 49 7 67 35 32 17 20 815 Liquid CDS HY Issuers 19 12 24 8 8 8 4 5 2 13 11 8 1 11 134 Note: Includes corporate issuers with high yield ratings by at least two of Moody’s. Beginners Guide to CDS Contract Jargon Investors new to the credit default swap market are sometimes thrown by a seemingly endless list of terms and definitions. with cash bonds outstanding of at least $100 million. Credit Default Swap Primer Glen Taksler 646. High Yield Cash Issuers Estimate as of April 2008 Count Sector Basic Materials Capital Goods .” It is a circumstance that allows parties to trigger a CDS contract. For details. we translate the most important points. High Yield Liquid CDS vs.855. the market uses a variant known as Modified-Modified Restructuring.
the Reference Entity. and establishes the seniority of CDS within the capital structure. Importantly. Only certain obligations. Following a Credit Event. please see the Chapter Appendix on page 17 x x Credit Event Bankruptcy Failure to Pay Description A company files for bankruptcy or becomes insolvent. x x Source: ISDA. The Chapter Appendix on page 19 discusses further Deliverable Obligation requirements. Reference Entity. appropriately called Deliverable Obligations.Credit Strategy Research May 27. maturity extension. A company's failure to make agreed upon payments on borrowed money. guaranteed by. After the Reference Entity is selected.855. such as maturity limitations. in exchange for the notional of the CDS contract (recall Figure 2 on page 8). the protection Buyer must deliver an obligation to the protection Seller. or in some cases. The Basics Around Credit Events For more details. Examples include reduction in Modified Restructuring interest or principal.7559 . the protection Buyer need not deliver the Reference Obligation. simply an obligation of equal or better seniority. The Reference Entity and Reference Obligation establish the Deliverable Obligations. Figure 11 shows how to often find the standard Reference Entity and Reference Obligation in Bloomberg: 16 Credit Default Swap Primer Glen Taksler 646. 2008 35 Figure 10. The Reference Obligation is typically a large and liquid bond issue. a Reference Obligation of that entity is chosen. Banc of America Securities LLC estimates. Deliverable Obligations must be issued by. Reference Obligation. and subordination to other obligations. are deliverable into the CDS contract. and Deliverable Obligations The Reference Entity establishes which legal entity must suffer a Credit Event in order to trigger a CDS contract The Reference Entity establishes which legal entity must suffer a Credit Event in order to trigger a CDS contract. A company changes outstanding obligations such that it adversly affects investors who own those securities.
but protection Buyers will be unable to trigger CDS contracts. Specifics of the CDS contract are spelled out in the term sheet (see example on page 75). the most common in North American corporates being Bankruptcy. Modified Restructuring. not security. Failure to Pay. Instead. we provide more explicit definitions of important CDS terms. Search field in Bloomberg Reference Entity (Specific legal entity on which a CDS contract is written) Reference Obligation (Establishes required seniority. Before entering into a trade.7559 17 . Banc of America Securities LLC estimates. ISDA. of the Deliverable Obligation) Sources: Bloomberg. CDS contracts do not protect against all defaults. The Credit Default Swap Primer Glen Taksler 646. and for selected credits. Finding the Reference Entity and Reference Obligation in Bloomberg REDL <GO> REDL is not always correct. Credit Events Credit Events include Bankruptcy. agree on a Reference Entity and Reference Obligation with your Counterparty. and for selected credits. CDS contracts protect against specific Credit Events. Failure to Pay. For example. Modified Restructuring Importantly.Credit Strategy Research May 27. bonds may be in technical default. 2008 35 Figure 11. if a Reference Entity violates covenants. Appendix I – The Basics of Credit Default Swaps Details around CDS Contract Terminology Below.855.
Europe (investment grade and high yield.Credit Strategy Research May 27. the date a Credit Event occurs). Sample Credit Event documentation appears on page 86. two-thirds of which consent to the Restructuring. The CDX indices use No Restructuring. Usually applies to borrowed money. single-name and iTraxx indices) uses Modified-Modified Restructuring. Cash flows are settled at T+3 days. 18 Credit Default Swap Primer Glen Taksler 646. Modified and Modified-Modified Restructuring generally limit the maturity of Deliverable Obligations to the front-end of the curve. So. a change in the priority of payment of an obligation. To prevent parties from profiting by triggering bilateral loans. The US investment grade market generally uses Modified Restructuring. Failure to Pay.855.. The protection Seller receives only the accrued periodic payment up to and including the Event Determination Date (effectively. Obligation Acceleration is subject to a minimum dollar threshold amount. The market standard is for CDS protection to begin at T+1 days. Repudiation/Moratorium: A Reference Entity’s rejection or challenge of the validity of its obligations. which causes the subordination of such obligation to any other obligation. and sets a minimum threshold of USD 10 million. Restructuring does not constitute a Credit Event). the protection Seller keeps the periodic payment (quarterly payments calculated by notional x coupon x actual/360. the obligation triggering the Restructuring must have at least 4 unaffiliated lenders. if applicable) in compensation for assuming 18 credit risk on the Reference Entity.7559 . and not be expressly provided for under the terms of the Obligation that were in effect as of the later of the Trade Date and the date the Obligation was issued or incurred. Source: 2003 ISDA Credit Derivatives Definitions. a broader category than simply bonds and loans. No longer used in G7 corporate contracts. Usually applies to borrowed money. No longer used in G7 corporate contracts. The US high yield market generally uses No Restructuring (i. A reduction of interest or principal. Failure to Pay A Reference Entity’s failure to make due payments. the protection Buyer receives a compensating payment depending on the settlement of the contract (discussed below).e. but credits that were downgraded from investment grade usually continue to use Modified Restructuring. obligations may become capable of being declared due earlier than normal as a result of default. For details. Additional criteria that do not involve an actual bankruptcy filing may trigger a Bankruptcy Credit Event. Not relevant to sovereign issuers. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. or maturity extension. or currency is changed to a non-permitted currency (G7 plus OECD members with a triple-A local currency long-term debt rating). Must result from a deterioration in the creditworthiness or financial condition of the Reference Entity. and have been of particular concern to monoline insurers. a broader category than simply bonds and loans. Restructuring If no pre-specified Credit Event occurs during the life of the transaction.S. 2008 35 European corporate market uses Bankruptcy. please see “The Transition from Spread to Points Upfront” on page 108. For details. if a Credit Event occurs on the same day that a trade is executed. Obligation Default: Although rarely used. 18 Upfront payments typically apply only to indices and Reference Entities with five-year CDS wider than approximately 700 bps. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days in the U. and Modified-Modified Restructuring. Figure 12 shows 2003 ISDA Defintions of Credit Events: Figure 12. Conversely. should a Credit Event occur during the life of the transaction. Restructuring criteria may also be triggered if the date for payment or accrual of interest is extended. the investor does not have protection. These criteria are discussed in Chapter VI – CDS Case Studies and Legal Issues on page 158. ISDA Definitions technically provide for three additional Credit Event triggers: Obligation Acceleration: When an obligation has become due and payable earlier than normal because of a Reference Entity’s default or similar condition. Or. Credit Event Definitions Credit Event Bankruptcy Description A corporation’s insolvency or inability to pay its debts. plus an up-front payment.—and usually sets a minimum threshold of USD 1 million.
the protection Buyer may deliver a bond or loan that is pari passu in seniority with the Reference 19 Obligation. Calpine filed for Bankruptcy at 10:57pm New York time on December 20. 2005 maturity. for holders of CDS contract with a December 20. The Reference Obligation determines only the required seniority. Reference Entity. Reference Obligation. For example. the market standard for Reference Entities and Reference Obligations is often found on the REDL screen in Bloomberg.7559 19 . a Reference Obligation of that entity is chosen. 19 There are additional restrictions surrounding Deliverable Obligations following a Restructuring. 2005. and its selection establishes the seniority of the CDS within the capital structure. While there are some exceptions. It is important to note that the protection Buyer does not have to deliver the Reference Obligation. Following a Bankruptcy or Failure to Pay Credit Event. following a Credit Event. For plain-vanilla CDS trades without a Reference Obligation. 2008 35 Deadline for a Credit Event Credit Events must occur by 11:59pm Greenwich Mean Time (GMT) on the maturity date All Credit Events must occur by 11:59pm Greenwich Mean Time (GMT) on the Scheduled Termination Date for the CDS Buyer to have protection. up to a 30-year maturity. As such. its original seniority 20 continues to set the seniority of CDS. If the Reference Obligation matures or is otherwise redeemed. Credit Default Swap Primer Glen Taksler 646. the priority is considered senior unsecured. of the Deliverable Obligation. the protection Buyer may deliver a senior unsecured bond. there was no Credit Event. which was later than 11:59pm GMT. After the Reference Entity is selected. For example.Credit Strategy Research May 27. if the Reference Obligation is a senior secured bond. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. For details.” we mean the seniority as of the later of the CDS trade date and the Reference Obligation issue date. and Deliverable Obligations The Reference Entity is the specific legal entity on which a contract is written The Reference Entity is the specific legal entity on which a CDS contract is written.855. The Reference Obligation is typically a large and liquid bond issue. not the security. 20 By “original seniority.
under no circumstance is holding company debt deliverable. debt from a subsidiary may be deliverable into CDS on a parent company Naturally. Please see the section “Secured CDS” on page 169. CDS Essential Vocabulary List Reference Entity Credit Event The legal entity (not the instrument) on which a contract is written. ISDA Definitions technically provide for additional Credit Event triggers. The Reference Obligation determines only the required seniority. An event that triggers the contingent payment on a credit default swap. Buyer does not have to deliver this exact obligation but must deliver a debt Deliverable Obligations instrument that is pari passu in seniority with the Reference Obligation. Complicated by mergers. Transferable. For Reference Entities located in North America. EUR. Protection Seller buys Deliverable Obligation from protection Buyer at par upon occurrence of a Credit Event. if the Reference Obligation is a senior secured bond. In Cash Settlement. or JPY). Bankruptcy and Failure to Pay. etc. described in Figure 12.855. Maximum Maturity: 30 years. There are two Credit Events currently used across CDS products (see Figure 12). Maturity limitation is typically more restrictive following a Modified.or Modified-Modified Restructuring. that operating company’s debt is deliverable into CDS on the holding company. Note: For senior unsecured CDS. up to a 30-year maturity (typically shorter for a Modifiedor Modified-Modified Restructuring). 2008 35 Figure 13. protection Seller pays protection Buyer the difference between the par and market values of a Reference Obligation. Consent Required Loan (if applicable). Specified Currency (typically. Single-name and index CDS contracts on European Reference Entities (investment grade and high yield) typically include Modified-Modified Restructuring.Credit Strategy Research May 27. See Figure 14. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. not the security. restructurings. if a holding company (parent) guarantees an operating company (subsidiary). Settlement Can be Physical or Cash Settlement. provided that another market participant is willing to take the opposite position. for details. CHF. That is. For example. Sources: ISDA. for CDS on an operating company.7559 . the protection Buyer may deliver a senior unsecured bond following a Credit Event. Assignable Loan (if applicable). 20 Credit Default Swap Primer Glen Taksler 646. Parties retain the option to physically settle. single-name CDS contracts on US investment grade and fallen-angel Reference Entities typically include Modified Restructuring. CAD. of the Deliverable Obligation. Important because different entities within the same company or organization may have different risk profiles and expected recoveries. under certain circumstances. Upstream guarantees (from subsidiary to parent) are not taken into account for Reference Entities located in North America. the recovery values on instruments of those different entities potentially will be very different following a Credit Event. Reference Obligation and Reference Obligation is cited in the CDS term sheet. Standard CDS documentation specifies Physical Settlement. Banc of America Securities LLC estimates. For details. In practice. Not Contingent. Consequently. defaults to senior unsecured. Deliverable Obligations typically are Bonds and Loans that meet the following criteria: Not Subordinated. debt from a subsidiary may be deliverable into CDS on a parent company. the financial and risk profiles of different entities that fall under the same organizational umbrella are not always the same. USD. market expectations are in the process of moving from Physical Settlement to Cash Settlement. Guarantees Under certain circumstances. GBP. Special language must be included for investors who wish to restrict the security of the Deliverable Obligation. parties to a credit default swap should recognize that. However. Please see Chapter VI – CDS Case Studies and Legal Issues on page 143 for details. and Not Bearer. If no Reference Obligation is chosen. The guarantee must be unconditional and irrevocable. where the holding company owns a majority of the operating company. Additionally.
and CDS will become near-worthless. Credit Default Swap Primer Glen Taksler 646. a broader class of guarantees applies to CDS contracts. each such entity and the original Reference Entity will be a Successor. regardless of security.Credit Strategy Research May 27. Also of note: If the parent (or subsidiary) guarantees a third-party. For Reference Entities located in Europe. If a third-party guarantees the parent (or subsidiary). guarantees must be unconditional and irrevocable to be valid for CDS contracts Indicates debt is deliverable North America Europe No If Parent Guarantees Subsidiary Is parent debt deliverable into subsidiary CDS? Is subsidiary debt deliverable into parent CDS? If parent owns majority of subsidiary If parent owns minority of subsidiary No No No No No No No No If Subsidiary Guarantees Parent Is parent debt deliverable into subsidiary CDS? Is subsidiary debt deliverable into parent CDS? If Subsidiary A Sideways Guarantees Subsidiary B Is subsidiary A debt deliverable into subsidiary B CDS? Is subsidiary B debt deliverable into subsidiary A CDS? Globally. that entity will be the sole Successor. Sources: ISDA. Regardless of Where Trade Is Executed Globally. or undergoes some other change in its corporate structure What happens if a Reference Entity is merged. The notional for each contract will be the original notional. Effect of Guarantees on CDS Contracts.7559 21 . Orphaned CDS (Lack of Deliverable Obligations) A CDS contract on a company that has no Deliverable Obligation is sometimes called “orphaned CDS. 2008 35 Figure 14. then parent (or subsidiary) debt is deliverable into third-party CDS. and that company subsequently becomes an operating company within the post-LBO entity. Succession Succession refers to changes in a CDS contract after a Reference Entity is merged.855. Unless the operating company issues new debt. and a $5 million Reference Entity in the Successor Reference Entity. or some other change is made with respect to its corporate structure? This issue is one referred to as Succession in CDS terms. If one or more entities succeeds to more than 25% but less than 75% of the Relevant Obligations. For example. there will be no Deliverable Obligation into CDS contracts. Banc of America Securities LLC estimates. Globally Based on Location of Reference Entity. an orphaned CDS situation may occur when a company’s debt is tendered for in connection with an LBO. for Europe only. acquired. for Europe only. an investor with a $10 million CDS contract may now have a $5 million CDS contract in the original Reference Entity. then third-party debt is deliverable into parent (or subsidiary) CDS. acquired. and replaced with the Successor Reference Entity. debt delivered must be pari passu or better than the Reference Obligation in seniority. and may be summarized as follows: If one entity succeeds to 75% or more of the Relevant Obligations (Bonds and Loans) of the Reference Entity.” For example. as illustrated in Figure 14. The original Reference Entity will be deleted from the contract. divided equally by the number of Successors.
there will be no Successor. the protection Buyer (generally) is only entitled to receive the notional value of protection (e. was relatively low. the settlement protocol set a precedent for including singlename CDS transactions. have allowed investors to cash settle single-name transactions as well. with an option to physically settle. and tranches) state that Credit Events are physically settled. The settlement protocols change the standard to Cash Settlement. Risk of a Short Squeeze Generally. and the Reference Entity continues to exist. please see Chapter VI – CDS Case Studies and Legal Issues on pages 129 and 132. with an option to cash settle. Additionally. on little fundamental news. bonds traded up from $58 immediately post-default to a high of $72 three weeks later. For Delphi. cash settlement protocols have asked banks and broker-dealers to quote the cheapest-to-deliver bond on a defaulted credit.Credit Strategy Research May 27. historically. according to standard confirms. the notional value of protection now exceeds the notional of Deliverable Obligations for many Reference Entities. For more on CDS settlement protocols. although single-name CDS notional for Dura Operating Corp. Section 9.. In regular CDS contracts. This may drive the price of bonds artificially high following a Credit Event As a partial solution. please see Chapter VI – CDS Case Studies and Legal Issues on page 143. the standard is Physical Settlement.7559 . Specifically. parties are not 21 subject to any obligation of confidentiality. provided that both parties consent. the CDS market has voluntarily adopted settlement protocols following all Credit Events since 2005.1(b)(iv)–(v).g. $10 million) if he delivers a bond or loan to the Seller. That is. it is the burden of the protection Buyer to find a deliverable bond or loan. The Reference Entity will not change. provided that another market participant 22 is willing to take the opposite position. For more details on Succession. including case studies on issues that have created recent market uncertainty. there has been a significant need for Buyers of protection to buy bonds post-Bankruptcy. just another participant in the settlement protocol. Generally. Protocols originally allowed investors to cash settle only index and index tranche transactions. but since the Dura Bankruptcy in October 2006. As a partial solution to the risk of a short squeeze. in Delphi. and such Credit Derivative Transaction does not create any obligation … to disclose to the other party any such relationship or information (whether or not confidential). unless otherwise agreed. After applying a filtering mechanism to eliminate off-market quotes. the protocol settles near an average of the dealer prices. This has driven the price of bonds artificially high following a Credit Event. the CDS market has voluntarily adopted settlement protocols 21 22 2003 ISDA Credit Derivatives Definitions. With rapid growth in the CDS market. The other participant need not be the original Counterparty. As such. For example. the 2003 ISDA Credit Derivatives Definitions contain representations surrounding information. parties acknowledge that they may be in possession of material information “that may or may not be publicly available or known to the other party. 23 Roughly speaking. 22 Credit Default Swap Primer Glen Taksler 646.” Moreover.855. 2008 35 If no one entity succeeds to more than 25% of the Relevant Obligations. the protocol helped to bring 23 bonds down from a peak of $72 to a cash settlement price of $63. indices. Information and Confidentiality Provisions Although credit default swaps usually are traded on the public side of the information wall. it is the burden of the protection Buyer to find a deliverable bond or loan Standard confirms for flow CDS products (single-name.375.
ISDA attempts to adjust for potential double-counting. and immediately unwinds with the same dealer: Reported size of the CDS market is unchanged An investor sells $10 million protection. 2008 35 CDS and Corporate Bond Market Surveys We look at CDS surveys from ISDA. That is. if an investor buys protection in an index and sells protection in underlying intrinsics. This is an overstatement. The adjustment factor estimates the extent of this double-counting. because the CDS market should grow only $10 million (the amount of the remaining trade between the original dealer and the new dealer to whom the trade was assigned). the size of the CDS market may grow without any change in overall risk exposure. reported size of the CDS market is likely to be unchanged ($10 million in initial trade – $10 million offset). and subsequently offsets the trade by buying $10 million in new protection (rather than an unwind or an assignment): If the offset is with the original dealer and has the same maturity date as the original trade. emphasizing differences between market size and overall risk exposure. in which the trades of two survey respondents offset each other. International Swaps and Derivatives Association (ISDA) Survey ISDA conducts two surveys per year of its primary members.855. This result accurately reflects net credit risk. We show several examples that illustrate the methodology. ISDA asks each institution to estimate the size of its credit derivatives notional. the adjustment factor should bring the reported growth in the CDS market back to $10 million. similar to an unwind. leading to double-counting. even though net credit exposure will be unchanged. reported CDS notional will grow. Credit Default Swap Primer Glen Taksler 646. As described below. An investor sells $10 million in protection. We then explain our methodology to estimate the size of the global corporate bond market. In principle. and the Bank of International Settlements (BIS). the British Bankers’ Association (BBA). and assigns the trade to another dealer: Reported size of the CDS market grows $20 million ($10 million initial trade + $10 million assignment). the British Bankers’ Association. This section provides more details on the methodology of popular CDS and corporate bond market surveys. New Trades An investor buys or sells $10 million in protection: Reported size of the CDS market grows $10 million Unwinds/Assignments/Offsets: An investor sells $10 million in protection. and the Bank of International Settlements We agree that the CDS market is growing rapidly but believe that under many circumstances. We focus on three CDS market size surveys: the International Swaps and Derivatives Association (ISDA). each dealer will report a $10 million trade with another dealer. This is because the original dealer is likely to consolidate the two trades. ISDA attempts to adjust for the error by multiplying the $20 million by a BISestimated adjustment factor for dealer-to-dealer trades. to show a net zero position.Credit Strategy Research May 27.7559 23 . and then aggregates the results to obtain an overall estimate of market size. For example.
across approximately 60 institutions in the G10 countries and Switzerland. rather than another dealer. Index vs. regardless of maturity date. reported CDS notional increases.7559 . Even though there is no net credit exposure. the reported size of the CDS market grows $20 million ($10 million in initial trade + $10 million in offset). the reported size of the CDS market grows $10 million Structured Credit (Correlation) An investor sells $10 million of 20x leveraged equity tranche protection. delta-hedged with protection in the underlying constituents: Reported size of the CDS market grows $210 million ($10 million tranche notional + $200 million of protection for the hedge). The result is the same if the investor hedges with single-name CDS or an index. there is no adjustment for the offsetting position. the last time in June 2007. Bank of International Settlements (BIS) Survey The Bank of International Settlements (BIS) conducts a semiannual survey on the derivatives markets. An investor sells $10 million of 20x leveraged equity tranche protection. British Bankers’ Association (BBA) Survey The bi-annual BBA survey does not use a standardized methodology to estimate the size of the CDS market. Unlike an assignment. reported size of the CDS market grows $20 million ($10 million in initial trade + $10 million in offset).Credit Strategy Research May 27. the BBA survey simply asks one question of each of its members: “What do you estimate the size of the GLOBAL market in credit derivatives to be? Please provide estimates in aggregate notional value outstanding in USD mns. an investor partially offsets an off-the-run CDS contract with an onthe-run CDS contract.500 institutions worldwide. However. each dealer faces the client. 24 Credit Default Swap Primer Glen Taksler 646. Instead. if the offset is with the original dealer but has a different maturity date (for instance.855. but keeps the tail risk between the maturity dates). 2008 35 However. Every third year. the reported size of the CDS market grows $250 million ($125 million index trade + 125 single-name trades of $1 million each) CDS—Cash Basis Trades An investor buys $10 million of a cash (corporate) bond and buys $10 million singlename protection. As such.” BBA then reports the average of these estimates. Intrinsics Arbitrage An investor sells $125 million in index protection and buys $1 million single-name protection on each of the 125 underlying constituents: Even though there is no net credit exposure. Even though the offset causes net credit risk to substantially decline. If the offset is with another dealer. one might argue that the reported size of the CDS market should grow $200 million ($10 million tranche notional x 20x leverage = $200 million single-name equivalent risk). unhedged: Reported size of the CDS market grows $10 million. the survey is conducted across approximately 1.
S. and commodities. corporate bond market. BIS surveys dealers. We look at BIS estimates of debt securities for corporate and financial issuers. Otherwise. To reduce double-counting. dealers. 2. anywhere in the world. relative to the U. 2008 35 In addition to credit.S. The BIS then calculates total notional amount outstanding as the sum of contracts bought and sold. residents through U. dealers are asked to report both their total notional and their notional with other dealers.S.S.. Adjust these estimates to reflect the approximate size of the global. banks.S. insurance and financial firms.S. Estimate the size of the portion of the global corporate bond market held by U. We then multiply the results in step one by this adjustment factor.S.855. residents. plus bonds issued by non-U.Credit Strategy Research May 27. as well as non-financial institutions. These estimates include bonds issued by U. corporations.S. we look at the global market. Corporate Bond Market Size We use the following methodology to estimate global corporate bond market size: 1. international and domestic. While the survey began in June 1998. minus one-half the sum of contracts bought and sold between reporting dealers. market. this methodology suggests that the global market is approximately twice the size of the U. In recent years. BIS’ methodology is similar to the ISDA survey. entities. we look at the U. which are purchased by U. interest rates. For the numerator.7559 25 . credit default swap reporting began in December 2004. based on Federal Reserve Flow of Funds data. market. For the denominator. the survey includes data on derivative contracts in foreign exchange. Credit Default Swap Primer Glen Taksler 646. equities.
discussed below. not LIBOR + 380 bps. While investment grade cash bonds are typically quoted as a spread to Treasury. credit default swaps are thought of as a spread to LIBOR The most important difference between the corporate bond (“cash”) and CDS markets is the benchmark spread curve. for the protection Buyer to pay 380 bps 26 Credit Default Swap Primer Glen Taksler 646. That is. we summarize various ways to compare relative value between CDS and corporate bonds. CDS payments in most instances are tied to the underlying cash instrument through no-arbitrage relationships. While investment-grade cash bonds are typically quoted as a spread to Treasury. Figure 15. or the fixed payment an investor would receive for providing protection: meaning going long credit risk. Source: Banc of America Securities LLC. the Buyer is assumed to fund at LIBOR. Notice the payment is 380 bps.000 per quarter) to the protection Seller. The Chapter Appendix on page 34 provides more complete details. The bid side in the CDS market reflects what CDS dealers will pay for protection. Investor’s Economic Position: Although relatively small. the offered side in the cash market reflects the price at which cash dealers will sell an asset. to short credit risk. The ABCs of Credit Spreads Below. 2008 35 Chapter II – Differences Between the CDS and Corporate Bond Markets Pricing in the CDS Market Quoting conventions have opposite economic meanings in the cash and CDS markets Credit default swap market pricing convention can be counterintuitive to cash investors because bids and offers in the cash and CDS markets have opposite economic meaning. please see Interest Rate Sensitivity on page 111.Credit Strategy Research May 27. Consider a single-name CDS trade at 380 bps. Similarly. or the fixed payment an investor must pay to purchase protection: meaning. The quoted spread will be 380 bps. The reason has to do with the cost of funding. credit default swaps have some exposure to interest rates. credit default swaps are thought of as a spread to LIBOR. In contrast. Though the form of CDS fixed payment quotations may be unfamiliar to some cash market participants. However. in CDS.7559 . because of the inclusion of LIBOR in the discount factor. on a $10 million notional. In contrast. a bond’s spread to LIBOR. the bid side in the cash market reflects what cash dealers will pay for an asset. and the protection Buyer will pay $380.855.000 per annum ($95. so that the investor would be long credit risk. For details. so that the investor would be short credit risk. In this sense. often provides a good indication—but not an exact metric—of credit default swap levels. CDS vs Cash Market Pricing Convention Credit Default Swap Market Bid for Credit Default Protection Investor’s Economic Position Investor’s Cash Flows Funding Long credit risk Receive coupon Unfunded Cash Market Market Bid for Cash Instrument Short credit and interest rate risk Pay yield Funded The reverse logic applies for market offer-side. the offered side in the CDS market reflects the fixed payment CDS dealers demand to provide protection.
that is. the investor has no recourse against Verizon. a protection Buyer who funds at LIBOR + 3/8 should view the same credit spread as LIBOR + 3/8 + 380 bps. only against the CDS Counterparty. Should the Counterparty fail to make a coupon payment (or appropriate payments following a Credit Event). the market generally views CDS as a LIBORbased market. Hence.855.7559 27 . and they view CDS as a LIBOR + funding spread market. the investor has no further exposure to the bank or broker-dealer. If a cash bond investor purchases a Verizon bond. only against the CDS Counterparty However. Alternatively. they would issue a bond at about the Treasury rate + swap spread. Hedge funds are a natural exception. Should the Counterparty fail to make a payment. effectively creating a spread of 24 LIBOR + 380 bps. payment for that transaction is solely a matter between the investor and Verizon.Credit Strategy Research May 27. he must borrow that money at LIBOR. While a bank or broker-dealer Counterparty may facilitate that trade by locating the bonds. Credit Default Swap Primer Glen Taksler 646. spread to LIBOR may be thought of as compensation for Counterparty risk. Figure 16 shows how to (theoretically) reconstruct a corporate bond from a credit default swap: 24 This gives an important lesson: Different counterparties should view the benchmark CDS spread differently. 2008 35 annually. the investor has no recourse against the Reference Entity. once the bonds have been delivered. For example. not just LIBOR + 380 bps. major CDS Counterparties fund at approximately LIBOR. in a credit default swap. payment for the transaction also depends on the creditworthiness of the Counterparty. Typically.
A quarterly CDS coupon (still with a semiannual corporate bond coupon) would widen the Z-spread by approximately 3 bps. Since single-name CDS trades usually begin at par. these trades often begin away from par.582%. In reality.7-bp spread to Treasury and the 380-bp CDS spread is the five-year swap spread (83 bps). Relaxing the coupon assumption would widen the Z-spread by approximately 3 bps. 7. single-name CDS trades often begin away from par for wide-spread Reference Entities. in this case. buy a AAArated bond that yields roughly LIBOR and sell CDS protection 25 In practice.Credit Strategy Research May 27. This is because most corporate bond buyers hedge with Treasuries. the relevant comparison is a corporate bond trading at five-year LIBOR + 380 bps. The difference between the 463.7 bps over the five-year Treasury.855.7559 .5 bps. To reconstruct a cash bond out of a Credit Default Swap. 2008 35 Figure 16. 28 Credit Default Swap Primer Glen Taksler 646. the same as the credit 26 default swap spread. For a five-year credit default swap trading at 380 bps. However. is 380 bps. In addition. Since the credit default indices trade with a fixed coupon. CDS trades with a quarterly coupon and ACT/360 day count. Reconstructing a Cash Bond out of a Credit Default Swap Par L+380 Swap Spread + 380 380 bps Assumes semiannual coupon for both corporate bond and CDS. a yield of 7. See the section. while relaxing the day count assumption would tighten the Z-spread by approximately 3. Sources: Bloomberg. while US corporate bonds pay a semiannual coupon and have a 30/360 day count. 26 For simplicity.” one of the spread to LIBOR measures we will discuss in this section. investors who want to reconstruct a cash bond out of a credit default swap may in principle buy a triple-A rated bond that yields roughly LIBOR—such instruments do not generally exist as of May 2008—and sell CDS protection. This yields the investor LIBOR (from buying the bond) plus the CDS spread (from selling protection). “The Transition from Spread to Points Upfront” on page 108 for details.582% is also the comparable cash 25 bond coupon. Banc of America Securities LLC estimates. leaving them exposed only to the credit spread component of risk. The equivalent cash bond spread is 463. we assume a semiannual coupon and 30/360 day count for both the corporate bond and CDS. The “Z-spread. investors do not often replicate cash bonds out of CDS contracts.
discussed below.Credit Strategy Research May 27. Zspread does not adjust for the dollar difference in recovery between cash bonds and credit default swaps. For bonds trading away from par. Asset Swap Spread is the incremental spread above LIBOR that an investor earns to swap a fixed-rate corporate bond to LIBOR-based floating payments. assuming an upward sloping yield curve. It incorporates the shape of the yield curve in its calculation and uses the timing of cash flows of the bond. For par asset swaps. CDS Spread CDS Spread is a pure and simple credit risk premium that a protection Seller is paid to take on credit risk in the credit default swap market. If there is a Credit Event during the life of the transaction. 2008 35 Which Spread to LIBOR? Below. The Chapter Appendix on page 34 provides more details. understate the actual level of spread when the cash bond is trading at a discount. which uses a higher discount factor to more accurately reflect credit risk. any premium or discount is settled upfront in cash. I-spread. Preferred Spread to LIBOR Measure for Bullet Bonds Par CDS Equivalent Spread is the spread level calculated for a cash bond that makes an investor indifferent between buying the cash instrument and selling CDS protection. For a coupon bond. It is calculated by discounting the premium or discount portion of cash flows at LIBOR flat. OAS to LIBOR is the same as Z-spread. Other Popular Spread to LIBOR Measures I-Spread. Par CDS equivalent spread does not adjust for optionality and therefore should be used only for bullet bonds. except that there is no funding requirement under the credit default swap contract. Credit Default Swap Primer Glen Taksler 646. and Z-spread. the Z-spread is higher than the I-spread. For non-bullet bonds.855. Z-Spread is the option-adjusted spread to LIBOR under an assumption of zero volatility. or interpolated spread to swap. while cash may trade away from par. this payment stops and the investor pays the Buyer of protection a onetime credit loss equal to par minus recovery. making it particularly appropriate for high yield bonds. I-spread is based solely on the yield and maturity of a bond. Z-spread is the same as I-spread. For bullet bonds. Preferred Spread to LIBOR Measure for Non-Bullet Bonds OAS to LIBOR is the option-adjusted spread to LIBOR. unlike Z-spread. asset swap spread. Par CDS equivalent spread more accurately reflects compensation for credit risk. but does not take into account that single-name CDS trades at par.7559 29 . Par CDS equivalent spread assumes a recovery value to keep total credit risk equal between the cash and CDS markets. we summarize popular spread to LIBOR measures. OAS to LIBOR is an approximate relative value measure. not cash flows. It is a percentage of the notional amount (expressed in terms of bps) that the investor is paid per annum. If the yield curve is completely flat. without an assumption of zero volatility. This measure estimates the value of call or put provisions. is the yield difference between a cash corporate bond and a matched-maturity swap yield. The key difference between asset swap spread and other spread measures is the way that asset swap spread breaks up the discounting of coupon flows (at the risky rate) versus premium or discount flows (at LIBOR). The economics of I-Spread for a par bond are identical to those of CDS Spread.
This date range incorporates periods in which the bond traded at both a premium (high of $110) and a deep discount (low of $69): Figure 17. Inc. and receive par. If CDS trades wider than cash (a “positive basis”). 2008 35 Example: Z-Spread vs. this relationship is nonlinear.875 % of 2013. the more Z-spread and Par CDS equivalent spread will differ. Negative-basis trades require attractive funding rates (to pay the CDS premium) and balance sheet availability (to buy the cash bond). This is due to a no-arbitrage relationship: If CDS trades tighter than cash (a “negative basis”). the more Z-spread and Par CDS equivalent spread will differ Notice that the error introduced by Z-spread is closely related to the dollar price of the bond. 7. or both. or borrowing the bond in the repo market. versus Price TOY 7.875% July April 15.875 % July April 15. tightening of the cash spread. versus Price TOY 7. an investor may consider buying protection and buying the cash bond. When the bond was trading at about $80. Positive basis trades require either having the bond in inventory (and available for sale).Z-Spread (bps) 200 150 100 50 0 Par CDS . The further a bond moves away from par.Z-Spread (bps) 250 Par CDS . 2013 Figure 18. …Be Careful About Your Spread Measure Par CDS – Z-Spread.855. the investor profits from tightening of CDS. Provided that the basis widens. the investor may deliver the cash bond to settle the CDS contract. an investor may consider selling protection and selling the cash bond. an investor may consider buying protection and buying the cash bond After converting a cash bond to spread to LIBOR. widening of the cash spread. the investor profits from widening of CDS. Provided that the basis tightens.Z-Spread Price 120 110 Price ($) 100 90 80 70 250 200 150 100 50 0 -50 65 75 85 95 Price ($) 105 115 -50 60 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Source: Banc of America Securities LLC estimates. 2013 Par CDS . If a Credit Event occurs. between October 2003 and April 2008. or both. the investor may use the bond received from physically settling the CDS contract. Z-spread and Par CDS equivalent spread were within 10 bps of each other. The Credit Default Swap Basis If CDS trades tighter than cash (a “negative basis”). If CDS trades wider than cash (a “positive basis”).7559 .Credit Strategy Research May 27. an investor might expect that the CDS spread for a Reference Entity should equal the spread to LIBOR on an identicalmaturity par bond. If a Credit Event occurs. By contrast. As a Bond Moves Further Away from Par… Par CDS – Z-Spread. Par CDS Equivalent Spread Figure 17 and Figure 18 illustrate the difference between Z-spread and Par CDS equivalent spread for the Toys “R” Us. when the bond was trading around par. an investor may consider selling protection and selling the cash bond 30 Credit Default Swap Primer Glen Taksler 646. Moreover. Source: Banc of America Securities LLC estimates. Z-spread understated Par CDS equivalent spread by about 45 bps (Figure 18). The further the bond moves away from par. to cover the short position in the bond.
As Figure 20 shows. but 1000 bps in CDS. CDS has outperformed cash. This makes it more difficult to sell bonds and sell protection. most basis package volume has been in the ten-year sector. Figure 21 shows cash versus matched maturity CDS spreads in the fiveyear sector. For details.400 1. in mid-May 2005. even for par bonds. the opposite occurred. assuming a 40% recovery rate. and vice-versa. Most recently. with CDS tightening more than cash. particularly in tighter spread credits.200 1. 13 bps (and the basis has increased 3 bps).125% July 2013 1.000 800 600 400 200 0 Oct-03 Interpolated CDS (bps) Matched-Maturity CDS Spread to LIBOR 1. making it difficult or expensive to find a bond to borrow. the CDS—cash basis tended to widen with the level of credit spreads Figure 19. Historically (less since summer 2007). in early 2008.500 Cash (Par CDS Equivalent Spread. demand for buying protection also rose.855. and the basis became more positive. That is. CDS spreads have often traded with a higher beta than their cash bond equivalent. even after adjusting for maturity differences. 27 Also.Credit Strategy Research May 27. In this sense. Cash spread reflects par CDS equivalent spread to LIBOR. and the basis tended to narrow or even become negative. For example.400 1.000 1. please see the Chapter Appendix on page 44. both CDS and cash have rallied. assuming a 40% recovery rate. We note that.1708 R2 = 0. bps) Cash spread reflects par CDS equivalent spread to LIBOR.9607 Spread (bps) Oct-04 Oct-05 Oct-06 0 500 1.125% July 2013 Figure 20. say. if the cash bond widens 10 bps. 2008 35 In reality. CDS versus Cash in a Volatile Market Recently. the basis widened with the level of credit spreads. CDS has aggressively outperformed cash. CDS spreads reached particularly wide levels versus cash.” Historically—but less since summer 2007—one of the most important factors determining the basis has been the level of credit risk (or spreads). In wider spread credits (Figure 22). as credit quality deteriorated.7559 31 . Figure 19 illustrates the historical relationship between CDS and cash for General Motors Corp. the repo market often dries up.3128x + 1. Credit Default Swap Primer Glen Taksler 646. at wide credit spreads. an investor could earn roughly 750 bps in cash.200 1. CDS has 27 tended to widen. Source: Banc of America Securities LLC estimates. When credit risk has declined. Notice that CDS almost always traded wider than cash during this approximately two-year period.600 1. cash spreads actually moved wider. for credits where five-year CDS spread is tighter than the CDX IG index. We define this difference (CDS – cash) as the “basis. as CDS spreads have tightened. we focus our graphs on the five-year sector due to better data availability. For example. a number of factors cause differences in CDS and the cash spread to LIBOR. When credit risk has risen. CDS Is More Risky than Cash… Interpolated CDS versus Cash Spread GM 7. Source: Banc of America Securities LLC estimates. This means that. however. …Particularly in Wide Spread Environments Cash Spread versus CDS-Cash Basis GM 7. driving the average CDS – cash basis to roughly -80 bps (CDS 80 bps rich to cash bonds) Since summer 2007.000 800 600 400 200 0 y = 1.
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May 27, 2008
Figure 21. Cash and Matched Maturity CDS Spread
For Credits with Five-Year CDS < CDX IG Index January 2005 to April 2008
Figure 22. Cash and Matched Maturity CDS Spread
For Credits with Five-Year CDS > CDX IG Index January 2005 to April 2008
160 140 120 100 80 60 40 20 0 Jan-05
Cash Matched Maturity CDS
600 500 Spread (bps) 400 300 200 100
Cash Matched Maturity CDS
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. The number of bonds analyzed each day depends on the availability of pricing data. Currently, we look at a portfolio of 66 bonds. Source: Banc of America Securities estimates.
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. The number of bonds analyzed each day depends on the availability of pricing data. Currently, we look at a portfolio of 66 bonds. Source: Banc of America Securities estimates.
Figure 23 illustrates the relationship between cash and CDS spreads more directly by taking the difference between the two spreads. Notice the gap tighter:
Figure 24. CDS – Cash Basis Volatility Increases Steadily Since Summer 2007
For Credits with 5y CDS < CDX IG Index January 2005 to April 2008
Figure 23. CDS Outperforms Cash Spread to LIBOR
CDS – Cash Basis (bps) January 2005 to April 2008
6m Rolling Daily Volatility of CDS -Cash Basis (bps)
100 CDS - Cash Basis (bps) 50 0 -50
Tighter Spread Credits Wider Spread Credits
6 5 4 3 2 1 0 Apr-05 Feb-06 Dec-06 Oct-07
-100 -150 Jan-05 Sep-05 May-06 Jan-07 Sep-07
The number of bonds analyzed each day depends on the availability of pricing data. Currently, we look at a portfolio of 82 bonds: 39 with five-year CDS wider than the CDX IG index and 42 tighter than the CDX IG index. Source: Banc of America Securities LLC estimates.
The number of bonds analyzed each day depends on the availability of pricing data. Currently, we look at a portfolio of 82 bonds: 39 with five-year CDS wider than the CDX IG index and 42 tighter than the CDX IG index. This figure is restricted to credits with five-year CDS tighter than the IG index. Source: Banc of America Securities LLC estimates.
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May 27, 2008
The heightened volatility in the CDS–cash basis is as striking as the record negative levels. Figure 24 shows that the volatility in the basis has grown steadily since summer 2007. To calculate volatility, we take a rolling six-month standard deviation of daily changes in the CDS–cash basis. Funding Costs As it becomes more expensive for financial institutions to fund, they tend to prefer synthetic risk, like CDS, relative to funded risk, like cash bonds. Alternatively, if funding costs rise, say, 50 bps, the relevant metric for cash bonds becomes a spread to L+50 bps rather than a spread to LIBOR flat. Figure 25 shows three-year AAA credit card spreads and the CDS cash basis. Notice that as the credit card spreads have widened (gray line is inverted), the basis has tightened.
Figure 25. CDS – Cash Basis and Funding Cost Moving Together CDS – Cash Basis and AAA Credit Card Spreads
For credits with 5y CDS tighter than the CDX IG index spread
Figure 26. CDS- Cash Basis and the Effective Basis after Adding Funding Cost Effective Basis = CDS – Cash Basis + Funding Cost
For credits with 5y CDS tighter than the CDX IG index spread
20 10 0 -10 -20 -30 -40 -50 -60 -70 -80 Jan-05
CDS - Cash Basis AAA Credit Cards
-20 20 40 60 80 100 120 AAA Credit Cards Spread (Inverted) (bps) 0
100 80 60 40 20 0 -20 -40 -60 -80 Jan-05
CDS - Cash Basis Effective Basis
CDS - Cash Basis (bps)
CDS - Cash Basis (bps)
Source: Banc of America Securities LLC estimates.
Source: Banc of America Securities LLC estimates.
2006: The Year of Swap Spreads
Tighter swap spreads may cause CDS to outperform
In summer 2006, the CDS—cash basis moved almost in lockstep with tightening swap spreads. The reason is a different investor base between cash and CDS. Cash bond investors, who typically are benchmarked versus Treasuries, paid little attention to the move in swap spreads. By contrast, CDS investors, who typically fund versus LIBOR, viewed cash bonds as cheapening to CDS, because their spread to LIBOR had widened. See Figure 27 and Figure 28.
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May 27, 2008
Figure 28. 2006: CDS-Cash Basis On Top of Swap Spreads
Interpolated CDS—Cash Basis, versus Five-Year Swap Spread 3 Jan 06—5 Jan 07
Figure 27. 2006: Cash Spread to Treasury Tightening, but Spread to LIBOR Widening
Shown for BAS Broad Market Index of Investment Grade Cash Bonds 3 Jan 06—5 Jan 07
Spread to LIBOR 50 48 94 46 92 44 90 42 88 40 86 38 84 36 82 34 Jan- Mar- May- Jul- Sep- Nov- Jan06 06 06 06 06 06 07 96
Cash Spread to Treasury (bps)
Spread to Treasury
Basis 5y CDS - Cash Basis (bps) 8 5 2 -1 -4 -7 -10 -13 -16 Jan-06 May-06
5y Swap Spread 56 54 52 50 48 46 44 42 40 38 Jan-07 5y Swap Spread (bps)
Cash Spread to LIBOR (bps)
Based on approximately 145 investment grade and crossover credits. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Sources: Bloomberg; Banc of America Securities LLC estimates.
Based on approximately 145 investment grade and crossover credits. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Sources: Bloomberg; Banc of America Securities LLC estimates.
Appendix II – Differences Between the CDS and Corporate Bond Markets
More on The ABCs of Credit Spreads
Particularly when a bond is trading away from par, various spread to LIBOR measures can be quite different
For relative value comparisons between cash and CDS, investors should convert the cash bond spread to LIBOR. Popular measures of spread to LIBOR include I-spread, asset swap spread, Z-spread, and par CDS equivalent spread. Particularly when a corporate bond is trading away from par, these measures can be quite different. For example, as illustrated in Figure 29 for a $68.50 bond, the asset swap spread (“ASW,” in red) is 576.7 bps, while the Z-spread (“ZSPR,” also in red) is 758.2 bps. To clear up the concepts, we now explain the various spread measures.
Credit Default Swap Primer Glen Taksler 646.855.7559
the corresponding I-spread is 7. For the sample bond in Figure 29.855. (To calculate the 10.3-year swap yield. I-Spread I-spread compares the yield of a bond with a matched maturity swap yield I-spread is the simplest way to define and understand spread to LIBOR. The corresponding 10. This matches up with the 751-bp I-spread from Figure 29 (“ISPRD. YAS Screen on Bloomberg Source: Bloomberg.38%.3-year swap yield is 4. I-spread simply compares the yield of a bond with a matched maturity swap yield.” in white toward the bottom-left of the circled area).Credit Strategy Research May 27.3-year (August 2018) bond is 11.and 15-year swap yields.51%. the yield to maturity of a 10.889%. we interpolate the 10. 2008 35 Figure 29. Credit Default Swap Primer Glen Taksler 646.) As illustrated in Figure 30.7559 35 .
Credit Strategy Research May 27.855.275 years) = 7. investors usually prefer the lower dollar-priced bond (4. Asset Swap Spread Most investment grade corporate bonds are structured as fixed-rate bullets. Asset swap transactions are designed to solve this problem. That is. Asset swap spread is the annual spread over floating-rate LIBOR that an investor earns in exchange for selling the fixed cash flows of the bond. In reality. whose cash flows are more front-loaded.51% I-Spread Sources: Bloomberg.5% coupon). with a flat coupon payment plus par at maturity. assuming no default. not the timing of its cash flows. there is an interest-rate mismatch. Calculating I-Spread 11.7559 . The reason for the 751 bps extra yield is the risk that the corporate bond issuer may fail to pay.38% Swap Yield (at 10. a credit investor earns 751 bps more per annum on the corporate bond than on a matched-maturity swap.889% Yield – 4. not the timing of its cash flows It is important to note that I-spread only considers the yield of the bond. a 4. For leveraged investors who fund the purchase of corporate bonds with a floating rate liability. That is. for the same yield and maturity. 2008 35 Figure 30. to meet cash flow requirements on the funding side. Banc of America Securities LLC estimates. I-spread only considers the yield of the bond. the investor buys the fixed-rate corporate bond and swaps the fixed-rate payment into floating LIBOR-based payments.5% coupon bond. in exchange for selling the fixed cash flows of the bond 36 Credit Default Swap Primer Glen Taksler 646. That is. because they will lose less of a premium following a Credit Event. A par asset swap is based on Asset swap spread is the annual spread over floating-rate LIBOR that an investor earns.5% coupon bond has the same I-spread as a 6.
the par portion of the bond is discounted at the risky rate. In ASW. Credit Default Swap Primer Glen Taksler 646. the fixed-rate cash flows are exchanged semiannually.25% semiannually (second column. An asset swap is a separate agreement between two parties. Figure 31. In this case. In exchange. while the premium or discount portion is discounted at LIBOR.5% coupon divided by two). while the floating-rate cash flows (floating-rate LIBOR plus the asset swap spread) are exchanged quarterly. Asset swaps have a quarterly day-count convention. The net cash flows (floating minus fixed) are shown in the fourth column. which represent the premium or discount portion of the bond. but will only pay out fixed-rate cash flows 28 Intraday movement in the swap curve may cause slight differentials in spreads between screens.5 2018 Corp ASW <GO> Discounted at LIBOR $31. an asset swap continues. are discounted at LIBOR. Calculating Asset Swap Spread F6. calculated as a 6. Net cash flows. the investor pays out fixed cash flows of 3. while the premium or discount portion is discounted at LIBOR The key difference between asset swap spread and other spread measures is the way that asset swap spread breaks up the cash flows. the investor receives LIBOR + 579 bps quarterly (circled area in the third column).855.” in 28 red) from Figure 29. Banc of America Securities LLC estimates. so if the underlying issuer defaults. with any premium or discount settled up-front in cash when the investor enters into a transaction. so in practice.5 Discount (Plus Accrued Interest) Sources: Bloomberg. to arrive at the present value in the far right column.7559 37 . the investor is expected to receive a present value of $1 million in floatingrate LIBOR over the life of the asset swap.Credit Strategy Research May 27. Notice that 579 bps roughly corresponds to the asset swap spread (“ASW. 2008 35 par. Consider Figure 31. The par portion of the bond is discounted at the risky rate (the bond coupon). In this case.
For readers familiar with option-adjusted spreads (OAS).5. I-spread. when the investor finances his purchase with a series of zero-coupon bonds. and asset swap spread are relatively close to each other. Z-spread may be interpreted as spread income on a corporate bond.855.889% and the coupon is 6. With the exception of cross-currency trades.5%. This fixed spread is called the Z-spread 38 Credit Default Swap Primer Glen Taksler 646. Zspread. Z-Spread Another often-used but easily misunderstood spread terminology is the Z-spread. The Z-spread is chosen to make the present discounted value of the cash flows equal to the price of the bond. the investor also pays 31.Credit Strategy Research May 27. The bond yield is 11. Each cash flow is discounted at the zero-coupon LIBOR rate plus a fixed spread on the cash flow payment dates. while I-spread ignores the timing of a bond’s cash flows. 2008 35 worth $68. Z-spread is the OAS to LIBOR under an assumption of zero volatility Each cash flow is discounted at the zerocoupon LIBOR rate plus a fixed spread on the cash flow payment dates. While I-spread is the incremental yield over a matched maturity swap. This fixed spread is called the Z-spread. In exchange. where an investor may actually want to swap US dollars for euros.7559 . they use asset swap spread as a relative value tool to estimate the appropriate spread to LIBOR against which to compare a CDS spread. Z-spread is the OAS to the LIBOR curve under an assumption of zero volatility. asset swap spread incorporates the timing of coupon payments. For bonds at par. The most important point to remember is that.5%.5 bond price). CDS—cash investors do not usually institute asset swaps. Instead.5 points upfront ($100 par – $68. The par portion of the bond is discounted at 6. The origin of Z-spread is the mortgage market. while the discount portion of the bond is discounted at LIBOR. Z-spread is the incremental yield over the entire LIBOR spot curve (or zero curve).
Credit Strategy Research May 27. Calculating Z-Spread F6. This gives a Z-spread of 763 bps.7559 39 . then Z-Spread is exactly the same as I-Spread. using the OAS1 screen in Bloomberg.” in red). Z-spread discounts the premium or discount portion at a more realistic rate. If the LIBOR yield curve is flat. 2008 35 Figure 32. Z-spread discounts the premium or discount portion of a BBB-rated bond at a higher (LIBOR + Z-spread) rate. and a BBBrated bond. with a discount rate of LIBOR. Banc of America Securities LLC estimates. So while both Zspread and asset swap spread take into account cash flows. We use a $68. is the same under asset swap spread. 30/360) Sources: Bloomberg. 29 roughly the same as that from Figure 29 (“ZSPR. Recall that I-spread ignores the timing of cash flows entirely. This is because all the zero29 Intraday movement in the swap curve may cause slight differentials in spreads between screens. Credit Default Swap Primer Glen Taksler 646. So. Figure 32 illustrates the calculation of Z-spread.5 2018 Corp OAS1 <GO> Zero Volatility Assumption (Valid for Bullet Bonds) USD Swap Curve (Semiannual. For our example bond. the discount rate on the premium or discount portion of a AAA-rated bond.855. We also use the USD swap curve because Z-spread is a spread to LIBOR. An asset swap assumes that the premium or discount portion of a bond bears very little risk. which is valid for a bullet bond. By contrast.5 bond price and add in a zero (the “Z” in Zspread) volatility assumption. The Z-spread (763 bps) is wider than the asset swap spread (579 bps) because of a difference in discounting methodology. recognizing the incremental default risk of a less creditworthy bond.
25% plus the Z-spread. an investor should relax Z-spread’s assumption of zero volatility and look at OAS to LIBOR. 2008 35 coupon LIBOR rates coincide with the LIBOR swap rates. A Note of Caution: Callable/Puttable Bonds The preceding analysis has looked solely at bullet bonds. To keep the present value equal to the bond price. the lower discount rate on the coupon due in six months would cause the present value of the cash flows to rise. Z-Spread adjusts upward to keep the present value of the cash flows equal to the price of the bond. for a 2015-maturity bond that is callable in 2011: When the LIBOR yield curve is upward sloping.10% plus the Zspread. Z-Spread tends to be higher than I-Spread Figure 33. Z-Spread tends to be higher than I-Spread.125 Source: Bloomberg.e. when the LIBOR yield curve is upward sloping. the Z-spread widens. However. Comparing OAS to LIBOR with Z-Spread for a Callable Bond Bond is Callable November 1.Credit Strategy Research May 27. Ordinarily. Figure 33 shows why it is important to relax the zero volatility assumption.7559 . This is because on balance.855. i. For bonds with options. zero rates are lower than the yield-to-maturity used in I-spread. 2011 at $105. Z-spread may discount the coupon due in six months at 3. For example. and the coupon due in one year at 3. The opposite is true when the yield curve is downward sloping.. 40 Credit Default Swap Primer Glen Taksler 646.
we look for the spread for which the present value of expected cash flows equals the bond price. and look at OAS to LIBOR Par CDS equivalent spread adjusts the Zspread for a bond’s premium or discount For bonds trading at a premium. By contrast. Namely. the investor will recover $40 on an initial $120 investment. The Par CDS equivalent spread adjusts the Z-spread for a bond’s premium or discount. For bonds trading at a premium. consider an underlying cash bond that trades at a premium. the value of the call option is the 557.2-bp Z-spread. In April 2008. Should there be a Credit Event with a 40% recovery rate. the bond investor’s actual recovery rate will be lower. In this case. say.5-bp OAS to LIBOR minus the 495. Par CDS Equivalent Spread All of the measures illustrated above ignore the value of a bond’s premium or discount. or 62 bps. For bonds with options. We look at the General Motors Corporation 7.7559 41 . Details on Par CDS Equivalent Spreads In this section. For example.5 bps.855. relax Z-spread’s assumption of zero volatility. for a spread of 874 bps over the 10 year Treasury and a Z-spread of 802 bps over Swaps. A spread of 143 bps for the cash bond is therefore called the Par CDS equivalent spread. say $120. Figure 34 illustrates the mechanics: Credit Default Swap Primer Glen Taksler 646. for cash bonds trading at discount (say an $80 price). the bond was bid at $78. 2008 35 The Z-spread is 495 bps. 150 bps of Z-spread in the cash bond may provide just as much compensation for risk as. from the pricing of a cash bond. or 33%. the investor is indifferent between the 150 bps of Z-spread for the cash bond and the 143 bps of CDS spread. For relative value purposes. Consequently. Par CDS equivalent spread is the same as the Z-Spread. the investor will recover $40 on an initial par ($100) investment.7% 2016 as an example. Par CDS equivalent spread is higher than the Z-spread. the 557-bp OAS to LIBOR should be compared with the CDS spread.Credit Strategy Research May 27. Par CDS equivalent spread is the Z-spread minus a recovery adjustment. because both cash and CDS are based on par. we show how to calculate par CDS equivalent spread to LIBOR. So in reality. 143 bps of CDS spread. Calculating OAS to LIBOR with a volatility of 22. To calculate the par CDS equivalent spread. adjusting for the difference in recovery rates between cash and CDS for the $120 bond. If the underlying cash bond is trading at par ($100 price). For example. for cash bonds trading at par. Similarly. and therefore should be used only for bullet bonds. the difference in recovery rate becomes a non-issue. Although Z-spread does adjust for the shape of the LIBOR curve. it ignores the value of the call option completely. or 40%. As another way to think of this. Par CDS equivalent spread is the Z-spread minus a recovery adjustment Par CDS equivalent spread should be used only for bullet bonds Par CDS equivalent spread does not adjust for optionality.6% gives an OAS to LIBOR of 557. Par CDS equivalent spread adjusts the Z-spread downward for a premium bond to more accurately reflect the recovery rate in the event of default. ignoring day count and other operational conventions. in a single-name credit default swap.
85 $2. look at the expected cash flow during a particular coupon period.39% 30. Add up the present value of expected cash flows across coupon periods.61 $6. Mathematically.49 $2.855. the investor receives recovery plus half the coupon.0 7. look at the marginal probability of default. minus the probability that the issuer does not default in the current 30 coupon period. that is. For details. 2008 35 Figure 34. How to Calculate Par CDS Equivalent Spread Solve for Par CDS Equivalent Spread. Third. Par CDS Probability Marginal Equivalent of Not Probability Years Spread Defaulting of Default exp( -[ Spread ] / [ 1 . Probability of Not Defaulting. approximately all of the coupon would be missed. This is the par CDS equivalent spread.51 $5.5 902 bps 902 bps 902 bps 92.7559 . if the issuer defaults. Second.00 Settlement on April 22. we 31 assume that default occurs halfway through a coupon period. For details.59% 71.11 Sum of PV of Expected Cash Flows = Bond Price $78. Then solve for the spread for which the present value of expected cash flows equals the bond price. we would expect an issuer to default shortly before (or after) the end of a coupon period.19 4.50% 96.85 $103. because there is little incentive for to default well before a coupon payment or principal is due.5 8.04% 3. Provided the issuer does not default. First. we assume that default occurs halfway through a coupon period.39% 73.05% 2.85 $6.82% 7. This probability rises as par CDS equivalent spread widens.80% $1. see the section “Implied Probability of Default” on page 100 of the main text.0 1.76% 86.04% 79. calculate the present value of the expected cash flow as follows. Such that the Present Value of Expected Cash Flows Equals Bond Price ($78) GM 7.08% 4. Banc of America Securities LLC estimates. In this case. 30 The one-year probability of default is the spread. 42 Credit Default Swap Primer Glen Taksler 646.72% 6.43 7. Marginal Probability of Default: Probability of Not Defaulting in Current Coupon Period – Probability of Not Defaulting in Prior Coupon Period Expected Cash Flow: (Probability of Not Defaulting ) * Coupon + Marginal Probability of Default * ( Recovery + ½ * Coupon ) Discount Factor: (1+LIBOR) ^ (-Years) PV of Expected Cash Flow: Expected Cash Flow * Discount Factor Sources: Bloomberg. or at maturity..7% 2016.5 1. expected cash flow is ( Probability of Not Defaulting ) x Coupon + Marginal Probability of Default x ( Recovery + ½ x Coupon ).31 $32.96% 95. The reason for including half the coupon is that.11% 98. discount the cash flow by LIBOR. see the section “Implied Probability of Default” on page 100.85 $3. divided by one minus the expected recovery rate.23% $3.18% 75.85 $3. Mathematically. we include accrued interest. survives the prior period). the marginal probability of default is the probability that the issuer does not default in the prior coupon period (i. par plus the coupon.11% 3.85 $3.94 $5.e. by market convention.53% 2.35% $3.70 $23. 2008. Since we are looking at the spread that makes a bond equivalent to a CDS contract.13 $5.73% 2. sometimes also called Survival Probability: exp( -[ Spread ] / [ 1 – Recovery ] * Years ). so that half the coupon is accrued upon default. However.68 3.48% $6.24% 6.88 $1.92% 32. the probability that an issuer defaults during a particular coupon period. the investor receives the bond coupon. Assumes a 40% Recovery Rate. For each coupon period.Credit Strategy Research May 27. By market convention.0 902 bps 902 bps 902 bps 34.13% 4.Recovery ] * Years ) Probability of Not Defaulting in Prior Coupon Period Probability of Not Defaulting in Current Coupon Period Bond Cash Flow Expected Cash Flow ( Probability of Not Defaulting ) * Bond Cash Flow + Marginal Prob of Default * ( Recovery + 1/2 * Coupon ) LIBOR Discount Factor ( 1 + LIBOR )^ ( -Years ) PV of Expected Cash Flow Expected Cashflow * Discount Factor 0. 31 More realistically.
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In this case, the par CDS equivalent spread is 902 bps, versus the Z-spread of 802 bps. Figure 35 illustrates the problem with Z-spread. Notice that, using the Z-spread, the present value of expected cash flows equals $81.13, versus an actual bond price of $78. As a bond moves further from par, the difference between Z-spread and par CDS equivalent spread grows; see Figure 18 on page 30 of the main text.
Figure 35. Why Z-Spread Fails to Account for Bond Premium or Discount
Present Value of Expected Cash Flows ($81.13) Does Not Sum to Bond Price ($78) GM 7.7% 2016. Assumes a 40% Recovery Rate.
Probability Marginal of Not Probability Defaulting of Default
exp( -[ Spread ] / [ 1 - Recovery ] * Years ) Probability of Not Defaulting in Prior Coupon Period Probability of Not Defaulting in Current Coupon Period
Bond Cash Flow
Expected Cash Flow
( Probability of Not Defaulting ) * Bond Cash Flow + Marginal Prob of Default * ( Recovery + 1/2 * Coupon )
( 1 + LIBOR )^ ( -Years )
PV of Expected Cash Flow
Expected Cashflow * Discount Factor
0.5 1.0 1.5
802 bps 802 bps 802 bps
93.54% 87.49% 81.83%
6.46% 6.05% 5.66%
$3.85 $3.85 $3.85
$6.31 $5.90 $5.52
3.04% 3.11% 3.11%
98.50% 96.96% 95.48%
$6.22 $5.72 $5.27
7.0 7.5 8.0
802 bps 802 bps 802 bps
39.23% 36.70% 34.32%
2.71% 2.54% 2.37%
$3.85 $3.85 $103.85
$2.65 $2.48 $36.64
4.08% 4.13% 4.18%
75.39% 73.59% 71.80%
$2.00 $1.82 $26.31
Sum of PV of Expected Cash Flows ≠ Bond Price
Settlement on April 22, 2008. By market convention, we assume that default occurs halfway through a coupon period, so that half the coupon is accrued upon default. Probability of Not Defaulting, sometimes also called Survival Probability: exp( -[ Spread ] / [ 1 – Recovery ] * Years ). For details, see the section “Implied Probability of Default” on page 100. Marginal Probability of Default: Probability of Not Defaulting in Current Coupon Period – Probability of Not Defaulting in Prior Coupon Period Expected Cash Flow: ( Probability of Not Defaulting ) * Coupon + Marginal Probability of Default * ( Recovery + ½ * Coupon ) Discount Factor: (1+LIBOR) ^ (-Years) PV of Expected Cash Flow: Expected Cash Flow * Discount Factor Sources: Bloomberg; Banc of America Securities LLC estimates.
Factors Driving the Basis
A number of factors cause differences in CDS and the cash spread to LIBOR, even for par bonds. The main text discussed the impact of the level of credit spreads on the CDS—cash basis. We now discuss other major factors that influence the credit default swap basis:
It is rare that the maturity of a cash bond and CDS contract match exactly. For example, the most liquid point on the CDS curve is usually the five-year. For a company that has not issued a five-year bond for one year, the benchmark five-year bond actually has a four-year maturity.
Matched-maturity versus benchmark relative value
For relative value comparisons, an investor often will look at the interpolated CDS spread (average of 3- and 5-year CDS quotes) versus the cash-bond quote. To keep the trade as liquid as possible, historically basis trades usually were executed with fiveyear CDS. This left the investor exposed to credit risk between years four and five of the trade. More recently, investors have shifted to matched maturity CDS, where CDS
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expires on the quarterly roll date (March, June, September, or December 20) following 32 the maturity of the cash bond.
The Repo Market
If the repo rate exceeds the positive basis between CDS and cash, it becomes unprofitable to sell protection and sell the cash bond
Assuming an investor has favorable funding rates and balance sheet availability—as was the case historically—arbitraging a negative basis is straightforward. An investor simply buys protection and buys a cash bond. In principle, this should prevent negative basis opportunities from persisting for extended periods. However, arbitraging a positive basis is significantly more difficult. As credit spreads widen, the repo market often dries up, so that an investor may be unable to find the bond to borrow. Even when the bond is available, it is often expensive, due to significant demand to borrow the security. This makes the “effective basis” equal to the CDS spread, minus the cash spread, minus the repo rate. If the repo rate exceeds the positive basis between CDS and cash, it becomes unprofitable to sell protection and sell the cash bond. Moreover, borrowing the bond may be dangerous. Even when the investor is able to borrow a bond in the repo market, it is frequently for a relatively short term. Consider the case where an investor is only able to borrow a bond overnight, and a Credit Event occurs the following day. The investor sold protection, so he receives a bond from the protection Buyer. The investor expects to use this bond to cover his short position (i.e., the investor sold the bond), but there is a timing mismatch. The protection Buyer has at least 30 days to deliver a bond, but the investor only has the bond overnight from the repo market. The cash bond is also issue-specific, instead of issuer-specific as in the credit default swap. This leaves the investor exposed to the difference in price between the bond he borrows in repo and the bond delivered into the CDS contract following a Credit 33 Event.
CDS underperformance may signal a high probability of default
Despite the difficulty in arbitraging a positive CDS—cash basis, it is not surprising that a wide basis may signal a high probability of default. Enron in 2001 clearly illustrates this case:
Generally, it is best for CDS to mature at least 30 calendar days after a cash bond. If a Reference Entity misses its last scheduled coupon or principal payment, an investor may only trigger a CDS Failure to Pay Credit Event upon the expiry of the grace period specified in the relevant bond indenture, often 30 days. The protection Buyer has no recourse should CDS mature before the end of that grace period. This assumes that the Reference Entity does not file for Bankruptcy or undergo a Modified Restructuring Credit Event—if so, the protection Buyer may trigger CDS immediately. See Figure 12 on page 18 for details. 33 That is, the investor sold CDS protection. Following a Credit Event, the investor should receive a bond from the Buyer of protection. The price of this bond may not equal the price of the bond the investor borrowed in the repo market, exposing the investor to basis risk.
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Figure 36. The Evidence of Things Unseen: Enron Basis Trades Perpetually Wide in 2001
Enron 60% 50% Relative Basis 40% 30% 20% 10% 0% -10% -20% 18-May-01 25-May-01 1-Jun-01 8-Jun-01 SRAC AT&T Ford Motor Credit
Source: Banc of America Securities LLC estimates.
In Figure 36, we show the relationship of the relative CDS basis (defined as the CDScash basis as a percentage of the asset swap spread) on several dates in 2001. Notice that Enron’s basis is clearly wider than other credits. This trend persisted throughout much of 2001, preceding Enron’s financial restatement and subsequent default. The relatively wide level of Enron’s basis was due to a large demand for protection. In hindsight, the wider level was signaling credit risk that was not apparent from cash market pricing alone.
As the CDS market evolves, perceptions of liquidity often tend to favor CDS over cash, helping to compress the CDS-cash basis. However, for less liquid credits and maturities, the reverse can be true, causing CDS to trade wide to cash.
Recovery Rate Risk Between Cash and CDS
The risk of a short squeeze could cause CDS to tighten, relative to cash bonds
As we discussed in the section, “Risk of a Short Squeeze” on page 22, the rapid growth in the credit derivatives market may result in a short squeeze following a Credit Event. In turn, the value of credit default protection may decline relative to cash. Consider an investor who buys $10 million notional protection and expects the same recovery rate as cash, say 40%. That is, the investor expects to recover $6 million ($10 million – $4 million recovery). If a short squeeze causes CDS to settle at, say, 50% recovery, then the value of protection becomes just $5 million ($10 million – $5 million recovery). Should a series of short squeezes cause investors to expect permanently lower recovery rates in CDS, they should become less willing to pay for protection. This would cause CDS spreads to tighten relative to cash, compressing the basis. However, recent CDS settlement protocols have reduced the risk of a short squeeze, so this factor may decline in importance over time.
Even without a short squeeze, “recovery rate” has a different meaning in cash and CDS
Even without a short squeeze, “recovery rate” has a different meaning in cash and CDS. Typically, CDS contracts settle 30 calendar days after a Credit Event. At that time, the market price of the cheapest-to-deliver obligation becomes the CDS recovery rate. By contrast, in cash, an investor may continue to hold a bond until the end of (e.g., bankruptcy) proceedings. Not until that time, which potentially could be years after CDS contracts settle, is the cash recovery rate determined.
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demand for structured portfolio investments caused dealers to hedge by selling protection. if a potential unwind of such structures were to occur. Additionally.7559 . 46 Credit Default Swap Primer Glen Taksler 646. entity. Historically. Although structured transaction volumes plummeted in 2007. please see Chapter VI – CDS Case Studies and Legal Issues on page 158. Perceived advantages for the investor included higher risk-adjusted returns. CDS market participants have become more aware of issues surrounding Succession Events. it is possible for an investor to end up with CDS protection that does not exactly replicate the LBO’d. as individual counterparty risks determine each user’s effective funding costs (both direct funding costs embedded in the CDS spread and implicit funding costs from haircut and margin agreements). because it is uncertain what entity a CDS contract will eventually reference. Under these rules. 34 This general observation may not apply to a specific user of CDS. or spun-off. Moreover.e. all senior unsecured debt at the Reference Entity may go away. which does not require funding. For details. protection Sellers (who are long credit risk) are increasingly attracted to the CDS market. cash bonds—particularly in high yield—may have covenant protection that prevents bond spreads from widening significantly. Similarly.Credit Strategy Research May 27. there may become no Reference Obligation for the CDS contract. and favorable regulatory capital treatment. For details on structured credit. making a 34 synthetic short position relatively cheaper to a cash short position. However. please see Chapter VI – CDS Case Studies and Legal Issues on page 132. it is important to understand their effect. for historical perspective. Consider a case where one or more entities succeed to more than 25% of bonds or loans outstanding for a Reference Entity. Also see several case studies in the same appendix.and ten-year maturities. as happened with monoline insurers in February 2008. 2008 35 Succession Language—The Corporate Finance Factor Succession risk can widen or tighten the basis Since leveraged buyout (LBO) and spinoff activity increased in 2006 and early 2007. less complexity relative to cash flow CDO waterfall rules. particularly at popular seven. Changes in the Cost of Funding Higher funding costs cause CDS to outperform As financial institutions’ funding costs rise. Succession risk may cause CDS to tighten.855.. it could cause wider CDS spreads. For more details. Succession risk often causes CDS to widen relative to cash. In this case. Then CDS language (2003 ISDA Credit Derivatives Definitions) allows a change in the Reference Entity of the CDS contract. for corporate finance activity accompanied by a tender offer. please see Structured Credit Market Basics on page 179. in case volume eventually returns. i. resulting in tightening pressure on CDS spreads. and in case existing structures ever unwind en masse. CDS has no such protection and often widens to reflect expectations of the new capital structure. A potential unwind should widen the basis. A proposed “good bank” / “bad bank” split led to concern that CDS contracts may succeed to a “good bank” business of primarily municipal bonds and tighter credit spreads. Structured transactions embedding credit default swaps provided a vehicle for investors to sell protection (go long credit risk). Demand for Structured Portfolio Investments Synthetic transactions tended to compress the CDS—cash basis. the influx of protection Sellers tends to drive CDS spreads tighter.
Modified Restructuring terminology has greatly limited. although not completely eliminated. while cash settles without accrued interest CDS spreads may widen after the announcement of a new convertible issue CDS trades on an Actual/360 day-count convention. protection Sellers demand a wider spread. This pushed CDS spreads wider. 2001 and Moody’s Investors Service. 2008 35 Cheapest-to-Deliver Option Less relevant in today’s CDS market. Credit Default Swap Primer Glen Taksler 646. there is a 7% price difference between straight and convertible bond issues. driving the CDS—cash basis wider. with the same seniority. The protection Buyer in a CDS transaction has an option to deliver the cheapest deliverable instrument he can find in the cash market. Additionally. To account for the greater potential loss following a Credit Event. while cash trades on a 30/360 convention. According to 35 a 2001 study conducted by Moody’s. the delivery option may impact the CDS—cash basis.Credit Strategy Research May 27. In the US. the cheapest-to-deliver option may cause CDS to underperform Less relevant in today’s CDS market. The second reason is a perception of lower recovery rates on convertibles. In certain cases.” July 2001. while cash settles without accrued interest. this may cause CDS spreads to widen relative to cash. There are two main reasons. The first reason is temporary supply and demand imbalance. 35 For more details. and the demand created from convertible arbitrage funds’ purchase of cheap equity options. the rapidly expanding convertible market was driven primarily by issuers tapping an alternative source of low-cost financing (in a deteriorating equity market). “Impact of Convertible Bond Issuance on the Credit Default Swap Market. “Default and Recovery Rates of Convertible Bond Issuers: 1970—2000. CDS settles with accrued interest following a Credit Event (up to and including the Event Determination Date). In 2001. please see BAS research report. after Credit Events. convertible arbitrage traders needed to buy credit protection in the CDS market.855.” October 19. Convertible Bonds CDS spreads may widen after the announcement of a new convertible issue. Technical Conditions CDS settles with accrued interest following a Credit Event. the cheapest-to-deliver option.7559 47 . To strip the perceived cheap equity option from convertible issues.
The North American Leveraged Loan index (LCDX. and XO roll on March 20th and September 20th. Each of the Reference Entities is equally weighted: In the Investment Grade (IG) index. designed to provide diversified North American credit exposure in the CDS market.0% (1 / 100 members). Currently.333% (1 / 30 members). Only Bankruptcy and Failure to Pay trigger Credit Events. 38 Reference Entities overlap between CDX HY and LCDX. 37 For eligibility in the investment grade index. The indices roll every six months The Reference Entities included in the CDS indices are selected by a consortium of market makers. each entity is weighted at 1. The North American Investment Grade index (CDX. The North American High Yield index (CDX.XO) consists of CDS on 35 North American four. HVOL is a subindex of IG. XO volume has declined substantially since mid-2007. The CDX indices are static portfolios of equally weighted credit default swaps. LCDX rolls on April 3rd and October 3rd. Key Features of CDX Indices CDX provides liquid exposure to the corporate CDS market.” These indices represent the evolution of the market toward a benchmark index recognized by the market. How the Indices Are Constructed Reference Entities in the CDS indices are selected by a consortium of market makers. designed to provide diversified credit exposure In the CDS market. 2008 35 Chapter III – CDX and iTraxx Indices The CDX and iTraxx indices are portfolios of equally weighted credit default swaps. each entity is weighted at 0.8% (1 / 125 members).NA) references CDS on 100 North American Reference Entities. The indices roll every six months.NA. Facilitates relative value trades. in March (to a June maturity) 36 and September (to a December maturity). at least 2 out of 3 ratings (Moody’s. at index inception. S&P. The weighting for each HVOL entity is 3.IG index) consists of CDS on 125 North American Reference Entities.HY) consists of 100 North American high yield Reference Entities.NA. For the crossover index. each entity is weighted at 1. it is possible to gain direct exposure to an index of liquid credits. intended to reflect the 30 most volatile credits. or double-B by two agencies and triple-B by one agency—each entity is weighted at 2.Credit Strategy Research May 27. at index inception. and Fitch) must be investment grade. Trades in an unfunded/CDS format. 37 BB and B subindices also exist.0% (1 / 100 members). 36 CDX IG. In the High Yield (HY) index. In the Crossover (XO) index—whose members are rated double-B by all three agencies.NA. Underlying CDS contracts based on “No Restructuring” Credit Event definitions. at index inception. Overseas versions also exist under the brand name “iTraxx. HVOL. The North American Crossover index (CDX. For the high yield index.855. at least 2 out of 3 ratings must be high yield.7559 . CDX HY rolls on March 27th and September 27th.857%. ratings must be either double-B by all three agencies. at the secured (first-lien) loan level. or triple-B by one agency and double-B by the other two agencies. The index represents a portfolio of individual CDS contracts purchased simultaneously at the same spread. 48 Credit Default Swap Primer Glen Taksler 646.and five-B rated Reference Entities. In the Leveraged Loan (LCDX) index.
Credit Strategy Research May 27. RH Donnelley Corp is in CDX HY and RH Donnelley Inc is in LCDX. For example. 38 Eight Reference Entities trade at different parts of the organizational structure in LCDX vs. The corresponding European indices are iTraxx Main (investment grade). consider a credit default swap at 102 bps. iTraxx Financials (two indices.7559 49 . the credit default indices may trade away from par Figure 37. and there is no accrued interest at trade inception. the credit default indices may trade away from par. but the iTraxx version is far more liquid. Owens-Illinois Inc is in CDX HY and Owens-Illinois Group Inc is in LCDX.855. Indices Trade Away from Par Unlike most single-name CDS. and LevX (leveraged loans). Sabre Holdings Corp is in CDX HY and Sabre Inc is in LCDX. See the Chapter Appendix on page 60 for a full list of Reference Entities. a North American IG Financials subindex exists. iTraxx HVOL (HVOL). Series 10). In single-name CDS. Intelsat Ltd is in CDX HY and Intelsat Corp is in LCDX. 39 Technically. Charter Communications Holdings LLC is in CDX HY and Charter Communications Operating LLC is in LCDX. CDX HY Series 10 (current on-the-run index): Alltel Corp is in CDX HY and ALLTEL Communications Inc is in LCDX. in the investment grade index (CDX IG. How Index Payments are Determined Unlike most single-name CDS. the coupon is fixed at 155 bps. 2008 35 plus 8 Reference Entities at different levels of the capital structure (operating vs. not to be confused with the North American definition of 39 XO). Six Flags Inc is in CDX HY and SIX Flags Theme Parks is in LCDX. iTraxx XO (high yield. Toys R US Inc is in CDX HY and Toys R US – Delaware Inc is in LCDX. as illustrated in Figure 37: Current Index Spread Index Coupon Up Front Payment Made By Seller of Index Protection Source: Bloomberg. However. Credit Default Swap Primer Glen Taksler 646. 38 holding company). one senior and one subordinated). Please see the Chapter Appendix on page 57 for more detail on the construction of the indices and index rolls. the Buyer of protection pays 102 bps running coupon.
(not spread-) based high yield cash market.50”).43 (“price”). 2008 35 The index trades at 155 bps (right hand side of the screen). because they require no ISDA contracts and operationally work in the same manner as trading in cash bonds. In this case.7559 . Bank of America. using a Special Purpose Vehicle structure. Since the notes incorporate an interest-rate swap. the funded note settles through a three-part dealer auction. Note that this is equivalent to a price of $102.654 (“market value”) per $10 million notional.855. Deutsche Bank. Credit Linked Notes – DJCDX <CORP> <GO> Funded versions of the High Yield CDX Index The CDX high-yield index is also available in funded form Although not as liquid. the CDX. although in practice most counterparties have agreed to cash settle. Lehman Brothers. 40 Although the definition of a Credit Event is the same for the CDX HY unfunded and funded products. These investment vehicles are a type of Credit Linked Note. to replicate the price movement of a fixed rate bond. This syncs the high yield indices with the traditional price. the Buyer of protection pays 155 bps running (the fixed coupon) and receives the present value of 53 bps upfront (the difference between the 102 bps traded spread and the 155 bps fixed coupon). Investors in the funded note receive a cash settlement price based on the auction results. for a total payment of $256.Credit Strategy Research May 27. the high yield indices are quoted in dollar price (“$96. Citigroup. there is a difference in settlement mechanics. but the coupon is fixed at 102 bps running (“deal spread”). Merrill Lynch.432 (“total value”). Series 10) at Baa2. they effectively add interest rate exposure (through the swap rate) to the CDS spread. HVOL10 (high volatility index. Credit Suisse. Series 10) is estimated at Baa3. HSBC. we estimate the credit quality of IG10 (investment grade index. The upfront payment equals $242. plus $13. BNP Paribas. Bear Stearns. Morgan Stanley. This leaves the investor exposed to basis risk between the funded and unfunded versions of the indices. UBS and Wachovia. XOVER10 (crossover index. 40 Liquidity is significantly lower in funded indices versus their unfunded counterparts.NA. JP Morgan. Barclays Capital. 50 Credit Default Swap Primer Glen Taksler 646. while the investment grade indices are quoted in spread (“102 bps”). HY10 (high yield index. Series 10) at B3 and LCDX10 (leveraged loan index. Investors who would not otherwise invest in derivatives can gain exposure to the credit default swap market. Series 10) at B2. By contrast. Note that. Goldman Sachs. Members of the CDX Consortium The consortium currently comprises ABN AMRO.HY index is also available in funded form. Ratings Although the indices are not rated. Series 10) at Ba2. The unfunded index is technically physically settled.778 accrued interest.
However..NA.000 of Deliverable Obligations of the Reference Entity.8% (that is. historically. Counterparties have had an option to cash settle the indices.000 (0.7559 51 . 2008 35 Figure 38.2%.NA. the Counterparty pays the fixed coupon of 155 bps on $9. Banc of America Securities LLC estimates.92 million. to $9. the index is cheap to intrinsics. and the Counterparty delivers to the market maker $80. type CDX10 CDS <Corp> <Go>. Please see the section “Risk of a Short Squeeze” on page 22 and Chapter VI – CDS Case Studies and Legal Issues on page 143 for details. If the average spread of the 125 names. For example.IG are physically settled. CDX. Trading the spread differential between the index and its underlying intrinsics is known as “index arbitrage.HY Series 10 Trades in Both Funded and Unfunded From Version Unfunded Funded Issuer CDX HY 10 T CUSIP 12514TAA8 Coupon (%) 5 8.8%.92 million.NA. The notional amount on which premium is paid from that point forward is consequently reduced 0. The market maker pays to the Counterparty $80. Credit Event Example: Counterparty Owns $10 Million CDX.875 Maturity 20-Jun-13 20-Jun-13 Price Movements Spread Only Spread + Swap Rate To view details regarding the unfunded CDX HY index on Bloomberg.8% of the CDX. By convention. Sources: Bloomberg. the index trades with a factor of 99.IG index). then select the corresponding issuer. Basis Between Intrinsics and the Index A popular analytic in index trading is the basis between intrinsics and the actual index spread The intrinsic spread is less than the simple average spread of underlying index components A popular analytic in index trading is the basis between intrinsics and the actual index spread. adjusted for convexity and Modified Restructuring. Modified Restructuring is not a Credit Event.855. type DJCDX <Corp> <GO>. Standard confirms state that Credit Events in CDX.8% x $10 million notional). so that a notional quote of $10 million results in cash flows being exchanged on $9. The Reference Entity weighting is 0. Credit Events in the CDX indices include Bankruptcy and Failure to Pay.” Figure 39 shows that the intrinsic spread is less than the simple average spread of underlying index components: Credit Default Swap Primer Glen Taksler 646. trades tighter than the index spread.NA. Following the Credit Event.Credit Strategy Research May 27. then select the corresponding index. To view details regarding the funded CDX HY index on Bloomberg.92 million until maturity. Please see the section “Credit Events” on page 17 for more details. IG is a 125-name equally weighted index. each entity makes up 0.IG Protection Assume that a Credit Event occurs on one of the index’s Reference Entities.
380. note that Beazer Homes trades as 18 points upfront + 500 bps running.380. The difference (703 bps minus 651 bps) is the distance between the gray estimated line and the red actual line in 41 To obtain the intrinsic spread. Figure 40 shows an example for a portfolio composed of just two CDX HY (Series 10) credits. This line takes into account that a 1 bp move at 20 bps is more significant—hence.169 1.000 3. Intrinsic Spread Determined by Average Present Value.7559 .375.000 1.: Figure 40. We show the equivalent running spread of 1075 bps for illustrative purposes.000 2.Credit Strategy Research May 27. take a DV01 weighted-average of the underlying spreads. Banc of America Securities LLC estimates. Not Average Spread April 2008 Based on a notional of $10 million x x Reference Entity Beazer Homes USA Inc The Goodyear Tire & Rubber Co Average Implied Spread Rating B2/B Ba3/BB- Spread Spread DV01 Present Value (bps) ($) ($) 1075 3.186 330 4. Notice.912 703 3. Instead of considering convexity. 2008 35 Figure 39. Taking the average spread of underlying index components is analogous to looking at the gray line. Banc of America Securities LLC estimates.000 4. Beazer Homes USA Inc and The Goodyear Tire & Rubber Co.385. the spread on Goodyear is 330 bps and the spread on Beazer Homes is 1075 bps. which shows the present value of a single-name credit default swap. Ignoring Convexity Actual Present Value ($ Thousand) 400 600 5y Spread (bps) 800 1000 Sources: Bloomberg. or 650 bps. What the investor should be using is the red line.149 3.659 2. 52 Credit Default Swap Primer Glen Taksler 646. however. a higher DV01—than a 1 bp move at 300 bps.855.000 0 0 200 Estimated Present Value.549 651 Sources: Bloomberg. This produces an average spread of 703 bps. For five-year CDS. the investor implicitly assumes the same DV01 for all of the underlying intrinsics. Also. which shows the actual present value of a single-name credit default swap. Actual Present Value of Single-Name CDS Versus Estimated Present Value Ignoring Convexity Based on a notional of $10 million Present Value ($ Thousand) 5. In this example. the DV01-weighted average is ( 330 x 4169 + 1075 x 3149 ) / (4169 + 3149 ). that the average present value is $2. Converting this back to spread gives an implied 41 spread for the portfolio (intrinsic spread) of just 651 bps.549.
an investor may hedge between indices by going long risk in one index and short risk in another. 2008 35 Figure 40. Including convexity reduces the actual intrinsic spread to 651 bps. using weekly data between January 2006 and April 2008. Indeed. just because a particular hedge ratio was realized historically does not mean it will be realized in the future. the investor would buy intrinsic protection and sell index protection. and vice-versa. in 2007. As such. Figure 41 illustrates the realized hedge ratio between CDX IG (investment grade) and CDX HY (high yield). Moreover. The greater the dispersion of credit spreads within an index.Credit Strategy Research May 27. Figure 41. Source: Banc of America Securities LLC estimates. Credit Default Swap Primer Glen Taksler 646. some investors were stop-lossed out of CDX IG—HVOL pair trades amid substantial mark-to-market 42 losses. it is important to look not just at the average hedge ratio (or beta from a regression). the greater the effect of convexity. When determining a hedge ratio. on any given day. For example. However.7559 53 . look for P&L to average out over time. Amount of CDX IG Protection Needed to Offset $10 Million of CDX HY Exposure Weekly. Instead. January 2006—April 2008 20 Percent of days (%) 42 Average: $47mm Standard Deviation: $120mm 15 10 5 0 -70 -50 -30 -10 10 30 50 70 90 110 130 150 170 Actual IG Hedge ($mm) to offset $10mm CDX HY On-the-run indices. If the intrinsic spread is tighter than the index spread. Hedging Between Indices Like single-name pairs trades. $47 million of investment grade protection was needed to offset $10 million of high yield index exposure. Past performance is not indicative of future results. the hedge ratio ranged from –$60 million to $180 million. investors should understand that P&L between two indices is unlikely to be fully hedged on any particular day. Appendix III – CDX and iTraxx Indices DV01 Neutral Index Arbitrage As discussed in the main text. On average. some investors attempt to arbitrage the difference between the index and underlying intrinsic spread. but also the shape of the distribution.855.
Consider an investor who bought protection on an index and sold protection on each underlying constituent in single-name CDS.999 per $10mm notional. 43 Assuming a Bankruptcy or Failure to Pay. so payments would cancel out.Credit Strategy Research May 27. the DV01 would fall to $2. intrinsics relative value is that single-name CDS and the indices have different durations. we assume that all single names where 5y CDS trades wider than 700 bps trade in points upfront + 500 bps running. in 2008. For iTraxx. To adjust for this risk. the investor would lose money if he sold singlename CDS or make money if he bought single-name CDS. relative to the DV01 of the single-name using the index coupon. 2008 35 A complicating factor in index vs. Modified-Modified Restructuring (“MMR”) is a Credit Event for both single-name CDS and the indices. but not in the CDX indices. which trades at 16 points upfront + 500 bps running in single-name CDS. For more on Restructuring clauses. notional-neutral. For the CDX HVOL Series 10 index. But at the index strike of 350 bps (a deeper discount). For tight-spread credits. The reason is that Modified Restructuring is a Credit Event in single-name CDS (for selected Reference Entities). because it trades at a premium. please see “Restructuring Alternatives” on page 153. and has a DV01 of $3. to keep them DV01neutral to the overall index.180 per $10mm notional. In the event of a Modified Restructuring (“MR”). Although the investor 43 would be hedged against Credit Events. index arbitrage investors have begun to adjust the notionals of single-name CDS. similar to a Bankruptcy or Failure to Pay in CDX. because it trades at a higher dollar price than the same single name struck at the index coupon. he would be exposed to some duration risk. Consider Radian.7559 . Figure 42 shows the difference in DV01 of single-name CDS. 54 Credit Default Swap Primer Glen Taksler 646. single-name CDS has a higher DV01. In general. for wide-spread credits. the single name struck at the index coupon has a higher DV01. because the coupons of single-name CDS differ from the fixed coupon of the index. We assume that all other single names trade at par (all running spread). as 44 of April 2008.855. 44 For our analysis.
and then Fortune Brands (FO) widens.4 0. As such. consider an investor who sells single-name protection and buys index protection. investors have been hedging DV01 mismatch between the index and underlying single names.0 -0. Based on Figure 42. by adjusting the single-name notional. only FON trades in running spread. while CIT trades at 690 bps running. 2008. to give them the same DV01 as the single name struck at the index coupon (350 bps for HVOL10). DV01 Calculated Using Single Name Strike. For Fortune Brands. 2008 35 Figure 42.7559 FON CTL 55 WY CIT FO . Figure 43 shows the adjusted notional for single names. The DV01 differential from Figure 42 suggests that notional-neutral index arbitrage leaves an investor exposed to mark-to-market risk.6 MBIA SFI Single Name Strikes Have Higher DV01s 5 Tightest Index Strike Has Higher DV01 DRI MDC RDN As of April 11.Credit Strategy Research May 27. Less DV01 Using Index Strike Tight Spread Name Have Higher DV01s When Using Index Strike Wide Spread Names Have a Higher DV01 When Using the Single Name Strike 5 Widest DV01 Differential ($ Thousands per $10mm) 0.855. Hedging the DV01 Mismatch In 2008. Source: Banc of America Securities LLC estimates. For example.6 0. RDN and MBIA have a lower differential than CIT because the former trade in points upfront + 500 bps running coupon. sending the overall index wider.2 0.2 -0. the investor would profit more from the index position—which would be positive because the investor buys index protection—than he would lose from the single-name position. Credit Default Swap Primer Glen Taksler 646.4 -0. Among the five widest credits. the CDS at the index strike has a higher DV01 than at the single-name strike.
reduce the single name CDS notional. the overall intrinsics (even after applying the DV01 neutral notionals) will have a different duration from the index.Credit Strategy Research May 27. Notional for DV01 Neutral Index Arbitrage Notionals Vary Inversely With Spread For wide spread credits.5 8. Figure 45 scales the total notional of intrinsic protection (in the same proportions as Figure 43).5 Notional ($ Millions) 11. single-name CDS has a higher DV01 than the single name struck at the index coupon. Source: Banc of America Securities LLC estimates.7559 RDN FO . the investor sells protection on a lower single-name CDS notional.5 10. For wide spread credits. single name CDS has a higher DV01 than the single name struck at the index coupon.0 10. To make the DV01s the same.0 8. 56 Credit Default Swap Primer Glen Taksler 646.0 5 Widest 5 Tightest MBIA KSS DRI MWV FON CTL SFI CIT As of April 11. 2008 35 Figure 43. After applying the DV01 neutral notionals to each name. As such. Figure 44 shows the difference in overall DV01s. For example. To make the DV01s the same. Since the whole point of index arbitrage is that the intrinsics differ from the index. to keep the overall DV01s the same between intrinsics and the index.855. 11. 2008. if the intrinsics are 295 bps versus the index at 280 bps.0 9.5 9. calculate the underlying intrinsics.
” or difference in spread between the old and new on-the-run indices. in DV01 neutral index arbitrage.Credit Strategy Research May 27. This results in a “roll. 2008 35 Figure 45. Notice that credits being added to the index traded at a tighter spread than credits being deleted. CDX Index Rolls Index Rolls Approximately every six months. and buys protection on the index. This will leave him with positive P&L for a wide-spread credit post-Credit Event. the indices roll to a new on-the-run version Approximately every six months (March and September). but the index trading with No Restructuring. Source: Banc of America Securities LLC estimates. which should reduce the overall IG10 index spread: Credit Default Swap Primer Glen Taksler 646. Eight credits dropped out of the on-the-run CDX IG index. Source: Banc of America Securities LLC estimates. he will have net bought protection on the credit. an investor uses less notional on wide-spread single names. Total Notional of Index vs Intrinsics Figure 44. consider the roll between IG9 and IG10 in March 2008. 2008. Post-Credit Event P&L in DV01 Neutral Index Arbitrage Wide or Tight Spread is Relative to the Index Coupon (350 Bps for HVOL10) Intrinsics Sell Protection Buy Protection Index Buy Protection Sell Protection Wide Spread Credits Notional Credit Event P&L Lower Positive Lower Negative Tight Spread Credits Notional Credit Event P&L Higher Negative Higher Positive Source: Banc of America Securities LLC estimates. 132 131 130 129 Jump-to-Default Risk After hedging out DV01 risk.7559 57 . Index DV01 vs Intrinsics DV01 Different Notional for Each Underlying Intrinsic. the indices roll to a new onthe-run version. Figure 47 shows the details.855. (2) an adjustment for intrinsics trading with Modified Restructuring. 312 310 308 306 304 302 300 298 296 CDX HVOL Intrinsics Index Notional Total Intrinsics Notional As of April 11. To Keep the Overall Index Arbitrage Trade DV01 Neutral 133 Index or Intrinsics DV01 ($ Thousands Per $300mm) Notional ($ Millions) CDX HVOL Index As of April 11. Figure 46 shows a more complete jump-to-default payoff profile: Figure 46. if an investor sells protection on single-name CDS. Recall that. 2008. the investor is left with potential risk following a Credit Event. and (3) a six-month maturity extension. For example. As such. We estimate the roll in three parts: (1) the change in credit quality.
Changes to On-the-Run IG Index. the IG10 index should trade 10. the maturity date of the five-year IG9 index. compared to IG10 intrinsics at 187 bps. we used a 2% haircut. from Series 9 to Series 10 As of March 17. Figure 48.7559 . More realistically. for IG9 and IG10.855. To execute the roll. we expected that a portion of index shorts (with buy protection positions) would want to roll to the Series 10 (new) index. To assess this factor. However. Bloomberg. while the CDX indices trade without Restructuring. This would tend to reduce the roll versus the estimate in Figure 48. as a way to both reduce carry and. Estimate of IG Roll from Series 9 to Series 10 As of March 17. Mid (bps) 200 275 400 435 460 570 730 740 Additions Black & Decker Corp MDC Holdings Inc Comcast Corp Viacom Inc Kohl's Corp Brunswick Corp/DE Masco Corp New York Times Co/The Mid (bps) 207 210 210 220 220 326 340 390 When performing this analysis. Banc of America Securities LLC estimates. 2008 35 Figure 47. Mid (bps) 198 187 -10. singlename CDS trades with Modified Restructuring.6 0 -10.Credit Strategy Research May 27.8 bps tighter than IG9. 58 Credit Default Swap Primer Glen Taksler 646. bringing the roll to –11 bps.8 -10. we assumed the same basis between intrinsics (underlying single-name CDS components) and the index. these investors needed to sell protection on Series 9 indices (driving spreads tighter).6 To December 20. perhaps more importantly. 2012. and buy protection on Series 10 indices (driving spreads wider). That is. 2008 Description IG9 Intrinsics to 20 Dec 12 IG10 Intrinsics to 20 Dec 12 Credit Quality Roll Credit Quality Roll with 2% Haircut Adjustment: MR vs No-R 6-month Maturity Roll Total Estimated Roll Source: Banc of America Securities LLC estimates. solely due to improved credit quality. IG9 intrinsics were 198 bps. 2008 Deletions Comcast Cable Communications LLC IAC/InterActiveCorp Belo Corp Pulte Homes Inc Jones Apparel Group Inc Centex Corp Countrywide Home Loans Inc Lennar Corp Sources: CDX. maintain maximum liquidity.
as compared to IG. There are no formal deletion/addition criteria. For most HY rolls. We think this difference is largely due to lower liquidity of HY underlyings. the roll should be $0. with both indices trading at par. Moody’s. The Administrator will add to the new index those entities receiving the greatest number of votes. also consider the coupon differential between the old and new indices Mechanics of CDX Index Rolls Approximately two weeks prior to the roll date. This is because.855. each market maker submits to the Administrator (currently Markit Group Ltd) a list of Reference Entities from the current index that. For example. our estimate was that Series 10 IG should trade 11 bps tighter than Series 9. should be added to the new index. HVOL is a subindex of IG. the spread differential will be 40 bps. market makers submit a list of entities for inclusion in HVOL. Then. versus an actual roll of 60 bps ($1 1/2). based solely on credit quality. Next. or triple-B by one ratings agency and double-B by the other two ratings agencies. Modified Restructuring vs. Moody’s. the first criteria changes to entities upgraded to investment grade by at least two of S&P. suppose that a new on-the-run high yield index should trade 40 bps wider than the old index. Special Issues for HY Index Rolls Since the high yield index trades in dollar price. to estimate the roll. Shortly before the roll date. rolling to IG10. In high yield. and Fitch (2) entities for which a merger or other similar corporate action has occurred or has been announced. For the crossover index.7559 59 . any entity in the new series of IG is eligible for inclusion in HVOL. until the new index totals 125 entities (100 entities for the high yield index. and (3) entities whose credit default swaps have become materially less liquid. The actual roll was IG10 trading 5 bps tighter than IG9. the Administrator releases the composition of the new index. No Restructuring. Adding up the credit quality. the effect of the maturity extension was negligible. reducing the roll. If the old index trades at par and the coupon on the new index is set 40 bps wider than the old index. or 35 entities for the crossover index). in its judgment.) Each market maker then submits to the Administrator a list of entities that. and Fitch. Affiliates of entities that are guaranteed by entities already in the index are ineligible.Credit Strategy Research May 27. in its judgment. (This is for the investment grade index. based on the following criteria: (1) entities downgraded below investment grade by at least two of S&P. After the composition of IG is established. we estimated a fair value roll of 40 bps ($2 5/16) from HY8 to HY9. the roll trades cheap to the methodology in Figure 48. We also thought that a short base in IG9. the first criteria changes to entities that are no longer rated double-B by all three ratings agencies. an investor also must consider the coupon differential between the old and new indices. 2008 35 That is. would result in IG10 trading cheaper to intrinsics. there is a six-month maturity extension for rolling from December 2012 to June 2013. For example. Non-guaranteed affiliates are eligible for inclusion. Since investment grade credit curves were flat around the roll date. For the high yield index. each market maker submits to the Administrator a suggested fixed rate for Credit Default Swap Primer Glen Taksler 646. should no longer be included. and maturity extension components suggested that Series 10 IG should trade 11 bps tighter than Series 9.
By “removed.2.2 Trac-X Recovery 41.2. Credit Events in the CDX Indices Date 22 Jan 08 19 Sep 07 30 Oct 06 06 Mar 06 21 Dec 05 08 Oct 05 14 Sep 05 14 Sep 05 17 May 05 Reference Entity Quebecor World Inc. HY4.250% 91. Advanced Micro Devices.5. not 100% Succession Events. Dana Corporation Calpine Corporation Delphi Corporation Delta Air Lines.4.5 HY 1.6.500% 22.214.171.124. Index LCDX8 LCDX8 LCDX8 Prepaid 11 Dec 07 28 Aug 07 20 Mar 08 Removed 28 Jan 07 10 Oct 07 06 May 08 BLUEGR Altivity Packaging.375% 18.4 Trac-X is an index that traded before the inception of CDX. Source: CreditEx. Movie Gallery.2. BB 6-7.000% 28.4. HB 8-9. Source: CreditEx. HB4.. ISDA. Events and Reference Entities in the CDX Indices Credit Events in the CDX Indices Figure 49.000% 43. Northwest Airlines. Alltel Corporation IG 1. LLC A Reference Entity may be removed from the LCDX index if it cancels its entire Syndicated Secured facility. 60 Credit Default Swap Primer Glen Taksler 646.7 IG 2. Sources: Markit Group Ltd.7559 .5 IG1.855. Inc. Markit Group Ltd.3.3. Dura Operating Corp.2. HY 1. Inc. HV 1.5.3. and does not replace it within 30 Business Days. HB 3-6 HY 1. Banc of America Securities LLC estimates.2. Banc of America Securities LLC estimates.5.2.3. ISDA. Prepayment Events in the LCDX Indices Figure 51.625% Collins & Aikman Products Co. Inc. 50% Idearc Inc. Indices HY 6-9. The median of these spreads rounded up to the nearest 5 bps will be the fixed rate for the new index.3.500% 3. HB 3. 2008 35 the index coupons at various maturities. Prepayment Events in the LCDX Index Event Reference Entity WLT AMD Walter Industries Inc. Succession Events in the CDX Indices Date 17 Nov 06 17 Jul 06 Original Reference Entity Indices Verizon Communications Inc.” we mean the weight of that entity is reduced to zero. 50% Windstream Corporation Only shows 50% / 50% CDS splits.Credit Strategy Research May 27.4. XO 6-7 LCDX8 HY 1-6.5. Markit Group Ltd.2. including any revolver. Inc. XO 5 HY 1. B 8-9.000% 19.4. B 1-3.6 New Reference Entities 50% Verizon Communications Inc.5.125% 63. BB4.4. BB 1. without changing the weight on any other Reference Entity.3. 50% Alltel Corporation. Succession Events in the CDX Indices Figure 50. Banc of America Securities LLC estimates.5.
Reference Entities Dominion Resources Inc/VA Dow Chemical Co/The Duke Energy Carolinas LLC Eastman Chemical Co EI Du Pont de Nemours & Co Embarq Corp Federal National Mortgage Association FirstEnergy Corp Fortune Brands Inc Freddie Mac Gannett Co Inc General Electric Capital Corp General Mills Inc Goodrich Corp Halliburton Co Hartford Financial Services Group Inc Hewlett-Packard Co Home Depot Inc Honeywell International Inc Ingersoll-Rand Co Ltd International Business Machines Corp International Lease Finance Corp International Paper Co iStar Financial Inc JC Penney Co Inc Kohl's Corp Kraft Foods Inc Kroger Co/The Liz Claiborne Inc Lockheed Martin Corp Loews Corp Ltd Brands Inc Macy's Inc Marriott International Inc/DE Marsh & McLennan Cos Inc Masco Corp MBIA Insurance Corp McDonald's Corp McKesson Corp MDC Holdings Inc MeadWestvaco Corp MetLife Inc Reference Entities Motorola Inc National Rural Utilities Cooperative Finance Corp New York Times Co/The Newell Rubbermaid Inc News America Inc Nordstrom Inc Norfolk Southern Corp Northrop Grumman Corp Omnicom Group Inc Progress Energy Inc Quest Diagnostics Inc Radian Group Inc Raytheon Co Rohm & Haas Co RR Donnelley & Sons Co Safeway Inc Sara Lee Corp Sempra Energy Sherwin-Williams Co/The Simon Property Group LP Southwest Airlines Co Sprint Nextel Corp Starwood Hotels & Resorts Worldwide Inc Target Corp Textron Financial Corp Time Warner Inc Toll Brothers Inc Transocean Inc Union Pacific Corp Universal Health Services Inc Valero Energy Corp Verizon Communications Inc Viacom Inc Wal-Mart Stores Inc Walt Disney Co/The Washington Mutual Inc Wells Fargo & Co Weyerhaeuser Co Whirlpool Corp Wyeth XL Capital Ltd Credit Default Swap Primer Glen Taksler 646. Series 10 Figure 52.NA.IG.NA. Reference Entities in CDX.7559 61 .IG.Credit Strategy Research May 27.855. Series 10 Reference Entities ACE Ltd Aetna Inc Alcan Inc Alcoa Inc Allstate Corp/The Altria Group Inc American Electric Power Co Inc American Express Co American International Group Inc Amgen Inc Anadarko Petroleum Corp Arrow Electronics Inc AT&T Inc AT&T Mobility LLC Autozone Inc Baxter International Inc Black & Decker Corp Boeing Capital Corp Bristol-Myers Squibb Co Brunswick Corp/DE Burlington Northern Santa Fe Corp Campbell Soup Co Capital One Bank USA NA Cardinal Health Inc Carnival Corp Caterpillar Inc CBS Corp/Old CenturyTel Inc Chubb Corp Cigna Corp CIT Group Inc Comcast Corp Computer Sciences Corp ConAgra Foods Inc ConocoPhillips Constellation Energy Group Inc COX Communications Inc CSX Corp CVS Caremark Corp Darden Restaurants Inc Deere & Co Devon Energy Corp Source: Bloomberg. 2008 35 Reference Entities in the CDX Indices Investment Grade: CDX.
62 Credit Default Swap Primer Glen Taksler 646.855.Credit Strategy Research May 27.XO.XO. Series 10 Figure 53.NA. Series 10 Reference Entities American Axle & Manufacturing Inc Belo Corp Bombardier Inc Boston Scientific Corp CA Inc Centex Corp Chemtura Corp Chesapeake Energy Corp Citizens Communications Co Echostar DBS Corp El Paso Corp Expedia Inc Flextronics International Ltd Gap Inc/The Host Hotels & Resorts LP Jones Apparel Group Inc KB Home L-3 Communications Corp Lennar Corp Liberty Media LLC MGM Mirage Mosaic Co/The Olin Corp Pioneer Natural Resources Co Pulte Homes Inc RadioShack Corp Royal Caribbean Cruises Ltd Sears Roebuck Acceptance Smithfield Foods Inc Sun Microsystems Inc Temple-Inland Inc Tyson Foods Inc Unum Group Wendy's International Inc Windstream Corp Source: Bloomberg.7559 . 2008 35 Crossover: CDX.NA. Reference Entities in CDX.
7559 63 .Credit Strategy Research May 27. Reference Entities El Paso Corp Energy Future Holdings Corp Fairfax Financial Holdings Ltd First Data Corp Flextronics International Ltd Ford Motor Co Forest Oil Corp Freeport-McMoRan Copper & Gold Inc Freescale Semiconductor Inc General Motors Corp Georgia-Pacific LLC Goodyear Tire & Rubber Co/The Harrah's Operating Co Inc HCA Inc/DE Hertz Corp/The Host Hotels & Resorts LP Idearc Inc IKON Office Solutions Inc Intelsat Ltd Iron Mountain Inc K Hovnanian Enterprises Inc KB Home L-3 Communications Corp Lear Corp Level 3 Communications Inc Levi Strauss & Co Liberty Media LLC Massey Energy Co Mediacom LLC MGM Mirage Mirant North America LLC Mosaic Co/The Nalco Co Reference Entities Neiman-Marcus Group Inc Nortel Networks Corp Nova Chemicals Corp NRG Energy Inc Owens-Illinois Inc PolyOne Corp Pride International Inc Qwest Capital Funding Inc RadioShack Corp Realogy Corp Reliant Energy Inc Residential Capital LLC RH Donnelley Corp Rite Aid Corp Royal Caribbean Cruises Ltd Sabre Holdings Corp Saks Inc Sanmina-SCI Corp Six Flags Inc Smithfield Foods Inc Smurfit-Stone Container Enterprises Inc Standard Pacific Corp Station Casinos Inc Sungard Data Systems Inc Tenet Healthcare Corp Tesoro Corp Toys R US Inc Tribune Co TRW Automotive Inc Unisys Corp United Rentals North America Inc Univision Communications Inc Visteon Corp Windstream Corp Credit Default Swap Primer Glen Taksler 646. 2008 35 High Yield: CDX.HY.NA.HY. Series 10 Figure 54.855. Series 10 Reference Entities Abitibi-Consolidated Inc Advanced Micro Devices Inc AES Corp/The AK Steel Corp Allegheny Energy Supply Co LLC Allied Waste North America Inc Alltel Corp American Axle & Manufacturing Inc Amkor Technology Inc AMR Corp Aramark Corp/Old ArvinMeritor Inc Avis Budget Car Rental LLC/Avis Budget Finance Inc Beazer Homes USA Inc Bombardier Inc Celestica Inc Charter Communications Holdings LLC Chemtura Corp Chesapeake Energy Corp Citizens Communications Co Clear Channel Communications Inc CMS Energy Corp Community Health Systems/Old Constellation Brands Inc Cooper Tire & Rubber Co CSC Holdings Inc Dillard's Inc DIRECTV Holdings LLC Dole Food Co Inc Domtar Inc Dynegy Holdings Inc Eastman Kodak Co Echostar DBS Corp Source: Bloomberg. Reference Entities in CDX.NA.
7559 . Series 10 Figure 55.855. 2008 35 Leveraged Loans: CDX. INC.LCDX.NA.Delaware Inc Travelport Inc Tribune Co TRW Automotive Inc United Air Lines Inc/Old United Rentals North America Inc Univision Communications Inc US Airways Group Inc Visteon Corp Warner Chilcott Co Inc Windstream Corp 64 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27.LCDX.NA. Series 10 Reference Entities Affiliated Computer Services Inc Aleris International Inc Allied Waste North America Inc ALLTEL Communications Inc AMC Entertainment Inc American Airlines Inc Aramark Corp/Old ArvinMeritor Inc Avis Budget Car Rental LLC/Avis Budget Finance Inc Bausch & Lomb Inc Berry Plastics Holding Corp Biomet Inc Blockbuster Inc Boston Generating LLC Boyd Gaming Corp Burger King Corp Calpine Corp Capital Automotive LP Cedar Fair -LP Celanese US Holdings LLC Cequel Communications LLC Charter Communications Operating LLC Community Health Systems Inc Constellation Brands Inc CSC Holdings Inc DaimlerChrysler Financial Services North America LLC DaVita Inc Dean Foods Co Del Monte Corp DIRECTV Holdings LLC Dole Food Co Inc Domtar Corp El Paso Corp Source: Bloomberg. -LCDS Realogy Corp Regal Cinemas Corp Reliant Energy Inc RH Donnelley Inc Rite Aid Corp Rockwood Specialties Ltd Sabre Inc Sensata Technologies BV SIX Flags Theme Parks Smurfit-Stone Container Enterprises Inc Sungard Data Systems Inc SUPERVALU Inc Swift Transportation Co Inc Texas Competitive Electric Holdings Co LLC Toys R US . Reference Entities in CDX. Reference Entities First Data Corp Ford Motor Co Freescale Semiconductor Inc Fresenius Medical Care AG & Co KGaA General Growth Properties Inc General Motors Corp Georgia Gulf Corp Georgia-Pacific LLC Goodyear Tire & Rubber Co/The Graham Packaging Co Inc Graphic Packaging International Corp Harrah's Operating Co Inc Hawaiian Telcom Communications Inc HBI Branded Apparel Ltd Inc HCA Inc/DE Health Management Associates Inc Healthsouth Corp Hertz Corp/The Hexion Specialty Chemicals Inc Idearc Inc Intelsat Corp Jarden Corp Las Vegas Sands LLC Lear Corp Level 3 Financing Inc Lyondell Chemical Co Masonite International Corp Mediacom LLC Metro-Goldwyn-Mayer Inc MetroPCS Wireless Inc Michaels Stores Inc Mirant North America LLC Momentive Performance Materials Inc Reference Entities Mylan Inc Nalco Co Neiman-Marcus Group Inc NewPage Corp Nielson & Associates Inc NRG Energy Inc Oshkosh Corp Owens-Illinois Group Inc PENN NATIONAL GAMING.
variation margin. Below. 2008 35 Chapter IV – CDS Operations Management The rapid growth of the CDS market has brought operational issues to the attention of investors. Language is relatively standard. The text is much more accountspecific than the ISDA Master Agreement and Schedule. 5. Confirmation (Master and Long formats). This document is optional. disclosure) Additional terms for foreign exchange 4. to trade in credit derivatives. The “Master” confirm is also called the “Short” form. (for illustrative purposes only) credit officer must approve a credit line.7559 65 . (in this example) and a Counterparty to ensure enforcement of the CDS confirmation document. Credit exposure is granted in a risk equivalent. not a notional number. an investor must have an ISDA Master Agreement in place. and a Bank of America. and even regulators. Schedule. which may replace part of the language on the ISDA Master Agreement. which form the standard language for CDS transactions.855. N. we highlight some of the most important details around CDS operations that are essential for investors who would like to add CDS to their portfolio. and in what increments. ISDA Master Agreement. For example. Confirms may note a CUSIP. banks and broker-dealers. Required Documentation A hedge fund typically must submit the following documentation to begin the ISDA process: Two years of audited financial statements Fund offering memorandum Monthly NAV (returns) since inception Credit Default Swap Primer Glen Taksler 646. which refer to the Reference Obligation of the Reference Entity. This agreement is negotiated between Bank of America. 3. margin requirements are due (initial margin. Main Documents The new credit derivatives investor should be familiar with five main documents: 1. 2. N. Credit Support Annex.A.A. CDS Operations In general. It is negotiated only after Credit approves a Counterparty. 2003 ISDA Credit Derivatives Definitions. a $10 million credit line refers to the total allowable risk of a Counterparty. and threshold amounts).Credit Strategy Research May 27. The schedule has several parts: Termination provisions Tax representations Agreement to deliver documents Miscellaneous (such as addresses for correspondence) Other provisions (waiver of right to trial by jury. Its main purpose is to predetermine when.
Alternatively. a bank or brokerdealer may facilitate the process. or other foundation documents Investment advisers: Form ADX Registered broker-dealer: Form BD Marketing materials.Credit Strategy Research May 27. about 95% of credit default swaps are eligible for electronic settlement. and other available information Electronic Settlement of Trades (DTCC) and CDS Operations Management About 95% of credit default swaps are eligible for electronic settlement. While non-banks and broker-dealers must supply personnel to confirm trades. banks and broker-dealers absorb the costs of DTCC registration and settlement. For Counterparties not already established on DTCC. Currently. a privately owned or a non-guaranteed subsidiary of a public company typically must submit the following documentation: Two years of audited financial statements and most recent quarterly statements Industry specific requirements: • • • • • • • Regulated broker-dealers: FOCUS reports for the last four fiscal quarters and the most recent month Non-leveraged mutual funds and pension funds: Prospectus and Statement of Additional Information Insurance subsidiaries: Statutory statements Other documents that may help the credit process: New clients: Articles of incorporation. Counterparties use one of two methods. However. Once the Counterparty submits the package and DTCC accepts it. 2008 35 Marketing materials / pitch book Authority documentation (Investment Management Agreement / Limited Partnership Agreements) Certificate of incorporation or other formation documents Other documents that may help the credit process For non-hedge funds. which involves a Membership Package of legal documents. Partnership or LLC agreement.com/information/products/metrics.” or “don’t know”) each trade. through the Depository Trust & Clearing Corporation (DTCC).. DTCC is web-based. so the Counterparty need not purchase software. biographies.855. According to Markit Group Ltd. 90% of total trades) settle 45 electronically. the Counterparty receives a membership number and may begin using electronic settlement. there is no charge to use the service itself. another nearly 95% (i. BAS Portfolio Management may obtain information on publicly traded companies and regulated depository institutions.html 66 Credit Default Swap Primer Glen Taksler 646.e.markit. Counterparties may manually submit trades to DTCC and allow DTCC to match them with the relevant bank or broker-dealer. To confirm trades. First.7559 . 45 http://www. Of those eligible trades. the Counterparty may allow the relevant bank or broker-dealer to submit trades DTCC and either accept (called “know”) or decline (called “DK.
matching without amendment. Exceptions to the above to be escalated internally and externally as 46 appropriate. In a give-up.newyorkfed. By July 2008: “90% T+1 submission. 90% submitted accurately. The prime broker then faces the client in a separate trade.org. The 2007 estimate compares with 9.7559 67 . faces the client’s prime broker (not the client) as a Counterparty 46 http://www. 2008 35 Goals for CDS Operations Management Goals for CDS operations management In a March 2008 letter to the Federal Reserve.A. Bank of America. 47 Preliminary results of ISDA 2008 Operations Benchmarking Survey. Bank of America. ISDA also estimates that unsigned credit derivatives confirmations rose to 6.Credit Strategy Research May 27. Figure 56 and Figure 57 compare a normal trade with a give-up: In a give-up. Credit Default Swap Primer Glen Taksler 646. N. on 100% of index trades and 90% of single name trades. N. and the Counterparty’s prime broker negotiate an agreement that allows a client to trade.9x for interest rate derivatives and 13. ISDA already estimates that 90% of electronic confirmations are normally sent by T+1. (for illustrative purposes only).pdf.A. Bank of America. Bank of America. sends a request to the client’s prime broker.6x the daily volume of new trades in 2007. If approved. excluding novations. N.isda. dealers noted the following goals for electronically eligible trades. “RED” denotes Reference Entity Database. available from http://www. However.org/newsevents/news/markets/2008/an080327.3x for equity 47 derivatives. N.A. After a client states that he would like to execute a trade. This process is called a “give-up” and requires that (1) a Counterparty have prime brokerage service and (2) the Counterparty’s prime broker has an ISDA Master Agreement with Bank of America. RED subscribers are to accurately submit 9-digit RED codes.9x in 2006.A. and ISDA 2007 Operations Benchmarking Survey. from 4.” For year-end 2007. 92% match by T+5. faces the client’s prime broker as a Counterparty. N. which comprises a list of standardized Reference Entities for CDS transactions. Give-Ups “Give-ups” allow a Counterparty to trade in CDS without an ISDA Master Agreement It is sometimes possible for a Counterparty to trade in credit derivatives without an ISDA Master Agreement.A. standard identifiers that greatly improve matching.855.
if a client sells CDS protection and spreads widen by the time a prime broker declines a trade. N. There are no hard assets set aside to guarantee payment. Counterparties are required to post collateral (margin). Counterparty Risk and Leverage As an unfunded market. i. For example. the client may incur significant Counterparty risk. Client's Counterparty Source: Banc of America Securities LLC estimates. As such. the client’s prime broker will specify a credit line for the client. 68 Credit Default Swap Primer Glen Taksler 646. The trade is automatically approved unless the prime broker declines the trade within a pre-specified period of time. ISDA estimates that there was approximately $2.7559 . Should a client sell CDS protection and spreads tighten by the time a prime broker declines a trade.Credit Strategy Research May 27. In a typical give-up agreement. CDS market participants promise to exchange cash flows following a potential Credit Event. rather than do new trades. As of year-end 2007.. Initial Margin To reduce Counterparty risk. If the prime broker declines the trade. the client will not receive the mark-to-market gain.855. the protection Buyer simply becomes a general 48 creditor of the protection Seller. because of more favorable margin requirements at the prime broker. for example. the client remains responsible for any associated unwind costs. within two hours.e. Normal Trade Client Sells Protection at 500 Bps Running Client Sells Protection at 500 Bps Running Client’s prime broker may charge a fee for this service Client Bank of America. So in return for lower margin. Some investors with ISDA Master Agreements prefer to trade CDS with give-ups Some clients with ISDA Master Agreements prefer to trade CDS with give-ups. the client will owe Bank of America. This reason for lower margin is that the prime broker should have a better sense of a client’s overall risk profile than one particular dealer. credit default swaps may have a different seniority post-Bankruptcy.A.1 trillion in 48 For the United States. Since all give-ups transact through the prime broker. NA Margin 1000 bps running Client 500 bps running 500 bps running Protection Protection Protection Client's Counterparty Source: Banc of America Securities LLC estimates. 2008 35 Figure 57. Give-Up Figure 56. should the protection Seller default on his obligation to pay the required cash flows post-Credit Event. money for unwinding the transaction. the client may be willing to pay a per-trade give-up fee to the prime broker. In Europe. the risk of a Credit Event at the prime broker.
Initial margin is based on both risk of a particular trade and Counterparty creditworthiness. 2008 35 collateral in circulation. with a loss of 8. Credit Default Swap Primer Glen Taksler 646. There are two types of margin. An as-yet unresolved question in the current market environment—and the subject of significant attention—is how best to measure the magnitude and volatility of expected losses.2 points potential loss x 80% scaling factor). and effect an unwind.7559 69 . Regardless of spread. Generally. and only when they sell protection. Separately. Initial margin then would reflect the dealer’s expected loss over a two-week period. highrisk Counterparties will pay more margin than low-risk Counterparties. only 50 hedge funds are required to post initial margin.isda. wider than 500 bps). with respect to that Counterparty’s portfolio. suppose that a dealer believes it would take approximately two weeks to discover that a Counterparty were no longer creditworthy. to reflect a lower likelihood of the Counterparty defaulting. The example in Figure 58 assumes that a dealer believes spreads could double during the forced unwind period. decide to unwind that Counterparty.org.6 points (8.Credit Strategy Research May 27. The dealer scales that potential loss by 80%. Initial margin is then 6. available from http://www.3 trillion in each of 2006 and 2005. up from $1. obtain the necessary approvals. initial and variation. not just credit derivatives. These numbers 49 are across all derivatives transactions.855.2 points. For instance. 49 50 ISDA Margin Survey 2008. to reduce the risk that a hedge fund may not be able to meet variation margin requirements. hedge funds may be required to post initial margin when they buy protection on wide-spread or risky credits (for example. All Counterparties will pay higher margin to sell protection at 500 bps than 200 bps. this is in part because the Counterparty is usually satisfied that investors’ internal regulations require the holding of (internal) reserves. Although other investors may not be required to post initial margin.
at 40% recovery.2 points x 80% = 6. Importantly. a different hedge fund that has more balanced sell. That hedge fund will face relatively high margin requirements on its sell-protection trades. protection Sellers are able to employ leverage. 2008 35 Figure 58. If a Counterparty and a Reference Entity were to file for bankruptcy at about the same time. initial margin requirements assume that a Counterparty will not default at the same time as a potential Credit Event. For example. at 80% scaling factor: Initial Margin = 8. Leverage Since initial margin is significantly less than 100%. In principle. For example. losses would be 60% of notional. far higher than the 6. Counterparties who share a greater portion of their portfolio with a particular dealer may face better margin requirements because of offsetting risk. For example. Hypothetical Example of Initial Margin Calculation Investor Sells Protection and Pays Initial Margin to Dealer Initial Spread Scenario where dealer believes spreads could double during potential forced unwind period Initial Margin = 8.7559 .6 points Sources: Bloomberg. at 10% margin. because the relevant dealer will believe the hedge fund is exclusively long risk.6% collected in Figure 58. losses would be significantly higher. because dealers will be aware that the hedge fund’s portfolio is more balanced.and buy-protection trades through dealers may face better margin requirements. suppose that one hedge fund sells protection exclusively through one dealer but buys protection exclusively to another dealer. By contrast.855. Banc of America Securities LLC estimates.2 points x Scaling Factor to Account for Likelihood of Counterparty Default. a protection Seller is able to leverage 70 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27.
he is required to pay variation margin. Required Collateral Required collateral is billed in cash (for example. although this should not be construed as a recommendation. so actual leverage is likely to be significantly lower. Source: Banc of America Securities LLC estimates.7559 71 . the threshold may be zero for a higher-risk Counterparty and several million dollars for a lower-risk Counterparty. are subject to variation margin requirements. 51 Some investors also choose to purchase third-party data. CDS investors receive marks for outstanding trades. Credit Default Swap Primer Glen Taksler 646. For example. This type of collateral accounts for markto-market P&L and is set in the Credit Support Annex. 2008 35 10x (1 / 10%). if the investor subsequently realizes mark-to-market gains.041 face value of securities ($100. an investor may be allowed to post five-year maturity Fannie Mae or Freddie Mac securities at a ratio of 98%. 51 Generally. Many investors hold additional. This means that. Figure 59 illustrates sample leverage that CDS protection Sellers may use. for every $100. Marks As part of the margin process. or “CSA. regardless of whether they buy or sell protection. Markit Group Ltd is one popular third-party data provider. If an investor suffers mark-to-market losses beyond a pre-established threshold. Posted collateral earns interest at the Federal Funds rate. daily). internal reserves. but may be posted with securities at a certain ratio. These payments may be reimbursed.. Sample Leverage that Protection Sellers May Employ in Credit Derivatives Leverage Estimated as 1 / Margin Requirement 60 50 40 30 20 10 0 100 Low Risk Counterparty High Risk Counterparty Leverage (X) 150 200 250 300 350 400 450 500 5y CDS Spread (bps) Margin requirements may vary significantly across Counterparties.000 / 98%).000 in required collateral. Figure 59.000). $100.g.Credit Strategy Research May 27. marks are supplied via website at a pre-established frequency (e. See Figure 58 for an example of initial margin calculation. All types of Counterparties.855. For example. the investor must post $102. Variation Margin The second type of margin is variation margin.” discussed in the operational overview on page 65.
(ii) may be chosen as the initial method. If there is any collateral shortfall.7559 . practically. 55 The allocation of losses applies only if a member of the clearinghouse were to fail. if a member of the clearinghouse were to fail. an internal model. The 2002 ISDA Master Agreement specifies a combination of the two approaches from the 1992 ISDA Master Agreement. or if such information is not available. including costs such as terminating hedges and funding. In some cases. Counterparties are required to exchange the net P&L at current marks (a “close-out” amount). discussed below. 53 This is just one method for determining a close-out amount. then the remaining party would follow the “Termination Events” 54 above. (ISDA). The non-defaulting party must supply details of its calculations to its Counterparty. As such. investors would face the clearinghouse. Rather than face banks or broker-dealers as Counterparties. the other party may force an unwind of all existing trades. and is one reason why the CDS market is working on the development of a clearinghouse. 2008 35 ISDA Master Agreement Rules surrounding margin and collateral posting often are agreed in a Credit Support Annex to the ISDA Master Agreement. credit derivatives. If a member (for example. Termination Events If a Counterparty breaches any one of “termination event” criteria specified in the ISDA Master Agreement. As one might imagine.” Recall that. known as “The Clearing Corporation. for replacement trades with identical terms to the trades being terminated. such as coupons or margin An event beyond a party’s control. The close-out amount is based on an average of these quotes. The non-defaulting party may obtain marks from 53 third-party dealer quotes. which is a governing document usually signed 52 during the approval process for derivatives trading. a medium-sized hedge fund). 54 For the United States. the close-out amount may be determined by either (i) obtaining quotes on the non-defaulting party’s side of the market (bid or offer). in the 1992 ISDA Master Agreement. as published by the International Swaps and Derivatives Association.Credit Strategy Research May 27. or if no quotes are obtained.855. The Clearing Corporation Currently. In Europe. then (ii) use internal models or third-party quotes. Inc. the clearinghouse would reduce 52 ISDA Master Agreements often are based on standardized 1992 or 2002 forms. that member would be responsible for all losses attributed to 72 Credit Default Swap Primer Glen Taksler 646. the CDS market is working on a clearinghouse to guarantee selected trades. payment may be due as soon as the same business day. a bank or broker-dealer) processes a trade for a non-member (for example. The net close-out amount across all products is offset against any collateral (margin) held by the non-defaulting party. equity derivatives. to high yield or triple-B Following a forced unwind. then losses would be allocated 55 among other clearinghouse members. and interest rate derivatives. The close-out amount is calculated on the same day for all types of trades covered by the ISDA Master Agreement—for instance. if a Counterparty defaults. become a general creditor in bankruptcy proceedings. By contrast. credit default swaps may have a different seniority post-Bankruptcy. such as a circumstance that makes it unlawful to continue the CDS contract Note that Counterparties also may agree to an additional termination event based on a material ratings downgrade. The actual method used depends on the ISDA Master Agreement. implementing this process may prove difficult and disruptive. for example. or in the extreme. Among the criteria are: Bankruptcy of the Counterparty Failure to Pay required payments. For example. currently.
Credit Default Swap Primer Glen Taksler 646. Exchange-Traded CDS Currently. exchange-traded CDS is a fixed recovery swap that trades in present-value terms. For example. the protection Buyer makes a single up-front payment for the present value of the swap. Following a Credit Event. such losses could be allocated among remaning clearinghouse members. rather than paying 100 bps running for five years. among a small number of counterparties. Broadly speaking. the non-member. with the exchange as a Counterparty. In the extreme case. if such losses were to cause the clearinghouse member to fail. the protection Buyer receives a fixed recovery rate rather than the actual recovery rate of the cheapest-to-deliver Bond or Loan. essentially all CDS trading volume is over-the-counter. this proposal may take effect for a small number of trades. but it is possible to trade credit default swaps on an exchange.855.7559 73 .Credit Strategy Research May 27. Figure 60 summarizes the major features of exchange-traded CDS versus over-the-counter CDS. In its early stages. toward the end of 2008. 2008 35 Counterparty exposure.
7559 . Jun. in which case the protection Seller usually is the Calculation Agent • Exchange Recovery Trading Hours Margin Requirements Set by Calculation Agent Open interest as of April 22. unless both parties are Banks or Broker-Dealers. type CBOE <GO> 1 (CBOE Equity Index. Sources: Bloomberg.855.Friday 3pm. Jun.g. CME. initially proposed to be Mar. 74 Credit Default Swap Primer Glen Taksler 646. Indices: Premium or discount + fixed running coupon. but may be increased by or Broker-Dealer broker • Typically the Bank or BrokerDealer. following a full tender) • 20th Day each of Mar. or Bankruptcy and Failure to Pay • N/A • Swap terminates early if no • N/A Relevant Obligation remains (e. • 3rd Friday each of Mar. To access CBOE contracts on Bloomberg. and Dec Sep.Friday 4pm. Baskets: • Fixed at contract inception by As specified by the exchange the exchange • Monday 8:30am . Jun. Chicago time Chicago time • Credit Support Annex with Bank • Minimum standard set by exchange. and • Failure to Pay or another Event • Depending on the product. Banc of America Securities LLC estimates. Then see “CEBO” (Credit Event Binary Option) products. • 2nd Business Day preceding Sep. Over-the-Counter CDS versus Exchange Traded CDS North America Over-the-Counter CDS Counterparty Execute trade with Market size Quotation Coupon Payments Initial Price • Bank or Broker-Dealer • Bank or Broker-Dealer $62 trillion total CDS market size estimate (ISDA 2007) • Spread • Quarterly Chicago Board Options Exchange (CBOE) Chicago Mercantile Exchange (CME) • Exchange • Broker for the Exchange • Zero open interest • Points Upfront (No Running) • None Trade size Credit Events Redemption Event Maturity • Single-names: Par. Sep and Dec • Floating (Determined by Physical or Cash Settlement) • Over-the-counter Trading Day • Single-names: Zero. Volatility and Credit Option Products) <GO>.000 • Depending on the product. • $2 MM . and Dec the third Wednesday of the Contract Month. type CEM <GO> 3 (CBT) <GO>. CBOE. 2008 35 Figure 60. of Default or Restructuring as same as for Over-the-Counter Modified Restructuring specified by the Exchange CDS.$10 MM • Contracts of $100. discount + 500 bp running coupon.. 2008. contracts of $100. as shown on Bloomberg. for selected Reference Entities. Then see contracts in the “CDS” category. • Sunday 5pm . or for wider• Par minus present value of the contract spread credits.Credit Strategy Research May 27.000 or fixed DV01 of $500 • Bankruptcy. To access CME contracts on Bloomberg. Failure to Pay.
A sample confirmation and excerpt of the Physical Settlement Matrix are shown below: Credit Default Swap Primer Glen Taksler 646.855.7559 75 . and similar features of CDS contracts.Credit Strategy Research May 27. 2008 35 Appendix IV – CDS Operations Management Sample Confirmations and Trade Recaps Sample Confirmation for a New Trade To help ensure that credit default swaps are standardized across Counterparties. Deliverable Obligations Characteristics. a standard confirmation references a Physical Settlement Matrix (“Matrix”). published by ISDA. The Matrix clarifies Credit Events.
Credit Strategy Research
May 27, 2008
Sample Confirmation (Term Sheet)
Date: To: From: Re: March 27, 2008 [Name and Address or Facsimile Number of (the “Buyer”) (Party B)] Bank of America, N.A. (the “Seller”) (Party A) Credit Derivative Transaction
The purpose of this “Confirmation” is to confirm the terms and conditions of the Credit Derivative Transaction entered into between us on the Trade Date specified below (the ”Transaction”). This Confirmation constitutes a “Confirmation” as referred to in the ISDA Master Agreement specified below. The definitions and provisions contained in the 2003 ISDA Credit Derivatives Definitions as supplemented by the May 2003 Supplement and the 2005 Matrix Supplement to the 2003 ISDA Credit Derivatives Definitions (as so supplemented, the “2003 Definitions”), as published by the International Swaps and Derivatives Association, Inc. (“ISDA®”), are incorporated into this Confirmation. In the event of any inconsistency between the 2003 Definitions and this Confirmation, this Confirmation will govern. This Confirmation supplements, forms a part of, and is subject to, the ISDA Master Agreement dated as of [date], as amended and supplemented from time to time (the “Agreement”), between you and us. All provisions contained in the Agreement govern this Confirmation except as expressly modified below. The terms of the Transaction to which this Confirmation relates are as follows: 1. General Terms Transaction Type: Trade Date: Matrix Publication Date: Effective Date: Scheduled Termination Date: Floating Rate Payer: Fixed Rate Payer: Calculation Agent: Calculation Agent City: Reference Entity: Reference Obligation NORTH AMERICAN CORPORATE March 27, 2008 December 6, 2007 March 28, 2008 June 20, 2013 Bank of America, N.A. (the “Seller”) (Party A) TBD (the “Buyer”) (Party B) Seller New York Comcast Corporation The obligation defined as follows: Primary Obligor: Comcast Corp Maturity: January 15, 2014 Coupon: 5.3% CUSIP: 20030NAE1 June 20, 2008, and thereafter, the 20th day of each March, June, September, and December 1.55% per annum USD 10,000,000 Applicable
2. Fixed Payments Fixed Rate Payer Payment Dates: Fixed Rate: 3. Floating Payment Floating Rate Payer Calculation Amount: 4. Credit Events Restructuring:
Please confirm your agreement to be bound by the terms of the foregoing by executing a copy of this Confirmation and returning it to us. Yours sincerely,
[PARTY A] By: ______________________________________ Name: Title: Confirmed as of the date first written above: [PARTY B] By: ______________________________________ Name: Title: Indicative sample, for illustrative purposes only. Sources: ISDA; Banc of America Securities LLC.
Credit Default Swap Primer Glen Taksler 646.855.7559
Credit Strategy Research
May 27, 2008
Physical Settlement Matrix
Transaction Type Business Days North American Corporate If the Floating Rate Payer Calculation Amount is denominated in USD: London & New York EUR: London, New York & TARGET GBP: London JPY: London & Tokyo CHF: London & Zurich New York Not Applicable Notice of Publicly Available Information Applicable Bankruptcy Failure to Pay Restructuring, if specified as applicable in the relevant Confirmation Restructuring Maturity Limitation and Fully Transferable Obligation Applicable Borrowed Money None Physical Settlement As per Section 8.6 of the Definitions capped at 30 Business Days Bond or Loan Not Subordinated Specified Currency Not Contingent Assignable Loan Consent Required Loan Transferable Maximum Maturity: 30 years Not Bearer Applicable Not Applicable Not Applicable unless otherwise specified as Applicable in the relevant Confirmation Not Applicable unless otherwise specified as Applicable in the relevant Confirmation Not Applicable unless otherwise specified as Applicable in the relevant Confirmation Not Applicable Quarterly European Corporate If the Floating Rate Payer Calculation Amount is denominated in EUR: London & TARGET USD: London & New York GBP: London JPY: London & Tokyo CHF: London & Zurich London Applicable Notice of Publicly Available Information Applicable Bankruptcy Failure to Pay Restructuring Modified Restructuring Maturity Limitation and Conditionally Transferable Obligation Applicable Borrowed Money None Physical Settlement 30 Business Days Bond or Loan Not Subordinated Specified Currency Not Contingent Assignable Loan Consent Required Loan Transferable Maximum Maturity: 30 years Not Bearer Applicable Applicable Not Applicable
Calculation Agent City All Guarantees Conditions to Settlement Credit Events
Obligation Category Obligation Characteristics Settlement Method Physical Settlement Period Deliverable Obligation Category Deliverable Obligation Characteristics
Escrow 60 Business Day Cap on Settlement Additional Provisions for Physically Settled Default Swaps – Monoline Insurer as Reference Entity (January 21, 2005) Additional Provisions for a Secured Deliverable Obligation Characterictic (June 16, 2006) Additional Provisions for Reference Entities with Delivery Restrictions (February 1, 2007) Additional Provisions for STMicroelectronics NV (December 6, 2007) Fixed Rate Payer Payment Dates frequency
Not Applicable Not Applicable Applicable if the Reference Entity is STMicroelectronics NV, otherwise Not Applicable Quarterly
Indicative sample, for illustrative purposes only. Although we highlight North American and European corporates, the full Physical Settlement Matrix contains more types of CDS transactions. Source: ISDA.
Credit Default Swap Primer Glen Taksler 646.855.7559
Credit Strategy Research
May 27, 2008
Sample Trade Recaps and Mechanics
Figure 61 shows a sample trade recap, in which Bank of America, N.A. (for example) buys $5 million protection at a premium of 40 bps:
Figure 61. Sample Trade Recap for a New Trade
For illustrative purposes only. Sources: Bloomberg; Banc of America Securities LLC estimates.
Mechanically, the protection Buyer (in this case, Bank of America, N.A.) will pay the protection Seller $5,000 per quarter (40 bps x $5 million notional / 4 quarters) on the th 20 day each of March, June, September, and December. In the first coupon period, the protection Buyer will pay only the premium for the number of days that the trade was effective (April 22, 2008 to June 19, 2008, which is one day prior to the first coupon date). In future periods, coupons will be paid at the th th th end of a quarter (e.g., coupon paid on June 20 is for March 20 to June 19 ). Note, by market convention, one month before a quarterly CDS roll, single-name trades st switch to a long coupon. For example, if a trade occurs on November 21 , one month
Credit Default Swap Primer Glen Taksler 646.855.7559
the 56 protection Buyer will pay a coupon for four months (November—March). Then coupon payments will stop and the Counterparties must settle the contract.A. must pay $531. 2015 to (including) June 20. However. or the next Business Day).240 to execute the trade: 56 The reason for a long first coupon dates to earlier years of CDS. the protection Buyer must pay accrued interest up to and including the Event Determination Date (usually the same day as the Credit Event. the first coupon will be on March 20.Credit Strategy Research May 27.7559 79 .855. 2015. 2008 35 before the December 20 roll. On $4 million notional. and runs from March 20. At that time.A. The market needed time to complete these tasks and therefore moved to a long first coupon one month before a roll. N. Bank of America. when Counterparties settled trades by facsimile and agreed upon quarterly coupon payments by spreadsheet. if a Credit Event occurs. The last coupon period will include the Scheduled Termination Date (maturity). Credit Default Swap Primer Glen Taksler 646. (for example) at 680 bps. N. Unwind Figure 62 shows a sample trade recap in which an investor bought protection at 399 bps and now wishes to unwind with Bank of America.
Attached to the trade recap are the calculations for the $531. 2008 35 Figure 62.855. Sample Trade Recap for an Unwind Sources: Bloomberg. shown in Figure 63: 80 Credit Default Swap Primer Glen Taksler 646.7559 . Banc of America Securities LLC estimates.Credit Strategy Research May 27.240 unwind fee.
A.7559 81 . On $8 million notional. but will only pay 20 bps running to the original (“Remaining”) Party.855. 2008 35 Figure 63.A. Credit Default Swap Primer Glen Taksler 646. buys protection at 50 bps. for a total of $109. N. Calculations Attached to Sample Trade Recap for an Unwind Notional Dates Unwind Spread Original Spread Unwind Effective Date Paid to Original Protection Buyer Sources: Bloomberg. the client will receive $109. pays the present value of the 30 bps difference (50 bps – 20 bps) discounted at a risky rate of LIBOR + 30 bps / [ 1 – 40% expected recovery rate ] to the client upfront. Assignment Figure 64 shows a sample trade recap in which a client bought protection at 20 bps and now wishes to assign that trade to Bank of America. less accrued interest.Credit Strategy Research May 27. N. Bank of America. Banc of America Securities LLC estimates.796. (for example) at 50 bps.796. N.A. This is because Bank of America.
shown in Figure 65: 82 Credit Default Swap Primer Glen Taksler 646. Attached to the trade recap are the calculations for the $109. Sources: Bloomberg. Banc of America Securities LLC estimates.796 assignment fee.7559 . Sample Trade Recap for an Assignment For illustrative purposes only. 2008 35 Figure 64.855.Credit Strategy Research May 27.
Expecting that the original broker-dealer (the Remaining Party) will agree to the assignment. an assignment may not occur unless the Remaining Party agrees to face the Transferee. historically.g.7559 83 .Credit Strategy Research May 27. and the “Transferee. where Remaining Parties may not know which Counterparty they face for months at a time. To remove the Transferor from the original CDS contract and replace it with the Transferee.” to whom the contract is assigned (transferred). Assignment Spread Sample Request for an Assignment 2005 Novation Protocol An assignment involves three parties An assignment involves three parties: the “Remaining Party. a hedge fund). This often results in a decrease in Counterparty risk. the “Transferor.855. and later sought permission from the Remaining Party. This is because the original CDS contract was a bilateral agreement between the Remaining Party and the Transferor. this resulted in a backlog of assignments.” who remains on the CDS contract even after the assignment takes place. the Remaining Party must agree to face the Transferee Credit Default Swap Primer Glen Taksler 646. assignments were executed without the permission of the Remaining Party.. Consider an original trade between a broker-dealer and a client. the Transferor must obtain permission from the Remaining Party. because the new broker-dealer is viewed as more credit worthy than the client (e. which is then assigned to a different broker-dealer. Operationally. Banc of America Securities LLC estimates.” who assigns (transfers) liability for the contract. the client (Transferor) and the new broker-dealer (Transferee) have simply assigned the trade. However. 2008 35 Figure 65. This is one of the concerns highlighted by market regulators. Should a Credit Event Prior to assigning a trade. Technically. Calculations Attached to Sample Trade Recap for an Assignment Notional Dates Original Spread Paid by Buyer Sources: Bloomberg.
7559 .Credit Strategy Research May 27.newyorkfed.org/newsevents/news/markets/2008/an080327. the trade would follow Figure 89. the assignment will be booked as a new trade The Transferee must receive consent from the Remaining Party by 6pm.855. the 2005 Novation Protocol took effect for the CDS market. 57 http://www. On October 24.pdf. on the day an assignment is agreed to. should either the Transferor or Transferee file for Bankruptcy. The 2005 Novation Protocol is interpreted as an amendment to the ISDA Master Agreement and is irrevocable. Clients who do not participate in the Protocol must obtain permission from the Remaining Party before attempting to assign (also called “novate”) a trade. below is a sample e-mail or Bloomberg message from the Transferor to the Remaining Counterparty. Moreover. the Remaining Party may not know its exact credit exposure for some time. the Remaining Party may contact the wrong Counterparty for payment. 84 Credit Default Swap Primer Glen Taksler 646. If the Transferee does not receive consent by 6pm. beginning in late 2008. dealers stated plans to implement a way for novation requests to be submitted by electronic platform. rather 57 than e-mail. This Protocol requires the following: The 2005 Novation Protocol requires that the Transferee receive consent by 6pm on the trade date. required to execute an assignment. 2008 35 occur before the assignment backlog is completed. In September 2005. 2004. instead of the mechanics of Figure 90. Otherwise. the Federal Reserve and 14 dealers met to discuss risks to the credit derivatives market. In a March 2008 letter to the Federal Reserve. in the location of the Transferee. That is. the assignment will instead be booked as a new trade. As part of the 2005 Novation Protocol.
DTCC and reference information] From: To: CC: Re: We have agreed with the proposed Transferee to the transfer by novation of the transaction described below (the “Transaction”). Transferor: Proposed Transferee: Novation Trade Date: Trade Date: Novated Amount: [ [ [ [ [ ] ] ] ] ] Details to Include for Credit Derivative Transactions Reference Entity / Ticker / RED Code: [ Reference Obligation / CUSIP: [ Scheduled Termination Date: [ [Notional allocation ] [ [Non-Standard Terms ] [ ] ] ] ] ] Details to Include for Interest Rate Derivative Transactions Termination Date: [ ] Notional Amount: [ ] [Fixed Rate:] [ ] [Floating Rate:] [ ] Please advise promptly as to your consent to the transfer by novation of this Transaction. Source: ISDA.Credit Strategy Research May 27.7559 85 . subject to your consent to such transfer. 2008 35 [contact name at Transferor] [contact name at Remaining Party] [contact name at Transferee] Request for Consent to Proposed Transfer Transaction References (include if available): [Our Reference Number: ] [Your Reference Number: ] [Third Party Reference: eg Swapswire. Indicative sample.855. Credit Default Swap Primer Glen Taksler 646. by replying to all addressees of this email and indicating your decision regarding consent. for illustrative purposes only.
Sources: Bloomberg. Bank of America. as discussed on page 67. A brief explanation appears in Figure 67. N. a series of notices must be served. resulting in potentially lower margin) or because a client only has one ISDA Master Agreement in place (with the prime broker. (for example) faces a client’s prime broker as a Counterparty. Sample Trade Recap for a Give-Up For illustrative purposes only. Figure 66. The prime broker then faces the client in a separate trade. followed by sample documentation below.Credit Strategy Research May 27. Figure 66 shows a sample trade recap. Sample Credit Event Documentation To trigger settlement of a CDS contract. 2008 35 Give-Up In a give-up. 86 Credit Default Swap Primer Glen Taksler 646. Give-ups may be done for margining purposes (the prime broker sees the client’s entire portfolio. as opposed to with each bank and broker-dealer).A. Banc of America Securities LLC estimates.855.7559 .
Bankruptcy Court in the [applicable bankruptcy court] (the “Bankruptcy Filing”). 2008 35 Figure 67. A Notice of Publicly Available Information documents the Credit Event A Credit Event Notice (“CEN”) states that a Credit Event has occurred. In a standard confirm.Credit Strategy Research May 27. Capitalized terms used and not otherwise defined in this letter shall have the meanings given them in the confirmation of the respective Transaction.855. A Notice of Publicly Available Information (“NOPAI”) documents the Credit Event and may consist of a copy of a Petition for Bankruptcy filing or newspaper articles: [Date] [Counterparty Address and Contact Information] [Non-Party Calculation Agent Address and Contact Information] SAMPLE CREDIT EVENT NOTICE AND SAMPLE NOTICE OF PUBLICLY AVAILABLE INFORMATION Re: Credit Derivative Transaction(s) referencing [Reference Entity] detailed on Annex A hereto Reference is made to the Credit Derivative Transaction(s) described on Annex A hereto (the “Transaction(s)”) between us. Sample Credit Event Notice and Notice of Publicly Available Information A Credit Event Notice states that a Credit Event has occurred.7559 87 .S. This letter is our Credit Event Notice to you in respect to each of the Transaction(s) that a Bankruptcy Credit Event occurred with respect to [Reference Entity] on or about [date of filing]. both the Buyer and Seller of protection are permitted to deliver a CEN at any time from the Credit Event date until trade maturity. published or electronically displayed news sources Two sources typically required Usually delivered at the same time as a Credit Event Notice Notice of Physical Settlement Details of the Deliverable Obligations that Buyer will deliver to Seller (in physical settlement) Must be delivered within 30 calendar days of Event Determination Date Source: 2003 ISDA Credit Derivatives Definitions. Credit Default Swap Primer Glen Taksler 646. when [Reference Entity] filed a petition for voluntary Chapter 11 protection in the U. Types of Notices Credit Event Notice Can usually be served by Buyer or Seller Describes in detail the Credit Event that has occurred Must be served no later than 14 calendar days after Scheduled Termination Date Day it is effective is called Event Determination Date Notice of Publicly Available Information Must contain a copy of the relevant Publicly Available Information Sources must be internationally recognized.
2008 35 This letter also comprises our Notice of Publicly Available Information with respect to this Credit Event. [Date] [Counterparty Address and Contact Information] [Non-Party Calculation Agent Address and Contact Information] SAMPLE NOTICE OF PHYSICAL SETTLEMENT Re: Credit Derivative Transaction(s) referencing [Reference Entity] detailed on Annex A hereto 88 Credit Default Swap Primer Glen Taksler 646. Instead.Credit Strategy Research May 27.855. Sincerely. Nothing in this letter shall be construed as a waiver of any rights we may have with respect to the Transaction(s).7559 . we provide the Publicly Available Information attached hereto. both Counterparties sign an adherence letter to the relevant CDS settlement protocol. For CDS (often called “cash”) settlement protocols that have taken place. Bank _______SAMPLE_______ Name: Title: ANNEX A Bank Reference Number Trade Date Effective Date Scheduled Termination Date Floating Rate Payer Fixed Rate Payer Index [Attach Notice of Publicly Available Information] Sample Notice of Physical Settlement For physically settled trades. a NOPS is not delivered. a Notice of Physical Settlement specifies which bonds the protection Buyer intends to deliver A “Notice of Physical Settlement” (NOPS) is typically delivered 30 calendar days after the Event Determination Date and specifies which bonds the Buyer of protection intends to deliver. to physically settle the Credit Default Swap. Accordingly.
Reference is also made to the Credit Event Notice(s) previously delivered. in the 2003 ISDA Credit Derivatives Definitions. if any.Credit Strategy Research May 27. This notice assumes all Deliverable Obligations will be denominated in USD. Subject to the terms of each Transaction. if no meaning is specified therein. Credit Default Swap Primer Glen Taksler 646. 2008 35 Reference is made to the Credit Derivative Transaction(s) described on Annex A hereto (the “Transaction(s)”) between us.7559 89 . assigned to such term in the confirmations of the respective Transactions or. Any capitalized term not otherwise defined in this letter will have the meaning. We hereby confirm that we will settle each Transaction and require performance by you in accordance with the Physical Settlement Method. Bank _______SAMPLE_______ Name: Title: ANNEX A Bank Reference Number Trade Date Effective Date Scheduled Termination Date Floating Rate Payer Fixed Rate Payer Index 58 The aggregate outstanding principal balance of all Deliverable Obligations identified should equal the aggregate of the Floating Rate Payer Calculation Amounts of all the Transactions. each with an outstanding principal balance equal to the outstanding principal balance specified below opposite such Deliverable Obligation: Outstanding Principal Balance to be Delivered 58 USD USD USD Issuer Coupon Maturity CUSIP ISIN Sincerely.855. This letter constitutes a Notice of Physical Settlement with respect to each of the Transaction(s). we will deliver to you on or before the Physical Settlement Date the following Deliverable Obligation(s).
6/20/2013). For investment grade credits. usually the most liquid part of the CDS curve. Sample Trader Runs Single-Name CDS Figure 68 shows a sample single-name CDS trader run. the bid-offer spread is typically 4 bps to 10 bps in five-year CDS. 2008 35 Chapter V – CDS Trading Management This section discusses trading and risk analytics specific to the CDS market. Notice that the bid-offer spread is 20 bps for a standard five-year maturity (in this case.855. In this case.7559 . the bid-offer spread widens to 30 bps for shorter-dated maturities (6/20/2010). 90 Credit Default Swap Primer Glen Taksler 646. Keep in mind that this example is for a relatively widespread credit (475/495 bps in five-year CDS). Readers looking for a basic introduction to credit derivatives may wish to focus on sections toward the front of this more advanced chapter.Credit Strategy Research May 27.
2018 for 10Y). 0. 2008 35 Figure 68.25 bp in IG. CDX Indices The CDX indices are available on Bloomberg at CDSI <GO> or CDX10 CDS <Corp> <GO> (CDX9 for Series 9. and 3 bps in HY. Credit Default Swap Primer Glen Taksler 646. Bloomberg Screen of Sample Single-Name CDS Trader Run For illustrative purposes only. The rows denote the maturity (June 20. when quoted in spread. Banc of America Securities LLC estimates. click the red “Members” icon.Credit Strategy Research May 27. etc. Prior to the credit crunch beginning summer 2007.). Sources: Bloomberg. The bid-offer spread is 1 bp in 5Y IG and 2 bps in 10Y. The Reference Entity composition of the selected index or sub-index may be viewed on Bloomberg by typing MEMB<GO>. the pricing convention is reversed from the cash market for investment grade. 2013 for 5Y and June 20. Figure 69 illustrates a sample trader CDX. Keep in mind that because the CDX indices are composed of credit default swaps.7559 91 .IG Series 10 run. on the CDSW (“Credit Default SWap”) screen. To use the customized CDSW screen. bid-offer spread was approx 0.855. CDX8 for Series 8.50 bp in HVOL. the bid is lower than the offer. select one of the indices (or sub-indices) and type CDSW <GO>. Alternatively.NA. That is. after selecting the relevant index.
This is different from single-name CDS. Since the index trades with a fixed coupon of 155 bps.560 upfront (based on a $10 million notional) and receives 155 bps running.7559 . Series 10) protection at 102 bps (dealer bids 102 bps).IG Trader Run For illustrative purposes only. Bloomberg Screen of Sample CDX. where the fixed coupon usually equals the running spread (i. Banc of America Securities LLC estimates. Sources: Bloomberg. single-name CDS usually trades at par)..855.NA. 2008 35 Figure 69. the protection Seller pays $256. at inception. 92 Credit Default Swap Primer Glen Taksler 646. Figure 70 shows the relevant CDSW screen for an investor who sells IG10 (Investment Grade index.Credit Strategy Research May 27.e.
855.10 Notional Coupon Settle Paid by Seller Sources: Bloomberg. and price and spread are inversely related.NA. Since the indices trade in dollar price.IG. Figure 65 shows a sample run of the overall index (HY10 and HY9) and the leveraged loan CDS index (LCDX10 and LCDX9). the bid is higher than the offer in spread terms. Banc of America Securities LLC estimates. an investor may buy the CDX HY Series 10 index at $96 7/8 in dollar price or 582 bps in spread. Sell Protection At 102 bps For the high yield market.7559 93 . Bloomberg CDSW Screen for CDX. Credit Default Swap Primer Glen Taksler 646. 2008 35 Figure 70.Credit Strategy Research May 27. That is.
CDS Rolls Every three months. 2008 35 Figure 71. Bloomberg Screen of Sample CDX.NA. Every three months. single-name CDS “rolls” to a new standard maturity date. single-name CDS “rolls” to a new standard maturity date To help make execution straightforward. 2013. a “five-year” trade executed on April 1. For example.NA Trader Run For illustrative purposes only. which is just over five years. 2008 matures on June 20.Credit Strategy Research May 27. Banc of America Securities LLC estimates. Sources: Bloomberg.855. credit default swaps have standardized maturities. The CDX indices roll every six months: 94 Credit Default Swap Primer Glen Taksler 646.HY and LCDX.7559 .
Other investors sell 7-year credit default protection and let their contracts roll down to the 5-year point on the curve. 2008 Roll Date On the roll date. Don’t Be Confused by Market Convention March 20. and XO roll on March 20th and September 20th. “4. this results in a potential mismatch between actual and quoted maturities.75 year” point on the curve (far right column of Figure 73). CDX Indices June No Roll December No Roll 20th. Single-Name CDS June September December March Single-name CDS rolls on March June September and December CDX IG.25 years.25 years 5 years That is.75 years" as of 20 Mar 08 5. LCDX rolls on April 3rd and October 3rd. Credit Default Swap Primer Glen Taksler 646. single-name CDS rolls down from 5. Typically. Over the following three months. investors roll to maintain liquidity. But by CDS market convention.25 years to 5 years (center column of Figure 73). For more on CDS rolls. that is. as detailed in Figure 73: Figure 73. New Maturities for CDX Indices. please see Figure 74. on the roll date. at which time they look to unwind contracts. “five-Year” CDS matures in 5. please see the Chapter Appendix on page 113. 2008 35 Figure 72.855. this is referred to as rolling down from the “5 year” point on the curve to the “4. Actual Maturity Contract 20-Jun-2013 20-Mar-2013 Source: Banc of America Securities LLC estimates. versus Single-Name CDS Roll Occurs on the 20th Day of the Month New Maturity Month of Roll March June September December 20th. CDX HY rolls on March 27th and September 27th. 20th.Credit Strategy Research May 27. HVOL.75-Year” CDS matures in 5 years. investors roll to maintain liquidity Typically. Source: Banc of America Securities LLC estimates. “five-year” CDS actually matures in 5. For more details. For single-name CDS. Market Convention "5 years" "4. 20th. the on-the-run five-year contract is usually the most liquid point on the credit default curve.7559 95 .25 years.
Banc of America Securities LLC estimates. Single-Name CDS EM and all iTraxx CDX HY Index LCDX Index ABX Index CMBX Index Indices Legal final (~40 years) June 20 June 20 June 20 June 20 Legal final (~40 years) September 20 Legal final (~40 years) December 20 December 20 December 20 December 20 Legal final (~40 years) March 20 - The ABX index was scheduled to roll to Series 08-1 on January 19. with cases in which the investor rolls or does not roll. 2008 to include more recent deals. under index rules. The CMBX index was scheduled to roll to Series 5 on April 25. 2008. The investor buys $10 million notional of credit default protection at 80 bps. Source: Markit Group Ltd. but was delayed because. 2008 35 Figure 74.7559 . only five deals qualified for inclusion. 2008. We show a six-month holding period. Roll Schedule Across Credit Derivatives Products Roll Date and New Maturity New Maturity Roll Date January 19 March 20 March 27 April 3 April 25 June 20 July 19 September 20 September 27 October 3 October 25 December 20 CDX IG. HVOL. 96 Credit Default Swap Primer Glen Taksler 646. XO. Sample P&L Calculation For a Buyer of Single-Name Protection Figure 75 shows sample P&L scenarios for a Buyer of single-name protection.Credit Strategy Research May 27.855. but was delayed until May 22. and subsequently unwinds the trade at 120 bps.
The roll costs the investor 4 bps. th Since the investor rolls on June 20 .000 in carry (84 bps x $10 million notional x 0.) 10. CDS stays constant at 80 bps over the first three months. the investor unwinds the original trade at 80 bps. The investor would earn $159. 2008.7559 97 . Buyer of Protection Rolls. To project forward P&L. 2008 35 Figure 75.25 years). the valuation date (toward the bottom-left) is the date on which the investor expects to unwind the trade.2% 151 -40 111 2. the effective date is one calendar day (T+1) following the roll.000 Total Roll. with all spread widening occurring before the roll 10. in this case September 20. As such. the investor earns zero principal over the first three months. Lastly. not an amendment to the original confirm. the roll increases the cost of carry to 84 bps per annum.25 0. assuming that 5-year CDS will widen to 120 bps. as shown in the “Principal” line of Figure 76 (toward the bottom-left).855.000 June 0. 2013.) ($ Thous. Figure 76 shows the CDSW screen that an investor would use to project profit on the new trade.000 Total No Roll 10.000 in principal.000 10.25 Roll Fees (bps) N/A 4 Spread (bps) 80 84 Buy Protection in March at 80 Bps and Unwind Six Months Later (in December) at 120 Bps Unwind Buy Protection (Sell Protection) Spread (bps) 80 120 Principal Carry P&L Net P&L Return ($ Thous. With All Spread Widening Occurring After the Roll In the first scenario.) ($ Thous.2% Sources: Bloomberg. Accordingly. Mechanically.) (Annualized) 0 159 159 -20 -21 -41 -20 138 118 2. is issued. The investor also pays $21. A new confirm.Credit Strategy Research May 27.25 0. Sample P&L Calculation for a Buyer of Single-Name Protection Contract Size ($ Thous. Credit Default Swap Primer Glen Taksler 646.50 N/A 80 116 June September 0.000 10. but pays $20.4% Roll.25 N/A 4 80 124 120 120 Expiry (Month) June September Horizon (Years) 0. 2008 and mature September 20. with all spread widening occurring after the roll 176 -17 159 -20 -31 -51 156 -48 108 2.000 in carry (80 bps x $10 million notional x 0. Banc of America Securities LLC estimates. and enters into a new trade at 84 bps.25 years). the new trade would be effective on June 21.
4% ($118. a 4-bp roll means that the investor enters into a new contract at 124 bps. 2008 35 Figure 76. the investor still earns $159. CDS widens from 80 bps to 120 bps. resulting in a $17.000 carry in the first three months – $21.50 years).000) during the second three months. With All Spread Widening Occurring Before the Roll The middle section of Figure 75 shows the scenario in which protection still widens to 120 bps. but this feature is currently not supported in Bloomberg. In the second scenario. Calculating P&L On A Sample Trade Investor Buys Protection at 84 Bps (On the Roll) and Unwinds at 120 Bps Investor rolls so that contract maintains an on-the-run five-year maturity (in this case. With credit quality constant. the investor earns $118. Then. Over the first three months. this contract rolls down to 120 bps over the second three months. 2013) Effective Date of New Trade Maturity of New Trade Strike of New Trade Expected Unwind Date Principal P&L from Spread Widening Current Market Spread This calculation uses the spot interest rate curve at trade inception. The main difference between the first two scenarios lies in the cost of carry.000 carry in the second three months). where spreads widen before the roll. Sources: Bloomberg. but in two parts.000 principal loss. resulting in a principal gain of $176. The total return is 2.000) 98 Credit Default Swap Primer Glen Taksler 646. carry is the same 80 bps ($20. Buyer of Protection Rolls.Credit Strategy Research May 27.000 / $10 million notional / 0. Over the six-month life of the trade. In this case.. It would be more accurate to use the 3-month forward curve (i.e.855.7559 . but now all spread widening occurs before the roll.000) during the first three months and 84 bps ($21.000 ($159. where spreads widen after the roll. Banc of America Securities LLC estimates.000 principal – $20. the expected interest rate curve at trade unwind). In the first scenario.000.000 principal. carry is 80 bps ($20. We show the Bloomberg screen to follow market convention. September 20.
000 in principal (roughly calculated as 36 bps spread widening. If an investor does not roll.7559 99 . 2008 35 during the first three months. If an investor rolls.2%. the investor unwinds a 4. which benefits P&L. In addition.000 carry). Overall Tradeoff for the Buyer of Protection Overall. x 4.000) during the second three months.50 years (second scenario).855. he pays a higher cost of carry (the roll fee) but keeps a roughly constant duration. For protection Buyers.319 duration). Moreover. In this case.000 (roughly calculated as 36 bps spread widening.Credit Strategy Research May 27.75-year contract after three months. spreads only widen to 116 bps.75-years. the duration shortens.000 / $10 million / 0. since CDS has a three-month shorter maturity than the on-the-run contract. from 84 bps after the roll to 120 bps. Lower carry reduces net P&L from $118. from 80 bps to 116 bps. This results in a return of 2. there is a tradeoff between carry and duration. However. the investor earns $151. rolls result in a tradeoff between carry and duration For a Seller of Single-Name Protection Figure 77 shows similar results for an investor who sells single-name protection at 80 bps. not 120 bps.143 duration). he saves the roll fee.000 in the spreads-widen-after-the-roll scenario.2% ($111.000 in the spreads-widen-before-the-roll case. Credit Default Swap Primer Glen Taksler 646.4% and 59 2. This reduces P&L from spread widening.50 years (first scenario) or $108. to $108. Rather than keeping a five-year on-the-run contract. there is a tradeoff for P&L: The investor does not increase the cost of carry by the 4-bp roll.000 principal – $40. but increases to 124 bps ($31. since CDS rolls down from 5to 4.000 net P&L / $10 million notional / 0. but suffers from a progressively shortening duration. the investor risks reduced liquidity by not maintaining an on-the-run contract.5 years). and subsequently unwinds the trade at 40 bps: 59 The annualized return is calculated as $118. x 4. Returns are 2. Buyer of Protection Does Not Roll The bottom section of Figure 75 shows the case in which the investor does not roll. respectively.000 net P&L / $10 million notional / 0. Net P&L is therefore $111.000 ($151. Rather than earning $158.
as in the no-roll scenario of Figure 77. If the investor did roll. the annualized ROE is 23% (4. the expected gain from selling protection must exactly offset the expected loss: Expected Gain = Expected Loss At a one-year horizon. Assuming that CDS is priced solely on default risk. protection Sellers do at least as well by rolling to a new on-therun contract Notice that.6% Sources: Bloomberg.75-year CDS contract. the expected gain is simply the spread. for total collateral of 20%. For example. Also noteworthy is that investors. he would lose money at the duration of the 5-year CDS contract—so that principal fell by more than in the no-roll case—but would keep the 4-bp roll premium. he would lose money at the duration of the 4.) (Annualized) 0 199 199 20 21 41 20 220 240 4. the protection Seller does at least as well by rolling to a new on-the-run contract.855.50 N/A 80 36 190 40 230 4. these two factors would counteract: If the investor did not roll.5% of internal reserves. often sell protection with margin.6% return / 20% collateral).) ($ Thous.000 June 0. If CDS is fairly priced.25 0. for spread tightening scenarios. it is possible to back out an implied probability of default It is possible to back out an implied probability of default.6% In spread tightening scenarios. 2008 35 Figure 77. June September 0. This is both because the investor receives a 60 premium for rolling (in this case.5% collateral for selling five-year protection at 80 bps ($350. Implied Probability of Default For investors who are willing to assume a recovery rate. Banc of America Securities LLC estimates.000 Total Expiry (Month) June September Horizon (Years) 0.25 0. An inverted curve could result in the protection Seller paying a premium to roll.000 10. with all spread tightening occurring after the roll Roll.7559 .) ($ Thous. with all spread tightening occurring before the roll 10. based on the traded credit default spread and an assumed recovery rate. That is: 60 We assume an upward-sloping curve.8% Roll. The logic is as follows. 100 Credit Default Swap Primer Glen Taksler 646. times the 61 probability of default. the expected loss is notional minus recovery.000 on $10 million notional) and keep an additional 16.6%.Credit Strategy Research May 27.25 Roll Fees (bps) N/A 4 Spread (bps) 80 84 Unwind Sell Protection (Buy Protection) Spread (bps) 80 40 Principal Carry P&L Net P&L Return ($ Thous.000 10. 4 bps) and because duration extends.) 10. an investor may post 3. particularly hedge funds.000 Total No Roll 10. If the annualized return is 4. Sample P&L Calculation for a Seller of Single-Name Protection Sell Protection at 80 Bps and Unwind at 40 Bps Contract Size ($ Thous.25 N/A 4 80 44 40 40 181 18 199 20 11 31 201 29 230 4. For spread widening scenarios.
such as liquidity and mark-to-market risks. investors should realize 61 If there is a default. the January 1999 point compares the five-year implied probability of default (based on Baa spreads in January 1999) with the five-year actual default rate (as realized for January 1999—January 2004). the probability of default is 1 – exp( -[ Spread ] / [ 1 – Recovery ] x [ Horizon ] ). 62 At longer horizons. The likelihood that this event will occur is simply the probability of default. For example. The implied probability of default extracted from CDS spreads includes these other factors. or 49%. divided by one minus the expected recovery rate Figure 78 compares the five-year implied probability of default with realized default rates. divided by one minus the expected recovery rate. Credit Default Swap Primer Glen Taksler 646. Implied Default Probability Generally Trades Wide to Realized Default Rate Baa-Rated Bonds (Not CDS) For example.Credit Strategy Research May 27.855. Assumes flat credit curve and 40% recovery rate. of Default Is 49% Implied Probability of Default by CDS Spread Figure 79. For example. the 5y Implied Prob. “Corporate Default and Recovery Rats. 5y Implied Probability of Default is based on Par CDS Equivalent Spread to LIBOR for Baa-rated cash bonds (not CDS) in the Banc of America Securities High Grade Broad Market Index. the market prices factors other than default risk into pricing. 62 The one-year probability of default is the spread. at a credit default spread of 400 bps and a recovery rate of 40%. the five-year implied probability of default is 1 – exp( – 0. with a CDS spread of 800 bps and an expected recovery rate of 40%. For example.4 ) x 5 ). Sources: Moody’s. the one-year probability of default is the spread. the one-year probability of default is 7% (400 bps / [ 1 – 40% ] ).7559 101 . At 800 bps. This is because the protection Seller owes notional on the CDS contract but receives a bond from the protection Buyer. for bonds (not CDS) rated Baa by Moody’s. Implied default probabilities trade wide to historic default rates Naturally. the Seller of protection loses notional minus recovery. 5y Realized Default Rate and 5y Long-Term Average Default Rate (1920-2007) obtained from Moody’s Investors Service. 1920-2007. Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates. As Figure 78 suggests. Figure 78.” February 2008.08 / ( 1 – 0. Jan-99 point compares 5y implied default probability with the default rate eventually realized over the same five years 100 bps 60 50 40 30 20 10 0 1 400 bps 800 bps Baa Default Probability 30% 25% 20% 15% 10% 5y Implied Probability of Default 5y Realized Default Rate 5y Long-Term Average Default Rate (1920 -2007) Implied Probability of Default (%) 2 3 4 Tenor (Years) 5 5% 0% Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Assumes flat credit curve and 40% recovery rate. 2008 35 Spread = [ Probability of Default ] x [ 1 – Recovery ] So that: [ Probability of Default ] = Spread / [ 1 – Recovery ] In other words.
investor loses money. Sources: Bloomberg. Figure 80 illustrates that an investor who earns. Unwind 800” discounted at L + 800 / ( 1 – 40% Recovery Rate). CDS P&L is Determined by the Discount Rate Investor Makes 400 Bps in One Case. Figure 80. Unwind 400” discounted at L + 400 / ( 1 – 40% Recovery Rate). Unwind 800 Buy 800. the implied probability of default becomes more meaningful because default risk starts to dwarf liquidity and mark-to-market risk factors.855. CDS Duration and Curve Trades Similar to cash bonds. unless the two trades have the same unwind spread. Unwind 400 Net “Buy 400. But Loses 400 Bps in Another Case Net.3 -16. because of different discount rates 20 15 10 5 0 -5 -10 -15 -20 13. 102 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. many single-name CDS investors use the CDSW screen on Bloomberg to calculate these sensitivities. Banc of America Securities LLC estimates. CDS contracts have an associated duration and DV01.2 Buy 400. 63 For near-distressed credits. 2008 35 that the actual probability of default is typically far lower than that implied by CDS 63 spreads. say. This reflects the market-implied risk that the Reference Entity may suffer a Credit Event during the life of the contract. “Buy 800. The reason is that each trade will have a different probability of default and therefore a different discount rate. By market convention. Mind the Discount Factor CDS trades are discounted at LIBOR plus the implied probability of default.7559 . 400 bps on one trade and loses 400 bps on another trade will not be P&L neutral.9 P&L (Points) -2.
This is the “Deal Spread” section on the left-hand side of the screen. at a 100-bp starting spread. Also note. for a $10 million notional position. as illustrated in the circled portion on the right-hand side of the screen. In Figure 81. Sources: Bloomberg. Credit Default Swap Primer Glen Taksler 646. but the market is slowly moving toward using a full credit curve (different spread for different maturities). As illustrated in Figure 82. Calculating CDS Duration and DV01 Implement Trade at 100 Bps Type: TICKER Equity CDSW <GO> Current Market Spread Coupon Dollar Value of a 1 bp Change in Spread Investors may also access the CDSW screen by typing TICKER Corp CDSW <GO>. duration varies inversely with spreads. the current (markto-market) spread is also 100 bps.572 DV01 / $10 million notional x 10.572. The multiplication by 10.000 of a dollar.572 of P&L.000. deal spread is referred to as “coupon” or “strike. an investor executes a CDS trade at 100 bps. and a basis point is 1/10. (Sometimes.”) Since we are analyzing the trade at inception.855.Credit Strategy Research May 27. we show a flat credit curve of 100 bps on the right side of Figure 81. Banc of America Securities LLC estimates.7559 103 . particularly in Europe. 64 Cash bond investors frequently refer to this number as a duration of 4. 64 The calculation is $4. Intuitively. a 1 bp move on a credit trading at 10 bps is more significant than a 1 bp move on a credit trading at 1.000 bps.000 occurs because DV01 refers to the change in P&L per basis point. Spread DV01 is shown in the “Sprd DV01” portion toward the bottom-center of the screen. 2008 35 Figure 81. For example. a 1 bp spread change will result in approximately $4.
75 4. carry is 60 bps per annum. this example often would be referred to as “buying $10 million 5s/10s DV01-neutral. Then divide the duration of one leg by the other. Payments are exchanged quarterly. an investor always should confirm the exact notionals before execution. Still.5).0 – 4.50 4. As a rule-of-thumb.7 times as much five-year protection as he buys in ten-year protection (7. 2008 35 Figure 82.” because the investor profits when the 5s/10s curve steepens. Five-year duration is about 4. investors may instead use notionalneutral curve trades.Credit Strategy Research May 27.855.25 – 7.75 3. durations are approximately 4. this trade is referred to as “buying 5s/10s.000 100 200 300 400 500 600 700 800 900 1000 5y CDS Source: Banc of America Securities LLC estimates. 5.000 bps 5. The investor should sell approximately 1. or 1.75 for ten-year CDS.7559 DV01 per $10mm Notional Duration . so th the investor receives $15.00 0 5. meaning $60.500 3. suppose an investor sells five-year protection at 100 bps and buys tenyear protection at 110 bps. In this case. 104 Credit Default Swap Primer Glen Taksler 646. A higher number means a flatter credit curve—for example.7 x 100 bps – 1 x 110 bps.000 3. The reason is that investors are less worried about duration risk 65 A note regarding analytics: To adjust for the absolute level of spreads.000 4. the CDS market often looks at credit curves in percent.” with the notional referring to the longer-dated (ten-year) maturity. June.5 and ten-year duration is 7.7 / 4. calculate the duration for each leg of the trade. September.5 for five-year CDS.25 4. and December.750 3. For example. multiply the weight on each leg by its respective spread.0 – 6. and 6.7. a 5s/10s curve at 80% (five-year spreads somewhat below ten-year spreads) is flatter than a 5s/10s curve at 50% (five-year spreads well below ten-year spreads). Duration Varies Inversely with Spreads Duration and DV01 vs.250 3. To find carry.00 3. Notional-Neutral Curve Trades (Jump-to-Default Hedging) Particularly for near-distressed or volatile credits. When trading.250 4.000 per $17 million of five-year and $10 million of ten-year notional.00 4.0 for seven-year CDS. 5y CDS A 1bp move at 10 bps is more significant than a 1 bp move at 1.25 3.750 4.50 3. Weights on DV01-Neutral Curve Trades 65 To calculate the weights on single-name curve trades.000 on the 20 day each of March. Often.500 4.
For example. 2008 35 (small spread changes) and more worried about jump-to-default risk (large spread changes. The breakeven spread for two-year protection that begins in three years is called the implied forward spread. parallel curve move and outright default. based on the current (spot) credit curve.” we mean the spread that makes the two trades equivalent. if the investor is wrong and the Reference Entity suffers a Credit Event (in the first year).Credit Strategy Research May 27. Implied Forward Spread The implied forward spread shows the market’s expectation of future spreads. “Butterfly trades” combine two curve trades to hedge both extremes. Consider two trades. For details. sell two-year protection. because he sells protection on the longer duration asset (five-year protection). The investor may not be fully hedged following a Modified Restructuring. By “breakeven. Both the 3s/5s and 5s/10s legs are DV01 neutral. The investor will be long duration. This supports the investor’s bullish view. an investor may sell five-year protection and buy both three. because gains on the short-maturity leg will exactly offset losses on the long-maturity 66 leg.7559 105 . or Sell three-year protection today and then in three years. Butterfly Trades With a curve trade. which fall between the extremes of a small.and ten-year protection. an investor with a bullish view may sell $10 million of five-year protection and buy $10 million of one-year protection. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. an investor may hedge one risk. For example. the investor will be hedged. illustrated in Figure 83. 66 Assuming a Bankruptcy or Failure to Pay Credit Event. An investor who wants to be long five-year risk may consider two trades: Sell five-year protection today.855. especially the section “Practical Trading Considerations Following a Restructuring” on page 157. or an outright Credit Event). Credit Default Swap Primer Glen Taksler 646. either small spread moves (DV01neutral) or jump-to-default moves (notional-neutral). However. The investor would still be exposed to moderate spread moves.
7559 . To do this. Sell 2y CDS at the Implied Forward Spread Sell 5y CDS Sell 3y CDS. Implied Forward Spread (bps) 2 3 Year 4 5 An investor who believes the implied forward spread is too high may execute a curve flattener. and then in three years. sell 2y CDS at implied forward 250 200 150 100 50 0 1 Assumes 40% recovery rate.Credit Strategy Research May 27. Figure 84 illustrates how to calculate the implied forward spread in Bloomberg: 106 Credit Default Swap Primer Glen Taksler 646. Source: Banc of America Securities LLC estimates. 2008 35 Figure 83. or Sell Three-Year CDS.855. Implied Forward Spread Two Equivalent Trades: Sell Five-Year CDS. and Then in Three Years. the investor would sell longer-dated protection and buy shorterdated protection.
2008 35 Figure 84. Calculating the Implied Forward Spread For a Two-Year CDS Contract Beginning March 20. 2011 Type: TICKER Equity CDSW <GO> Starting and Ending Dates of Forward Contract Full Credit Curve Implied Forward Spread Investors may also access the CDSW screen by typing TICKER Corp CDSW <GO>. Credit Default Swap Primer Glen Taksler 646. the CDS market has seen significant volatility in CDS curves.Credit Strategy Research May 27. coupled with dealers’ desire to reduce default risk. Sources: Bloomberg. In these trades. the real story was unprecedented flattening (and inversion) in the second half of the year. Figure 85 shows recent performance of 5s/10s CDS curves. resulted in DV01-neutral 5s/10s flatteners. Banc of America Securities LLC estimates.855. Front-end illiquidity. After CDS curve steepening in the first half of 2007. giving them a hedge against outright defaults while remaining long duration. CDS Curve Flattening (And Inversion) Since Summer 2007 Though 1H07 saw CDS curves steepen on record LBO activity. the real story was unprecedented curve flattening (and inversion) during 2H07 Since summer 2007.7559 107 . on record LBO activity. dealers buy more five-year protection (short risk) than they sell in ten-year protection (long risk).
as shown in Figure 86: 108 Credit Default Swap Primer Glen Taksler 646. the Buyer of protection pays $1. the change means: Under a points upfront convention.640. the Seller of protection would keep the points upfront. Unprecedented Flattening (And Inversion) in CDS Curves Since Summer 2007 On-the-Run CDX IG 5s/10s Curve (bps) 40 CDX IG 5s/10s Curve (bps) 30 20 10 0 -10 -20 -30 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 Not adjusted for changes in on-the-run index constituents. the Buyer of protection pays $125.855. beginning on the next quarterly coupon date. instead of a “1000-bp” five-year CDS spread.4 points upfront plus a 5% running coupon.000 per $10 million notional quarterly (5% per annum). The Transition from Spread to Points Upfront Once five-year CDS spreads approach the 700-bp range. the Seller of protection loses notional minus recovery.4 points on $10 million notional) at inception. the quoting convention often changes from running spread to points upfront plus a 5% running coupon Once five-year CDS spreads approach the 700-bp range. Points upfront reduce Credit Event risk for the protection Seller The logic in moving to a points upfront convention is as follows: Suppose a Reference Entity were to default on the day that a trade becomes effective. the quoting convention often changes from running spread to points upfront plus a 5% running coupon.000 (16. quotes typically change to “16. Under a points upfront convention. without ever having received a coupon payment from the protection Buyer. Source: Banc of America Securities LLC estimates. Moreover.7559 . 2008 35 Figure 85. For example.” Mechanically. Under a spread convention.Credit Strategy Research May 27.
Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. please see the Chapter Appendix on page 115.4 = 6 Notional . Assignments. Original Trade Investor Buys Protection at 500 bps 500 bps is $500. and 16. To terminate the trade. In general. An Unwind is Straightforward Investor Unwinds Trade. Source: Banc of America Securities LLC estimates. homebuilder. unwinds are settled in present value (points upfront).64 = 4. 40% Recovery Rate. Source: Banc of America Securities LLC estimates. with Same Counterparty. Mechanics for a Credit Event Occurring on Effective Date of Single-Name CDS Trade $10 Million Notional. In this case. at 1000 bps 1000 bps is equivalent to 16.855. as illustrated in Figure 88.000 per annum on $10 million notional Figure 88.4 Points Upfront + 5% Running Coupon Five-Year CDS Quoting Convention Spread Points Upfront Seller Loses (Buyer Profits) P&L Example Notional . in which an investor buys protection at 500 bps running. 1000 bps is equivalent to 16.4 points upfront + 500 bps running Client Client 500 bps running Protection 16. and Jump Risk How does a CDS investor terminate an existing trade? Consider Figure 87. Unwinds. Client's Counterparty Payments are made quarterly. there are three ways to do this: Figure 87.1. 2008 35 Figure 86. which shows a sample trade. Source: Banc of America Securities LLC estimates. the unwind spread is 1000 bps. points upfront have affected the automobile. Unwind CDS unwinds occur when an investor terminates a trade with the original Counterparty The investor may unwind his position with the original Counterparty. or running) spread is 500 bps.4 points upfront plus 500 bps running. and the investor wishes to terminate the trade at a profit. Suppose that protection widens to 1000 bps.4 points upfront Client's Counterparty Payments are made quarterly. and paper sectors. and the deal (also called original. Since summer 2007.Points Upfront 10 .36 Assumes a flat credit curve. media. monoline insurer. For more details.7559 109 .Recovery 10 .4 .Recovery .
The running coupons cancel out. a new trade often requires the investor to post margin Naturally. one with the original Counterparty and one with the new Counterparty.4 points upfront plus 500 bps running. The running coupon would cancel out.9 points upfront + 300 bps running (assuming 40% recovery). because the client is selling protection to the new Counterparty. and terminate the original trade. …An Assignment Adds Risk Investor Sells Protection at 1000 bps. The original trade is then terminated.e. less accrued interest. one way is to simply sell protection at 1000 bps.9 points upfront plus 300 bps running. the client owes 500 bps.855. As Figure 89 shows. by selling protection to the new Counterparty on assignment (sometimes called “novation”). by trading with a new counterparty on assignment The client may avoid posting margin. so that the client would simply receive 22.4 points upfront. the original trade is terminated. the original Counterparty may not always have the most favorable market. while an unwind allows the client to terminate the original trade. The new Counterparty pays the client 16.4 67 points upfront. the original trade is amended. on Assignment from 500 bps Client does not post margin. Now the client would owe 300 bps running. and the counterparty would owe 22. If the client instead wants to take profits through a new counterparty. Bank of America. 2008 35 So.4 points upfront Client 500 bps running 1000 bps running Protection Protection Protection Client's Original Counterparty Payments are made quarterly. less accrued interest. and the unwind still at 1000 bps. BANA faces additional risk. 110 Credit Default Swap Primer Glen Taksler 646. and the Counterparty owes 16. Source: Banc of America Securities LLC estimates. NA Margin Client 500 bps running Client's Counterparty Payments are made quarterly. Figure 90 shows the setup. i. Moreover. so that the client simply receives 16. BANA pays the original Counterparty 500 bps running. the original Counterparty faces the new Counterparty (BANA). and terminate the original trade. Moreover. Bank of America. now the client has two trades. The client’s name is removed from the trade. realizing profit over the remaining life of the trade. he will likely be required to post margin (collateral). A New Trade Requires Client to Post Margin… Investor Sells Protection with A New Counterparty at 1000 bps Investor faces both BANA and original Counterparty Figure 90.Credit Strategy Research May 27. NA 16. the client receives 1000 bps running from the new Counterparty (BANA) and pays 500 bps running to the original counterparty. from the client’s perspective. New Trade To terminate a CDS trade with a different Counterparty. Assignment The client may avoid posting margin. First.. Going forward. The client keeps the difference. Source: Banc of America Securities LLC estimates.7559 . Figure 89. so that going forward. This adds complexity from an operational and risk perspective. 67 If the original trade were at 300 bps. There are two main disadvantages that make new trades unpopular in the marketplace.9 points upfront. the appropriate conversion would be to 22.
and the new Counterparty would have been better off trading at 1000 bps running spread (1000 bps x 1 day’s accrued interest = 3 bps) than at 15. the new Counterparty would have paid (and would lose) 16.4 points for the same protection.7559 111 . if the investor sells protection. the new Counterparty would have paid just one day’s accrued interest for that protection (the running coupon / 360)..g. but spreads widen. suppose a Credit Event never occurs. If interest rates decline. which requires an investor to obtain permission before assigning a trade. If interest rates decline.7 + 5 x 5 years = 15. please see 2005 Novation Protocol on page 83. “Jump to Default Risk” accounts for the difference in quoting CDS protection in points upfront vs. consider a Credit Event on the Effective Date of the new CDS contract. The investor will have a mark-to-market gain. interest rates still affect the present value of trades. because a dealer buying protection in points upfront faces this risk (and therefore would pay less for the protection) than when buying protection on running spread. the new Counterparty only pays 500 bps running for protection that is currently worth 1000 bps in the market. But if a Credit Event occurs immediately. resulting in further losses. 69 This risk exists in any CDS trading in points upfront. resulting in further gains. to the 68 original counterparty (500 bps). in an assignment.855.7 points) than it would have been at 1000 bps running (10 x 5 years = 50 points). 68 This amount goes to the client in return for the right to pay only 500 bps running to the original Counterparty for protection.7 points upfront. and is calculated based on market expectations. This is because an assignment or unwind adds additional risk. Figure 91 shows that the impact of interest rates increases as CDS moves away from par. Why? In an assignment. By contrast. In a new trade. running spread. he will have a mark-tomarket loss. Market convention requires that an investor state that the trade is on assignment before executing the 69 trade. In a new trade.4 points). Consider an investor who sold protection and then spreads tighten. 2008 35 Take Profits in Small Chunks: Jump Risk on Assignments and Unwinds Quotes for CDS contracts traded on assignment may be wider than for new trades Quotes for CDS contracts traded on assignment or unwind are often less favorable than for new trades. The reason is that CDS contracts discount cash flows at LIBOR plus the implied probability of default (page 100). But in an assignment. the Federal Reserve and 14 dealers met to discuss risks surrounding assignments. This is commonly called jump to default risk in the CDS market: Since the new Counterparty would lose more if a Credit Event occurred early on in the life of the trade. is the 16. In September 2005. the present value of that gain will increase. quotes for an assignment may be less favorable than quotes for a new trade. while a steeper LIBOR curve led by the back end approximates an interest rate rise. Then the market applied too high a discount rate in calculating the 15. 16. For more details.” we mean dates close to the maturity of the CDS contract.7 points upfront + 500 bps running (15. and the new Counterparty was better off having traded the credit at 15.Credit Strategy Research May 27.7 points upfront + 500 bps running (total payment: 15.7 + 25 = 40. Interest Rate Sensitivity Although CDS is based on credit risk. the market applied too low a discount rate in calculating the points upfront. over the life of the trade. By contrast. which is worth 1000 bps running in the current market. the new Counterparty may receive margin from the client. the present value of that loss will increase.7 + 5 x 1 day’s accrued interest = 15. This meeting resulted in the 2005 Novation Protocol. and cash flows are paid quarterly. The present value of the difference between the market spread and the premium paid by the new Counterparty. the new Counterparty receives no collateral.4 points. Credit Default Swap Primer Glen Taksler 646.71 points). and instead must pay the client cash flows upfront (e. The present value of the 500 bps running depends on the timing of default. By “back end. For more details. To understand the risk. please see the Chapter Appendix on page 123. A steeper LIBOR curve led by the front-end approximates an interest rate decline. For example.
Banc of America Securities LLC estimates. Banc of America Securities LLC estimates. 2008 35 Figure 91. CDS investors should understand the implications. while interest rates only affect the discount rate.Credit Strategy Research May 27. the effect of interest rates is relatively small. this is because spreads affect both the discount rate and the amount of money being discounted (unwind spread minus coupon). as illustrated in Figure 92. Compared to spread duration.855. given the magnitude of recent declines in interest rates. Sensitivity of CDS Contracts to Interest Rates “IR01” Means CDS P&L Due to 1 Bp Move in Interest Rates Assumes parallel shift in LIBOR curve Investor sold 5y CDS protection at 500 bps IR01 ($ per $10mm notional) 600 400 200 0 -200 -400 -600 -800 0 Protection Seller Made Money Lower Rates Increase Gain Strike (Coupon) Protection Seller Lost Money Lower Rates Increase Loss 200 400 600 800 1000 1200 1400 1600 1800 2000 5y CDS Sources: Bloomberg.7559 . Figure 92. CDS Contracts Are Much Less Sensitive to Interest Rates Than to Spread “IR01” Means CDS P&L Due to 1 Bp Move in Interest Rates Assumes parallel shift in LIBOR curve Investor sold 5y CDS protection at 500 bps IR01 6000 5000 4000 3000 2000 1000 0 -1000 0 200 400 $ per $10mm notional Spread DV01 Strike (Coupon) 600 800 1000 1200 1400 1600 1800 2000 5y CDS Sources: Bloomberg. Nonetheless. Intuitively. Figure 93 shows how to calculate interest rate sensitivity in Bloomberg: 112 Credit Default Swap Primer Glen Taksler 646.
the reason we look at the 4s/5s curve is that an investor who rolls is extending a contract’s quoted maturity from 4. Below. beginning summer 2007. CDS liquidity became strongly focused on the five-year (historic benchmark) maturity.855.72 per 1 bp Parallel Tightening in the LIBOR curve Result Depends on Recovery Rate Appendix V – CDS Trading Management More on Single-Name CDS Rolls Beginning in summer 2007. Type <TICKER> Corp CDSW <GO> IR01 Displayed in Bottom Row of Center Column Current Spread Notional 5y CDS (Better to use full credit curve) Coupon Protection Seller Gains $2. single-name CDS “rolls” to a new standard maturity date. liquidity became strongly focused on the five-year maturity. As discussed in the main text (page 94). making the roll harder to predict.. Models of the CDS curve became less accurate.682.Credit Strategy Research May 27. December) to 5 Credit Default Swap Primer Glen Taksler 646.g. making the roll harder to predict As discussed in the main text. But. We take the 4s/5s CDS credit curve across a variety of single-name CDS contracts and divide by four. As a simple model for the single-name CDS roll in the five-year sector. Calculating Interest Rate Sensitivity (IR01) in Bloomberg In Bloomberg. Protection Seller Loses $361. every three months. we look at the value of three months on the 4s/5s CDS credit curve.7559 113 . we describe our general methodology for estimating the roll in single-name CDS. Banc of America Securities LLC estimates.49 per 1 bp Spread Tightening Sources: Bloomberg. 2008 35 Figure 93.75 years (e. comparing its performance in early 2007 with early 2008.
look at the value of three months on the 4s/5s (or 3s/5s) CDS credit curve We then regress this “estimated roll” against five-year credit default spreads.24 bps For every 10% (percent.24).5 bps (3.37 bps (0.) If five-year CDS widens by less than the predicted roll. five-year Citizens Communications CDS widened 6 bps versus a predicted widening (roll) of 8 bps. assuming an upward-sloping curve. fewer Reference Entities are in Figure 95 than in Figure 94. the estimated roll is 9. Simple Model of the Single-Name CDS Roll: Feb 07 Estimated roll widens about 0. But for Reference Entities with five-year spreads tighter than 50 bps. For example. the estimated roll widens about 0. which is 10% wider than 200 bps. Notice that the model worked significantly better in 2007.373 bps to be more exact).3 bps This equation means that.37 bps per 10% widening in spread For example. Based on 312 Reference Entities with five-year CDS 350 bps or tighter.82 14 11 8 5 2 -1 -4 -7 -10 0 y = 1. five-year CDS should widen. on December 20. to model the single-name CDS roll. the estimated roll is 9. Figure 95.31Ln(x) . We recognize that in most credit environments—not that of summer 2007 and early 2008—four-year CDS may trade at 90% of five-year CDS. March). not bps) change in spread. estimated roll is 9. At 220 bps. 2012 to March 20. Model Doesn’t Work in Feb 08 Weak explanatory power (low R2) Variation in roll estimates is extreme.22 100 200 5y CDS (bps) 300 27 Feb 07. Source: Banc of America Securities LLC estimates. we look at the 3s/5s curve and divide by eight quarters.3. Three-Month Roll (bps) 100 200 5y CDS (bps) 300 Est. as compared with February 2008 in Figure 95.9 bps (3. not bps) change in spread. In general. for Reference Entities with five-year spreads wider than 200 bps. we use a logarithmic regression. Figure 94.24 R2 = 0.7559 . For February 2007. CDS 114 Credit Default Swap Primer Glen Taksler 646. at 200 bps.. a number of Reference Entities started to see significantly inverted curves. “five-year CDS” extends maturity--for example.5 bps.855.” For example. the estimated roll widens about 0.73 * ln(220) – 10. even if credit quality remains constant. At 220 bps. If the 4s/5s curve is not available. Based on 258 Reference Entities with five-year CDS 350 bps or tighter. On a roll date.73Ln(x) . In both cases. a Reference Entity is said to “capture less than the roll. at 200 bps.Credit Strategy Research May 27. 2013. from December 20. As such. estimated roll is 9.73 * ln(200) – 10.24). To account for the tendency of credit curves to flatten (in percentage terms) at wider spreads. we only look at Reference Entities with five-year CDS trading 350 bps or tighter. 27 Feb 08.9 bps.74 R2 = 0. Due to spread widening. (Beginning in summer 2007.g. 2006. in part due to liquidity concerns 14 11 8 5 2 -1 -4 -7 -10 0 Est. Three-Month Roll (bps) y = 3. Source: Banc of America Securities LLC estimates. for every 10% (percent.73 x ln(5-Year CDS Spread) – 10. Figure 94 shows the results for February 2007.10. four-year CDS may trade at just 75% of five-year CDS. 2008 35 years (e. we estimate the following equation: Estimated Three-Month Roll = 3.
the model is not perfect and will work less well for Reference Entities with flatter credit curves or liquidity concerns. 1000 Bps Is About the Same as 16. Do not use the model for very unusual sectors. More on Points Upfront Converting Between Spread and Points Upfront Figure 96 shows how to convert between spread and points upfront plus a 5% running coupon in Bloomberg. Set the deal spread equal to 500 bps to reflect the 5% running coupon. such as the autos and auto parts.4 Points Upfront + 5% Running Spread This is about equal to 1000 bps all running spread Source: Bloomberg.4 Points Upfront Plus 5% Running Coupon 5y CDS at 1000 bps (Better to use full credit curve) 5y CDS 500 bps Running $1. we have chosen five-year CDS. For publicly traded companies. On the far-right portion of the screen.7559 115 . Not surprisingly. Result Depends Heavily on Recovery Rate The circled fields show major points of which to take note. Converting from Spread to Points Upfront + 500 Bps Running Coupon In Bloomberg. a shortcut is to type <TICKER> Equity CDSW <GO>: Figure 96. but simply enter the actual maturity date of the credit default swap. such as those seen since summer 2007.Credit Strategy Research May 27. Type <TICKER> Corp CDSW <GO> In Five-Year CDS. and select the reference obligation.370 / $10mm Notional = 16. Banc of America Securities LLC estimates.638. We have chosen to keep the Credit Default Swap Primer Glen Taksler 646. Type <TICKER> Corp CDSW <GO>. enter the credit curve.855. 2008 35 traders may refer to this situation by saying that the market captured 75% of the roll (6 bps actual / 8 bps predicted). For the maturity date.
In the bottom-right hand corner. Then change the “Mode” on the blue “Calculator” bar to “2. On $10 million notional. 2008 35 credit curve flat at 1000 bps (the five-year CDS spread). an inverted credit curve decreases points upfront. Enter the points upfront (“up-front fee”) and 500 bps running coupon (“deal spread”). to all running spread. a protection Buyer will pay less for credit risk with a higher recovery rate. Intuitively. Figure 98 shows how to convert from points upfront + 500 bps running. Similarly.” Notice that the resulting value of the credit default swap is $1. this is equivalent to 16. 116 Credit Default Swap Primer Glen Taksler 646. This is because the protection Buyer is entitled to par minus recovery. This is because front-end cash flows will have a higher discount rate. we have chosen 40%.4 points upfront. enter the assumed recovery rate. in the field marked “Principal.855.Credit Strategy Research May 27. Major Issues to Consider When Converting Spread to Points Upfront The conversion between spread and points upfront depends on the assumed recovery rate and credit curve Risk Factor Effect on Points Upfront + 5% Running Coupon for a Given Spread Assumed Recovery Rate Rises Credit Curve Steepens Source: Banc of America Securities LLC estimates.” This mode allows you to convert from points upfront to all running spread. following a Credit Event. although it would be more accurate to enter a full credit curve. A steeper credit curve increases points upfront. Now look near the bottom-left hand corner.7559 . raising the present value. a five-year CDS spread of 1000 bps is about equal to 16. lowering the present value.370.4 points upfront. Figure 97. In other words. Recovery Rate and Credit Curve Matter Raising the assumed recovery rate reduces points upfront. This is because front-end cash flows will have a lower discount rate. plus a 5% running coupon. How to Convert from Points Upfront to Spread Similarly.638.
simply 70 convert the unwind level into its equivalent running spread.000 per $10 million notional) less accrued interest. just convert points upfront + 500 bps running to all running spread. and then calculate the unwind as normal. 70 The present value of trades in points upfront versus running spread is identical. assuming a 40% recovery rate. output spread) Sources: Bloomberg. As shown in Figure 99. 10 points upfront + 500 bps running is 781 bps to a five-year maturity. Converting from Points Upfront + 500 Bps Running Coupon to All Running Spread In Bloomberg. Banc of America Securities LLC estimates. if any. Type <TICKER> Corp CDSW <GO> In Five-Year CDS. However. because all cash flows in an unwind are exchanged immediately (more accurately. but unwound in points upfront.7559 117 . 2008 35 Figure 98. As shown in Figure 100. Credit Default Swap Primer Glen Taksler 646. the distinction between points upfront and running spread is not meaningful. consider an investor who bought protection at 600 bps and now wishes to unwind at 10 points upfront + 500 bps running. at T+3 calendar days). the protection buyer receives 6. 20 Points Upfront Plus 5% Running Coupon Is About the Same as 1142 Bps All Running Spread (Flat Curve) 5y CDS 20 Points Upfront + 500 Bps Running Equivalent Running Spread Change Mode to calculate spread (input points upfront.Credit Strategy Research May 27.45 points ($645. 40% Recovery Rate Unwinding Trades with Points Upfront Unwinding a Trade in Points Upfront That Was Executed in Running Spread For a trade that was executed in running spread. As such.855. For example. The only difference is the timing of cash flows.
output spread) Sources: Bloomberg.855. at a Given Maturity 10 Points Upfront + 500 Bps Running Equivalent Running Spread Change Mode to calculate spread (input points upfront. Unwinding a Trade in Points Upfront. Which Was Executed in Running Spread: Part I In Bloomberg. 40% Recovery Rate 118 Credit Default Swap Primer Glen Taksler 646.7559 . Banc of America Securities LLC estimates. Type <TICKER> Corp CDSW <GO> Enter Points Upfront + 500 Bps Running (Deal Spread).Credit Strategy Research May 27. to Obtain Equivalent Running Spread Points Upfront Level is for a Trade Effective T+1 (4/11/08). 2008 35 Figure 99.
Type <TICKER> Corp CDSW <GO> Enter Original (Deal) Spread and Equivalent Running Spread on Unwind Notional. and that cash flow is done. Following the unwind. See Figure 101. less coupon payments on the 500 bps running. Unwinding a Trade in Points Upfront. with the coupons canceling out. consider an investor who bought protection at 15 points upfront + 500 bps running. If the investor now wishes to unwind at 20 points upfront + 500 bps running.Credit Strategy Research May 27. 2008 35 Figure 100. he will receive 20 points.12 less $33. Change Mode to calculate price (input spread. net profit will be 5 points (20 points received upon unwind – 15 points paid at trade inception). Credit Default Swap Primer Glen Taksler 646.662. Banc of America Securities LLC estimates.79 Sources: Bloomberg.328. and then is unwound in points upfront. For example.33 accrued interest = $611. of 500 bps. Effective Date.333.7559 119 .855.” or deal spread. The investor paid 15 points upfront. Which Was Executed in Running Spread: Part II In Bloomberg. simply use a “strike. output present value) 40% Recovery Rate Unwinding a Trade in Points Upfront That Was Executed in Points Upfront For a trade that was executed in points upfront. and Maturity Date Equivalent Running Spread on Unwind (From Part I) Original Spread Protection Buyer Receives $644.
000.Credit Strategy Research May 27.222.” or deal spread. Change Mode to calculate spread (input points upfront) Unwinding a Trade in Running Spread That Was Executed in Points Upfront Similarly. If the investor now wishes to unwind at 400 bps running. 71 To a one-year horizon. for a trade was executed in points upfront and then is unwound in running spread.22 Sources: Bloomberg.1 points profit on the unwind.855. use a “strike. Net profit will be 10 points received at trade inception plus 4. 120 Credit Default Swap Primer Glen Taksler 646. plus coupon payments on the 500 bps running. Effective Date.7559 . Which Was Executed in Points Upfront In Bloomberg.000 less $27. consider an investor who sold protection at 10 points upfront + 500 bps running. discounted at LIBOR plus the unwind probability of default. The investor received 10 points upfront.777.78 accrued interest = $1. and that cash flow is done. Type <TICKER> Corp CDSW <GO> Deal Spread is 500 Bps Running. please see the section “Implied Probability of Default” on page 100. Upfront Fee is the Unwind Level Notional. and Maturity Date Both Original Trade and Unwind Use 500 Bps Running 40% Recovery Rate Protection Buyer Receives $2. For details. of 500 bps. the discount rate is L + 400 bps unwind spread / ( 1 – 40% assumed recovery rate ). Unwinding a Trade in Points Upfront. he will receive the present value of the difference in coupons (500 bps – 71 400 bps). Banc of America Securities LLC estimates. For example. 2008 35 Figure 101.972.
In-between. Unwinding a Trade in Running Spread. and Maturity Date Points Upfront Were Exchanged at Inception.36 plus $27. if there is no Credit Event.4 points upfront plus a running coupon of 500 bps. Change Mode to calculate price (input spread.4 points (16. the protection Seller receives a higher premium for trading in points upfront plus a running coupon. versus nothing for the running spread investor.538. If a Credit Event occurs prior to the breakeven.14 Sources: Bloomberg. the investor would have been better off selling protection in points upfront Credit Default Swap Primer Glen Taksler 646. Type <TICKER> Corp CDSW <GO> Enter Original Coupon (Deal Spread) of 500 Bps and Unwind Spread Notional. then the points upfront investor receive a lower total premium over the life of the trade Breakeven Between Running Spread and Points Upfront It is possible to calculate a breakeven. the protection Seller receives a higher premium for trading in points upfront… …But. So Irrelevant Upon Unwind Original Trade Uses 500 Bps Running Coupon Unwind Spread Protection Seller Receives $411.Credit Strategy Research May 27.777. the points upfront investor receives 16. However.78 accrued interest = $439.4 points upfront. 2008 35 Figure 102. the points upfront investor will receive a lower total premium over the life of the trade: 41.855. between which an investor is indifferent between trading in running spread or points upfront plus a running coupon. In our example.7559 121 .4 points upfront + 5 points per year x 5 years) versus 50 points for the running spread investor (1000 bps = 10 points per year x 5 years). there is a breakeven. Figure 103 illustrates the breakeven graphically. Take an investor who is considering two trades: a running spread of 1000 bps. Which Was Executed in Points Upfront In Bloomberg.760. or 16. if there is no Credit Event. At trade inception. Banc of America Securities LLC estimates. output present value) 40% Recovery Rate At trade inception. Effective Date.
1000 bps—is subject to duration risk on the whole trade. the investor would have been better off selling protection in running spread. Breakeven Between Running Spread and Points Upfront 1000 Bps Running vs. The assignee then pays the original (“Remaining”) Party 500 bps running coupon.e. they have no duration risk—i. 122 Credit Default Swap Primer Glen Taksler 646. 16.4 Points Upfront + 500 Bps Running 60 50 40 30 20 10 0 0 Total Cashflows (Points) Assignment (Pts Upfront + Running Coupon) New Trade (Running Spread) Cashflows Breakeven after 3. a trade entirely in running spread—in our example. the investor should have received fewer points upfront for selling protection.” and is described more fully on page 123 in this Appendix. Should a Credit Event occur relatively late in the trade (or not at all). 500 bps—has duration risk. That is. The difference in cash flows is called “jump risk.3 years 1 2 Year 3 4 5 Assumes flat credit curve. See Figure 104. Actual results will depend on interest rate curve at trade inception.4 points upfront. regardless of whether spreads widen or tighten. However. The reason is that points upfront are certain. ex-post the investor learns that he should have applied a lower discount rate to the cash flows. he sells protection at 1000 bps running spread. 2008 35 plus a running coupon. If the investor trades on assignment. If a Credit Event occurs after the breakeven. the assignee (bank or broker-dealer to whom the trade is being assigned) pays the investor 16.855.. Figure 103.7559 . Source: Banc of America Securities LLC estimates. If the investor implements a new trade. and now wants to unwind at 1000 bps. Our setup is identical to an investor who originally bought protection at 500 bps.Credit Strategy Research May 27. the points upfront remain constant. Lower DV01 in Points Upfront A trade in points upfront plus a running coupon has less DV01 risk than running spread It is also noteworthy that a trade in points upfront plus a running coupon (or an assignment) has less DV01 risk than running spread (or a new trade). Only the running coupon—in our example.
the price of the CDS contract has fallen from par to $86 ($100 – $14).000 0 0 250 500 750 1000 1250 5y CDS (bps) DV01 All Running 1500 1750 2000 Source: Banc of America Securities LLC estimates. wants to unwind at 450 bps. 2008 35 Figure 104. 2007. Trades that are unwound often result in lower payout than the investor might expect. issuer exposure would decline $10 million x (1 – 40%). This setup leaves the bank or broker-dealer with “jump risk”: If there is a Credit Event at the underlying Reference Entity immediately after trade inception. In other words.4 million (14 points) to the Credit Default Swap Primer Glen Taksler 646. with a profit of 14 points.7559 123 . The reason is “jump risk”: as investors look to bank and broker-dealers to pay out significant profits. the bank or broker-dealer will lose 14 points: Bank or broker-dealer buys protection from investor. and then in December 2007. Normally. buyers of CDS protection take a haircut to unwind trades For credits that gap wider in spread. Points upfront are certain.Credit Strategy Research May 27. and then hedge the transaction with a new trade at par (450 bps). the dealer would also pay $1. with expected recovery of 40%. investors who bought protection may find their contracts relatively difficult to unwind. However.000 4.000 1. consider the change in issuer exposure to the bank or broker-dealer from buying $10 million notional protection. CDS Profit Creates Jump Risk Consider an investor who bought MBIA AA protection at 85 bps (the “strike”) on September 21.855. and expensive. A bank or broker-dealer that accepts this trade must pay the investor 14 points. or $6 million. it becomes progressively more difficult. Points Upfront + Running Coupon (Or An Assignment) Has Less DV01 Risk Than Running Spread (Or a New Trade) Only the running coupon has DV01 (mark-to-market) risk.000 3. More on Jump to Default Risk – Take CDS Profit in Small Chunks The Unwind Surprise As spreads gap wider. for the bank or broker-dealer to hedge positions. in our sample unwind/assignment. DV01 Points Upfront + 500 bps Running DV01 per $10mm Notional 5. and pays 14 points: P&L post-Credit Event = 100 – Recovery – 14 Bank or broker-dealer hedges by selling protection in a new trade: P&L post-Credit Event = – (100 – Recovery) Net P&L post-Credit Event = – 14 Alternatively. This results in reduced ability to unwind trades with substantial profits.000 2.
Assignment/Unwind from 85 bps 0 -1 -2 -3 -4 -5 -6 -7 $10mm x ( 1 . buying protection on unwind/assignment becomes less valuable to the bank or broker-dealer.7559 . Failure to Pay. Figure 106 illustrates jump risk across a range of five-year CDS spreads.Credit Strategy Research May 27.4mm Payment Source: Banc of America Securities LLC estimates.Recovery ) $10mm x ( 1 . 124 Credit Default Swap Primer Glen Taksler 646. Accordingly. Modified Restructuring. 72 By “default risk. $10mm Notional Change in Issuer Exposure from Buying Protection ($ MM) Buy $10mm Protection at 450 bps Buy $10mm Protection at 450 bps .” we mean the Credit Events specified in North American corporate CDS contracts: Bankruptcy. Change in Issuer Exposure from Buying Protection Five-Year CDS. Jump Risk Unwind (or Assignment) from 85 bps 30 25 20 15 10 5 0 0 100 200 300 400 500 600 5y CDS (bps) 700 Jump Risk (Points) New Contract 800 900 1000 Source: Banc of America Securities LLC estimates. and for selected Reference Entities. Figure 105. 2008 35 investor. less the $1.4 million payout to the investor. for an investor who originally bought protection at 85 bps: Figure 106.855. issuer exposure would only decline the normal $6 million. because it 72 serves as less of a hedge against fundamental default risk.Recovery ) minus Initial $1.New Trade . See Figure 105. In other words.
based on the expected recovery rate.39 million.Credit Strategy Research May 27. Somewhat offsetting the lower coupon.31 million notional is that.577. which compares cash flows in a new trade (450 bps) with an older trade (85 bps coupon): At trade inception.7559 125 . To hedge jump risk. the bank or broker-dealer may buy front-dated protection. but declines to zero just before maturity New Trade at 450 bps Cumulative Payout (Points) 25 20 15 10 5 0 0 1 2 Jump Risk at Trade Inception Original Trade (85 bps Coupon) Breakeven just before maturity 3 Calendar Year 4 5 Five-year CDS matures after 5. assuming trade inception on a quarterly roll date. assuming reinvestment at 3-month LIBOR. The trades break even just before maturity. Original trade (85 bps coupon) adjusted to reflect loss of reinvestment income on jump risk. but remains positive until year 4. Assume $10 million of five-year CDS notional. Then: At trade inception (year 0). 2008 35 Adjusting CDS to Compensate for Jump Risk It is possible to adjust the unwind (or assignment) spread on CDS to account for jump risk. with an expected recovery rate of 40%. which reduces jump to default risk. the bank or broker-dealer loses reinvestment income on the initial 14 points paid out to the investor. the bank or broker- Credit Default Swap Primer Glen Taksler 646. Consider Figure 107. meaning that the bank or broker-dealer would lose this amount. jump risk is 14 points. Unwind or Assignment Struck at 85 bps Jump risk is 14 points at trade inception. while Figure 109 shows the notional needed to hedge that jump risk. versus an Unwind (or Assignment) New Trade at 450 bps vs. Jump risk declines over the life of the trade. expected P&L post-potential Credit Event would be $2.75.855. However. Figure 108 shows jump risk by year (the difference between the two lines in Figure 107). To hedge.25 calendar years. or $1. jump risk is $1. Source: Banc of America Securities LLC estimates. the same as initial jump risk. if a Credit Event were to occur. with a present value of $124. as time passes.39 million (13. the bank or broker-dealer benefits from paying a lower coupon (85 bps) on the old trade. The bank or broker-dealer buys $2.9 points x $10 million notional). Cash Flows on a New Trade. The reason for buying $2. when the unwind breaks even with a new trade.31 million of one-year protection at 500 bps. Figure 107.31 million x (1 – 40%).
Unwind or Assignment Struck at 85 bps Five-Year CDS 4. in reality. the bank or broker-dealer subtracts $255. the bank or broker-dealer would. 1y: 500 bps.75. 4y: 460 bps.492. for a total payment of $1. while a new trade would be quoted at 450 bps. the cumulative payout on a new trade would exceed the cumulative payout on the unwind. To make the two trades equivalent. Jump Risk to Hedge an Unwind/Assignment versus a New Trade New Trade at 450 bps vs. Consider the reverse of the previous trade.75.0 3.39 million that normally would be paid upon a CDS unwind (from 85 bps to 450 bps).5 1.0 1. an unwind or assignment (strike 85 bps) would be quoted at 372 bps. By “the beginning of year one. Actual quotes may vary substantially.13 million.5 2. 2008 35 dealer buys smaller amounts of one year protection at the beginning of years one– three.0 40% Recovery 60% Recovery Jump Risk ($ Millions) Notional to Hedge Jump Risk ($ Millions) 0 1 2 3 4 1y Protection Needed in Beginning of Year Source: Banc of America Securities LLC estimates. the market does not use this model.492 from the $1. the dealer effectively has negative jump risk. in practice. we caution that. Figure 108. The present value of all 73 protection purchased. 3y: 475 bps. Assumed credit curve: 6m: 500 bps. the implied likelihood of a Credit Event decreases. 5y: 450 bps.577). 2y: 490 bps. To compensate for the cost of buying protection. that is. in theory.590).0 3.5 0.0 0.5 0. is $255.” we mean one year after trade inception. such short maturities do not trade. Although 372 bps is the fair value for an unwind in this model.5 2. $1.0 0 1 2 3 Beginning of Year 4 4. jump risk is far more important for CDS widening than for CDS tightening.79 million of one year protection beginning in one year (present value $73. the bank or broker-dealer buys $2.0 1.609). and $0. Of course.0 0.372).0 2. Source: Banc of America Securities LLC estimates. The reason is simple: as CDS tightens.241. Jump Risk is Far More Important for CDS Widening than for CDS Tightening Importantly. $1. 126 Credit Default Swap Primer Glen Taksler 646.5 1. $0. This payout is equivalent to a CDS unwind at 372 bps. As such.71 million of one year protection beginning in three years (present value $15. sell a small amount of three-month protection at the beginning of year 4.092).Credit Strategy Research May 27. Unwind or Assignment Struck at 85 bps Five-Year CDS Figure 109.26 million of one year protection beginning in two years (present value $37.5 3.855. as a hedge to jump-to-default risk.31 million of one year protection (present value $124. where an investor now sells protection at 450 bps and wishes to unwind at 85 bps.0 2.7559 . The total present value of all protection purchased is $255. CDS Notional Needed to Hedge Jump Risk New Trade at 450 bps vs.5 3. 73 Net. After the breakeven in year 4.13 million of one year protection beginning in four years (present value $4.
For example.7559 Adj. 5y: 450 bps. consider unwinding after moderate profits (3–5 points). an 74 We assume one-year CDS at 65 bps. for Unwind from 450 bps 450 400 350 3 bps 300 Haircut 250 200 150 100 50 0 0 75 150 225 300 375 450 5y CDS (bps) 127 . Assumed credit curve: 6m: 65 bps. September. 2008 35 With improved credit quality. keeping CDS more liquid. a rapid widening in spreads intra-roll causes CDS to fall well below par. although we acknowledge that none is ideal: For credits with only moderate spread changes. it costs the bank or broker-dealer substantially less to hedge jump risk. 5y: 85 bps. and December). for Unwind from 85 bps 5y CDS (bps) 5y CDS Adj. 2y: 490 bps. while one-year CDS was 500 bps in our earlier example. For example. 75 Note that the five-year CDS (red-dashed line) is in Figure 111. Source: Banc of America Securities LLC estimates. 1y: 65 bps. But as shown in Figure 111. and five-year CDS at 85 bps. As illustrated in Figure 110. Unwind from 85 bps Strike (bps) 5y CDS (bps) 5y CDS Adj. but unwind at 88 bps). June. with MBIA AA. Unwind from 450 bps Strike (bps) Adj. it is hard to see simply because it is so close to adjusted CDS (thick gray line). For credits with substantial spread changes intra-quarter. Haircut is Greater When Credit Deteriorates… 5y CDS. With each roll. and then immediately re-implement the trade. we assume that one-year CDS tightens to just 65 bps. …Than When Credit Improves 5y CDS. However. Note that the five-year CDS (red-dashed line) is in the figure. 74 at improved credit quality. 3y: 75 bps. four-year CDS at 80 bps. Reducing Jump Risk Most of the complexity surrounding jump risk occurs when spreads widen significantly th in-between a quarterly CDS roll (the 20 each of March. Source: Banc of America Securities LLC estimates. the unwind haircut for CDS tightening is just 3 bps (CDS tightens from 450 75 bps to 85 bps. This generally keeps CDS liquid and avoids the jump risk issues outlined above. reducing jump risk and maintaining on-the-run liquidity. 4y: 80 bps. Adjusted for Unwind from 85 Bps Investor Bought Protection Figure 111. A lower cost to hedge jump risk means a lower adjustment to “fair value” on an unwind. several options are available to CDS investors. 3y: 475 bps. Credit Default Swap Primer Glen Taksler 646. 2y: 70 bps. 1y: 500 bps. it significantly reduces jump risk. in our improving credit scenario. roll each quarter. Figure 110. the “fair value” unwind haircut for CDS widening is 78 bps (CDS widens from 85 bps to 450 bps. but unwind at 372 bps). Adjusted for Unwind from 450 Bps Investor Sold Protection 450 400 350 300 250 200 150 100 50 0 78 bps Haircut 0 75 150 225 300 375 450 5y CDS (bps) Assumed credit curve: 6m: 500 bps. two-year CDS at 70 bps. increasing jump risk and reducing liquidity. the bulk of investors unwinds existing trades. Although this results in some extra paying of bid-offer spread.855.Credit Strategy Research May 27. 4y: 460 bps. it is hard to see simply because it is so close to adjusted CDS (thick gray line). Currently. three-year CDS at 75 bps. and resets them with new trades at par. Rolls cause CDS to reset to par.
855. rather than leaving the entire bidoffer payment for jump risk until the final trade unwind. would have paid extra bid-offer but 76 maintained substantially higher liquidity. 128 Credit Default Swap Primer Glen Taksler 646. 76 The paying of bid-offer in this example may be thought of as paying for jump risk at each smaller jump. but give the undesirable effect that payments are only accrued over time (450 bps per annum. sell protection in a new trade at 450 bps. Consider an offsetting new trade rather than an actual unwind. 2008 35 investor who bought protection at 85 bps.Credit Strategy Research May 27. rather than unwinding CDS at 450 bps (from an original strike of 85 bps). This will eliminate jump risk entirely.7559 . However. paid quarterly) rather than immediately (14 points). paying at each smaller jump should improve liquidity. but unwound and then immediately rebought CDS every 150 bps of widening. because more banks or broker-dealers should be willing to transact at smaller jumps. For example.
Domtar Inc. In connection with an LBO by Blackstone Group LP. notes. Tembec borrows a new four-year term loan. focusing on events since 2005. primarily by protection holders. The remainder of this Chapter focuses on many of the outcomes from these case studies. proposed “good bank”/”bad bank” splits raise concerns about a potential split of CDS contracts into one entity with structured finance assets and another entity with primarily municipals. and to plan for physical settlement if necessary. For more details. Tyco spins off into three separate divisions. CDS contracts are not triggered.7559 129 . Despite a payoff for bondholders that resembles a default. CDS succeeds to Domtar Corp. 132 21 132 Credit Default Swap Primer Glen Taksler 646. with greater than 25% but less than 75% of original Tyco debt assumed by each division. resulting in a presumed recovery rate close to par.Credit Strategy Research May 27. Moreover. Some protection holders do not tender. Even if protection Buyers were to find a way to trigger. with 1/3 of the original notional per entity. bondholders agree to exchange more than 75% of outstanding debt into new Domtar Corp. ISDA organizes a committee to address possible changes to CDS (“cash”) settlement protocols for monolines. Tembec had missed a coupon payment.855. Tembec bondholders agree to cancel their existing notes in exchange for equity. please see the page number indicated in the far-right column. a tender offer is announced for existing EOP bonds. to ensure a deliverable into CDS contracts. rules and procedures are clarified through individual cases. 2008 35 Chapter VI – CDS Case Studies and Legal Issues Case Studies The CDS market is an evolving one. wide disparity in the price of potential Deliverable Obligations raises concern that typical CDS (so called-”cash”) settlement protocols may not work. Tyco International Ltd CDS and Tyco International Group SA CDS each split into three entities. we highlight some case studies. To avoid Bankruptcy. Events are sorted by year. only the new term loan would be deliverable. 158 Tembec (TMBCN) 17 2007 Domtar (DTC) Equity Office Properties (EOP) Tyco (TYC) Domtar Inc. Below. but notes are canceled before the indenture’s grace period expires. Small notional remains of EOP bonds. and then alphabetically. Significance Credit Description Result Page 2008 Major Monoline Insurers As the market considers the possibility of a potential Credit Event at a monoline insurer. As the industry matures.
To overcome restrictive covenants in RJR (OpCo). 143 130 Credit Default Swap Primer Glen Taksler 646. LLC) .855. WEN CDS widens to reflect increased leverage. RAI acquires Conwood. Inc. but with the added twist that some existing Verizon Bonds are exchanged for Loans in the new directories business (Idearc). only assets.) CDS. 21 Major Cendant (CD) 132 RJR 132 Major Verizon (VZ) VZ CDS splits 50% Verizon. CDS Succeeds to RJR. Cendant Corp (later renamed Avis Budget Group. OpCo debt becomes deliverable into HoldCo (Cendant Corp.Credit Strategy Research May 27. However. a guarantee is added. 50% Idearc. Investor debate ensues as to whether a Bondfor-Loan exchange counts in calculations for CDS Succession. Overall market later agrees that such exchanges do count. Verizon spins off directories business. Inc. Beginning February 2007. Following a spin-off of four divisions. to ensure a Deliverable Obligation into CDS. because Cendant Corp does not guarantee OpCo Cendant Car Rental Group (later renamed Avis Budget Car Rental. The transaction structure is similar to Alltel. However. renamed Avis Budget Group. Some protection buyers buy CRE bonds and then refuse to accept a tender offer. 132 2005 Major Calpine (CPN) (Part I) Calpine files for Bankruptcy. 50% Windstream. In 2006. RAI does not guarantee existing RJR debt. not debt. 132 Bombardier (BOMB) Bombardier Capital CDS expected to become nearworthless after last bond matures. new OpCo debt is not deliverable into existing Cendant Corp CDS contracts. a temporary spin-off company (SpinCo) exchanges more than 25% of Alltel debt for new notes.) remains a HoldCo. in full. AT CDS splits 50% Alltel. RAI (HoldCo) exchanges existing RJR bonds for new RAI bonds. No Succession. SpinCo then merges with Windstream. move to Tim Hortons. 2008 35 Significance Credit Description Result Page 2006 Alltel (AT) AT spins off wireline business. 21 CarrAmerica (CRE) Blackstone acquires CRE. making new OpCo debt deliverable. RAI purposely structures transaction so that RJR CDS can Succeed to RAI.7559 . Specifically. To keep spin-off tax-free. due to lack of a Deliverable Obligation. with no debt. in May 2009. Wendy’s sells Tim Hortons. of all Calpine secured Parties adhering to the CDS (so-called “cash”) settlement protocol agree that only the convertible 19. Bombardier states that no new debt will be issued out of Bombardier Capital. Bombardier announces that Bombardier Capital (OpCo) financials will be consolidated with Bombardier Inc (HoldCo). two Calpine convertibles are expressly subordinated to the prior payment. which generates more than half of Wendy’s EBITDA. 132 Wendy’s (WEN) No Succession. CDS becomes nearworthless. in February 2007. Although convertible bonds normally are deliverable into CDS trades (see Railtrack case study in 2000).
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May 27, 2008
debt. One of those convertibles is also expressly subordinated to five Calpine senior unsecured notes. None of those notes is the Reference Obligation. This raises a question of whether the convertibles are pari passu or better in seniority to the Reference Obligation, making them deliverable into CDS contracts, or subordinated to the Reference Obligation, making them not deliverable into CDS contracts.
which is not expressly subordinated to the five senior unsecured notes will be deliverable. Parties who do not agree must either physically settle or reach a bilateral agreement with an individual dealer. No Succession. December 20, 2005 maturity CDS protection holders cannot trigger a Credit Event. CDS market adopts a voluntary CDS (so-called “cash”) settlement protocol. Standard CDS contracts continue to specify physical settlement, but market begins to expect an option to cash settle in the future. MAY and FD CDS succeed to Federated Retail Holdings, Inc. 19
Calpine (CPN) (Part II)
Calpine files for Bankruptcy at 10:57 pm New York time on December 20, 2005, after the 11:59pm GMT expiration time of CDS contracts with a December 20, 2005 maturity.
Delphi files for Bankruptcy. Bonds short squeeze on concern that protection buyers may not be able to find a Deliverable Obligation because of the large notional of CDS.
Federated (FD)—May (MAY) Hertz (HTZ)
Federated Department Stores, Inc. (FD) acquires The May Department Stores Company (MAY), including all of MAY’s debt. On the same day, FD’s debt is transferred to Federated Retail Holdings, Inc. In connection with a HTZ LBO, HTZ announces a $2.3 BB tender plan. In addition, Ford Motor Credit (FMCC) anounces plans to offer to exchange $2.4 BB of HTZ debt, for FMCC debt. The exchange offer raises concerns that HTZ CDS may split 50% HTZ / 50% FMCC. FMCC later cancels the exchange offer.
Xerox extends the maturity of a syndicated bank loan facility, triggering a Modified Restructuring Credit Event. Sellers of protection suffer when Buyers deliver JPY-denominated bonds that trade significantly below USD bonds.
Obligations payable in USD, GBP, EUR, CAD, CHF, and JPY are deliverable into CDS contracts.
Conseco extends maturities on loans. Although many loanholders do not view this event as particularly negative for the
CDS contracts adopt Modified Restructuring
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May 27, 2008
credit, some protection buyers trigger a Credit Event and deliver long-maturity bonds that trade significantly below par. Protection sellers suffer significant losses.
(North America) or Modified-Modified Restructuring (Europe), which significantly shortens the maximum maturity of obligations deliverable following a restructuring. ISDA issues a memo and legal opinion suggesting that the convertible bond is deliverable. Later, the 2003 ISDA Credit Derivatives Definitions generally allow convertibles to be delivered into CDS contracts. 47
Railtrack, Britain’s national rail-system owner, files for Bankruptcy. The cheapest-to-deliver is a convertible bond, which leads to debate about whether convertible bonds are deliverable into CDS contracts.
Domtar (2007): Succession for a trade date on or prior to November 19, 2007. Tyco (2007): Tyco International Group SA split for a trade date on or prior to June 29, 2007, with 1/3 of the original notional to each of Tyco International Group SA, Covidien International Finance SA, and Tyco Electronics Group SA. Tyco International Ltd split for a trade on or prior to June 29, 2007, with 1/3 of the original notional to each of New Tyco International, Covidien Ltd, and Tyco Electronics Ltd. Alltel (2006): Split for a trade date on or prior to July 17, 2006. RJR (2006): Succession for a trade date on or prior to May 30, 2006. Verizon (2006): Split for a trade date on or prior to November 17, 2006. Delphi (2005): The first CDS (so-called “cash”) settlement auction was for Collins and Aikman (CKC), which filed for Bankruptcy in May 2005. However, intense public interest in cash settlement started after the short squeeze for Delphi, which filed for Bankruptcy in October 2005. Federated—May (2005): Succession for a trade date on or prior to August 30, 2005. Conseco (2000): We note that only selected North American Reference Entities, generally investment grade, use Modified Restructuring. Other Reference Entities trade with No Restructuring, so that restructuring is not a Credit Event. Railtrack (2000): Convertibles are deliverable, provided that the right to convert or exchange the obligation, or to require the issuer to purchase or redeem the obligation, has not been exercised on or before the delivery date. Additionally, the option to convert must be solely at the option of holders, or a trustee acting on behalf of holders. Sources: ISDA; Banc of America Securities LLC estimates.
Succession—How Corporate Finance Affects Credit Derivatives
What happens if a Reference Entity is merged, acquired, or some other change is made with respect to its corporate structure? This issue is one referred to as Succession in CDS terms and is addressed specifically in the 2003 ISDA Credit Derivatives Definitions. However, as we discuss below, Succession rules are among the most unclear portions of the Definitions, and have at times created significant uncertainty in the marketplace since late 2005. In general, the Succession rules may be summarized as follows: If one entity succeeds to 75% or more of the Relevant Obligations of the Reference Entity (meaning Bonds and Loans, hereafter referred to as Relevant Obligations), that entity will be the sole Successor for the entire Credit Derivative Transaction. If one or more entities each directly or indirectly succeeds to more than 25% of the Relevant Obligations and more than 25% of the Relevant Obligations remain with the Reference Entity, each such entity and the Reference Entity will be a Successor for a new Credit Derivative Transaction. The notional for each Credit Derivative contract will be the original notional, divided equally by the number of Successors.
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May 27, 2008
If one or more entities succeeds to a portion of the Relevant Obligations but no entity succeeds to more than 25% of the Relevant Obligations and the Reference Entity continues to exist, there will be no Successor and the Reference Entity and Credit Derivative Transaction will not change. Additionally, there are some special cases: If one entity succeeds to more than 25% but less than 75% of the Relevant Obligations and the original Reference Entity remains with 25% or less of the Relevant Obligations, the entity that succeeds to more than 25% of the Relevant Obligations will be the sole Successor for the entire Credit Derivative Transaction. If more than one entity succeeds to more than 25% of the Relevant Obligations and not more than 25% of the Relevant Obligations remain with the Reference Entity, the entities that succeed to more than 25% of the Relevant Obligations will each be a Successor for a new Credit Derivative Transaction. The notional for each Credit Derivative contract will be the original notional, divided the number of Successors. Finally, if one or more entities succeeds to a portion of the Relevant Obligations but no entity succeeds to more than 25% of the Relevant Obligations and the Reference Entity ceases to exist, the entity that succeeds to the greatest percentage of Relevant Obligations will be the sole Successor for the entire Credit Derivative Transaction. If two or more entities succeed to an equal percentage of Relevant Obligations, the entity that succeeds to the greatest percentage of obligations of the Reference Entity—namely, all obligations, not just Bonds and Loans—will be the sole Successor for the entire Credit Derivative Transaction.
Main Issues Surrounding Succession
Succession highlights that CDS and cash are different assets
Succession highlights that CDS and cash are different assets. While a cash investor owns a specific bond, a CDS investor owns protection on a class of debt (e.g., senior unsecured) within a company. As a derivative instrument, CDS contracts therefore have additional uncertainty. There are five main issues surrounding Succession: 1) the percent of Relevant Obligations that succeed to a new company, 2) the timeline associated with an early repayment or tender offer, 3) guarantees, 4) covenants and indentures, and 5) accounting considerations. We illustrate each category with a case study. In addition, page 162 in this chapter discusses the implications of a proposed “good bank” / “bad bank” split on CDS Succession for monoline insurers.
Percent of Relevant Obligations that Succeed to a New Entity
In September 2005, in connection with a Hertz LBO, Hertz announced a $2.3 billion tender plan for debt maturing prior to 2010. In addition, Ford Motor Credit announced plans to offer to exchange $2.4 billion of Hertz debt, maturing in 2010 and beyond, for Ford Motor Credit debt. Although in the end, Hertz announced the exchange offer, not Ford Motor Credit, it is worthwhile to note the effect on the CDS market, had the exchange offer remained with Ford.
CDS may split into multiple contracts
If Ford Motor Credit had succeeded to more than 25% of the Relevant Obligations of Hertz, Hertz CDS would have split into two contracts. For every $10 million notional in original Hertz protection, the investor now would have held $5 million in Hertz
Credit Default Swap Primer Glen Taksler 646.855.7559
78 The exchange date may be referred to as the Succession Event date. All of the original Hertz CDS notional would have continued to reference Hertz debt. total debt may have still included the tendered notes. 77 77 In the extreme case. $10 million notional of original Hertz protection would become $10 million notional of Ford Motor Credit protection. making it harder for Ford Motor Credit to succeed Hertz. 134 Credit Default Swap Primer Glen Taksler 646. The denominator would be larger. then CDS contracts would simply reference Ford Motor Credit. Figure 112 shows an analysis of possible scenarios for Ford Motor Credit succeeding Hertz. This means that. which prompted Hertz spreads to widen following the exchange offer announcement. should the tender and exchange have occurred simultaneously. the 2003 ISDA Definitions suggest that total debt should be calculated as of the date immediately prior to the exchange. depending on the calculation method—and this is subject to interpretation—Ford would have been either slightly above or below the 25% threshold. 2008 35 protection and $5 million in Ford Motor Credit protection. However. Relevant Obligations excluded debt outstanding between Hertz and its Affiliates. there would be no succession. as determined by the Calculation Agent. if Ford Motor Credit succeeded to 25% or less of the Relevant Obligations of Hertz. By contrast. Importantly.855. As an important note. Relevant Obligations 78 included Hertz Bonds and Loans outstanding immediately prior to the exchange date. Overall. That is.Credit Strategy Research May 27. if Ford Motor Credit were to succeed to 75% or more of Hertz debt.7559 . it looked likely that Ford Motor Credit would have succeeded to more than 25% of Hertz.
400.198 1. Banc of America Securities LLC estimates. meaning that all notional protection would stay with Hertz. 2008 35 Figure 112.855. 79 Our initial belief was that foreign subsidiary debt should be excluded.Credit Strategy Research May 27. Ford Motor Credit only would have succeeded to 22. So we believe the most likely outcome would have been that half of notional protection would remain with Hertz and half would become Ford Motor Credit protection. Credit Default Swap Primer Glen Taksler 646.000 31. Provided that Hertz issued new senior unsecured debt under the LBO’d entity.575.7559 135 .000 25. as announced at the time.000 5. But Borderline EXCLUDED 7.400. Under both of these scenarios. Would Ford Motor Credit Have Succeeded to More than 25% of Hertz? Based on 10-Q. which is how the actual 25% threshold is determined. This is the second column of Figure 112. but we show both scenarios to emphasize that the results are subject to interpretation. However.678. We would expect Hertz spreads to trade wider to reflect higher leverage at the new company. June 2005 Dollars Excluding Affiliate Debt All Debt Debt: ABS Debt Note to Ford (Subordinated debt) Senior Notes Debt at Foreign Subsidiaries: Banks Commercial Paper Other borrowings Total debt Exchange Amount % of Total Debt Would CDS have split into 1/2 Hertz. we note a caveat: the combination tender-exchange. Ford Note Excl. for Hertz protection. the two right columns subtract Affiliate debt. Bloomberg. Ford Motor Credit would have succeeded to more than 25% of Hertz debt. meaning that half of notional protection would have remained with Hertz and half would have become Ford Motor Credit protection. Ford Note and Subsidiary Debt 2.000 22. Excl.3% No 9.078 2.1% Yes. would have taken out all senior unsecured debt.198.400. This left the question of what Hertz CDS would reference: 1.3% of Hertz debt. ISDA Definitions are broad regarding the definition of Affiliate debt.142 EXCLUDED EXCLUDED 1.896. the Reference Obligation would change to reflect the new issuance. one which excludes a note between Ford 79 and Hertz. and one which also subtracts foreign subsidiary debt. so we include two scenarios.738 10.078 2.480.3% Yes Based on all Hertz debt outstanding. Hertz.185.760.340 2. A Caveat: What Happens If There Is No Reference Obligation A tender or exchange offer may result in no Reference Obligation for a CDS contract Moreover. 1/2 FMCC ? Sources: Securities and Exchange Commission.
and Hospitality would all emerge with investment grade ratings. the same amount of debt but fewer assets. This led to a belief that Cendant would prepay its debt obligations shortly before the spin-offs. CDS Follows Debt. That obligation would be likely to have a higher recovery rate than senior unsecured debt. Should a Credit Event have occurred. not equity Timeline Surrounding an Early Repayment or Tender Offer In October 2005. If Hertz later had issued senior unsecured debt under the LBO’d entity. Management suggested that Real Estate. Spreads widened to reflect higher leverage. Management acknowledged that the newly spun off entities would likely need to tap the markets. These two entities accounted for close to 70% of EBITDA and pretax earnings.5 million recovery). Hospitality. we now analyze the implications of those initial market beliefs. and tighter spreads from the Buyer of protection only being able to deliver debt structurally senior to senior unsecured. 2008 35 2. say with a recovery rate of 50%. The key issue for CDS is timing: 80 There are two counteracting factors: wider spreads from a new parent company with higher leverage. we discuss the implications in the “Guarantees” section below. As such. which generated more than half of Wendy’s EBITDA.. general market belief was that the Cendant name would disappear. Initially. This assumption later proved incorrect. that is. not equity. 80 Succession language is based on debt. Car Rental (Avis) would acquire the broader Cendant Corp. and Car Rental. Wendy’s sold Tim Hortons. The timeline associated with an early repayment of debt matters According to bond indentures. For example. which would make credit default protection less valuable. unveiled plans to split the company into four separate publicly traded companies (by summer 2006) in an effort to increase shareholder value: Cendant announced plans to spin off into four separate entities: Real Estate. Existing debt would be apportioned between Real Estate and Travel.. Tim Hortons did not assume any of Wendy’s existing debt. suggesting that Cendant did not intend to disadvantage its existing bondholders. But if there were no senior unsecured debt and the protection Buyer were forced to deliver a more senior obligation. Car Rental would emerge with a high BB rating. secured debt). and remain the surviving entity. the protection Buyer would profit only $2. Cendant Corp. In the less-likely scenario that Hertz did not issue senior unsecured debt under the new parent company. the protection Buyer would profit $3 million post-Credit Event ($5 million notional – $2 million recovery). 136 Credit Default Swap Primer Glen Taksler 646.7559 . Cendant could not sell or transfer a substantial portion of properties or assets.5 million post-Credit Event ($5 million notional – $2. all CDS notional remained with Wendy’s. Less valuable protection would suggest potentially tighter Hertz spreads. the Buyer of protection would be forced to deliver an obligation structurally senior to senior unsecured debt (e.Credit Strategy Research May 27. But for illustrative purposes. Travel. there would be no Reference Obligation for the Hertz protection. However.855. credit default spreads should have widened back out to reflect senior unsecured recovery rates. For example. Travel Distribution.g. in 2006. if senior unsecured debt had a recovery rate of 40%. Not Equity Notice that CDS Succession language is based on debt.
CDS should price at about the expected new issue 81 spread for the Car Rental division. all notional CDS eventually would become Car Rental (Avis). all notional CDS would remain as Cendant.g.) For example.. Should the Cendant name have disappeared and Car Rental (Avis) became the surviving entity. CDS should tighten to zero because protection references no debt. cash bonds tightened approximately 30 bps in anticipation of an early repayment of debt. By contrast. This is because Cendant stated that all existing debt would be apportioned between these two divisions. the only relevant entities for CDS would have been Real Estate and Travel.855. In turn. 81 On the opposite extreme. In turn. With Real Estate and Travel combined representing about 70% of EBITDA and an expected investment grade rating for both entities. Otherwise. Hypothetical Scenarios for Cendant CDS If Real Estate takes 75% of CD debt Real Estate takes 60% of CD debt Then a $10mm CD trade becomes a $10mm Real Estate division trade a $5mm Real Estate trade and a $5mm Travel Trade Assumes that all debt not transferred to Real Estate would have been transferred to Travel. 5 years). Scenario 2: Real Estate and Travel assume all existing Cendant debt before an early repayment In this case. multiplied by the expected spread at re-issuance. If either Real Estate or Travel assumed at least 75% of all debt. if Car Rental never issued new debt. protection would succeed to Car Rental (Avis). the market initially placed the greatest weight on Scenario 1. assuming that Cendant would repay its debt before the company split. What We Saw in the Market As shown in Figure 114. CDS should widen significantly because of an expected high-BB rating versus BBB+ for Cendant before the initial spin-off news. all CDS would have gone to that division. CDS would price roughly as the probability of Avis reissuing debt over the remaining life of the contract (e. This caused CDS to widen approximately 20 bps in the immediate aftermath of the news (an effective downgrade from triple-B to double-B). This is not a particularly realistic scenario following an LBO. (This is the same as for the Hertz case study above. Source: Banc of America Securities LLC estimates. If Car Rental were to issue debt shortly after the company split.7559 137 . 2008 35 Scenario 1: Cendant repays its debt before the company splits In this case. CDS notional would have split evenly between the two divisions. Credit Default Swap Primer Glen Taksler 646. this scenario could have occurred if Real Estate or Travel borrowed from a bridge loan facility and used the proceeds to exchange existing Cendant Corp debt for new Real Estate or Travel debt: Figure 113. the CDS spread would not have widened significantly.Credit Strategy Research May 27.
Cendant Corp. Banc of America Securities LLC estimates. Cendant Corporation later changed its name to Avis Budget Group. 1 June 2005 – 1 December 2005 CD 6. In March 2006. Cendant Cash versus CDS. Cendant Car Rental Group. LLC later changed its name to Avis Budget Car Rental.855. LLC.. Moreover. Sources: Cendant. would not guarantee Cendant Car Rental Group. making Cendant Car Rental Group Deliverable into Cendant CDS Cendant CDS Cendant Corp Initially. the initial market belief that the Cendant name would disappear proved wrong. No Guarantee X Intermediate Holding Cos Sr Sec Sr Unsec New Debt Cendant Car Rental Group . Figure 115.7559 .25% 2010 110 100 90 Spread (bps) 80 70 60 50 40 30 1-Jun Interpolated CDS 1-Jul 1-Aug 1-Sep 1-Oct 1-Nov 1-Dec Source: Banc of America Securities LLC Estimates. Guarantees and “Orphaned CDS” The effect of Guarantees As noted in the previous section. 2008 35 Figure 114.Credit Strategy Research May 27.. as illustrated in Figure 115. Inc. Without a Downstream Guarantee. as a holding company for Cendant Car Rental Group (Avis). Cendant announced that Cendant Corp. Cendant Car Rental Group Debt Would Not Be Deliverable Into Cendant Corp CDS Reference Entity Remains Cendant Corp In February 2007. would continue to exist. 138 Credit Default Swap Primer Glen Taksler 646. a Downstream Guarantee was added.
New debt (likely) would be issued only out of the Cendant Car Rental Group operating company. With the downstream guarantee. basically became a shell corporation. 2008 35 The significance of a downstream guarantee is as follows.7559 139 . with no assets and no debt. Moreover.) CDS only if the holding company (Cendant Corp. initially. In turn. More Generally For Reference Entities located in North America. under no circumstance is holding company debt deliverable. If the holding company does not provide a guarantee. bonds become deliverable into Cendant Corp. As a further twist. as with Cendant Corp. operating company debt cannot be delivered against a CDS contract in the original (Cendant Corp. are valid For Reference Entities located in North America. holding) company.’s case. a group of investors paid Cendant Corp. company became near-worthless and spreads tightened.855. Cendant Corp. Guarantees. (by then renamed Avis Budget Group. See Figure 116. giving CDS fundamental value and causing spreads to widen. The guarantee must be unconditional and irrevocable.) guarantees the operating company’s debt. CDS later widened on LBO concerns at the new (post-spinoff) entity. This debt would be deliverable against holding company (Cendant Corp. CDS contracts written on the original 82 Cendant Corp. where the holding company (parent) owns a majority of the operating company (subsidiary). we note that upstream guarantees (from subsidiary to parent) are not taken into account for Reference Entities located in North America. although not applicable to Cendant.) $14 million to guarantee $1 billion in senior unsecured bonds at Cendant Car Rental Group (by then renamed Avis Budget Car Rental. CDS.Credit Strategy Research May 27. Inc. only downstream guarantees. in February 2007. only downstream guarantees (from parent to subsidiary) are valid in standard CDS confirms. 82 We note that. in Cendant Corp. Credit Default Swap Primer Glen Taksler 646. from parent to a majority-owned subsidiary. LLC). For CDS on an operating company.
140 Credit Default Swap Primer Glen Taksler 646.855. the entity providing the guarantee must receive sufficient consideration. As such. Effect of Guarantees on CDS Contracts. in exchange for an upstream guarantee. Sources: ISDA. to be taken into account for CDS contracts. rather than each distinct corporate entity. guarantees must be unconditional and irrevocable to be valid for CDS contracts Indicates debt is deliverable North America Europe No If Parent Guarantees Subsidiary Is parent debt deliverable into subsidiary CDS? Is subsidiary debt deliverable into parent CDS? If parent owns majority of subsidiary If parent owns minority of subsidiary No No No No No No No No If Subsidiary Guarantees Parent Is parent debt deliverable into subsidiary CDS? Is subsidiary debt deliverable into parent CDS? If Subsidiary A Sideways Guarantees Subsidiary B Is subsidiary A debt deliverable into subsidiary B CDS? Is subsidiary B debt deliverable into subsidiary A CDS? Globally. the general view of the CDS community was that guarantees were more likely to be upheld in European courts. 2008 35 Figure 116. a guarantee must be unconditional and irrevocable. The reason for the discrepancy is precedent for U. for Europe only. Globally Based on Location of Reference Entity.Credit Strategy Research May 27. For example. after Bankruptcy proceedings begin. a broader class of guarantees applies to CDS contracts on Reference Entities located in Europe. Regardless of Where Trade Is Executed Globally. courts to declare upstream (and sideways) guarantees invalid. 83 as illustrated in Figure 116. the upstream guarantee may be declared invalid post-Bankruptcy because the subsidiary received no clear benefit. the view was that European courts would tend to look at benefits to the organization as a whole. the upstream guarantee should be valid because the subsidiary received a clear benefit. A CDS contract on an operating company that has no Deliverable Obligation is sometimes called “orphaned CDS. confirmations for Reference Entities located in North America state: “All Guarantees: Not Applicable. parent (or subsidiary) debt is deliverable into third-party CDS. third-party debt is deliverable into parent (or subsidiary) CDS. By contrast.S. the parent provides a downstream guarantee to the subsidiary. Owing to this uncertainty.7559 . Banc of America Securities LLC estimates. Downstream guarantees are taken into account because anything benefiting a majorityowned subsidiary also benefits the parent company. When ISDA Definitions were last written in 2003. Confirmations for Reference Entities located in Europe state: “All Guarantees: Applicable. an orphaned CDS situation may occur when a company’s debt is tendered for in connection with an LBO and that company subsequently becomes an operating company within the post-LBO entity. suppose that. If the parent has significant assets that improve the overall credit profile of the subsidiary. If a third-party guarantees the parent (or subsidiary).” Globally.” regardless of where the trade occurs. In particular. if the parent has no assets. debt delivered must be pari passu or better than the Reference Obligation in seniority. for Europe only. regardless of security. For a guarantee to be valid.” For example. Also of note: If the parent (or subsidiary) guarantees a third-party. 83 To implement these issues. upstream guarantees are not taken into account for CDS contracts on North American Reference Entities.
not protection. CDS does not benefit from bond indentures and was expected to succeed to the new. buy bonds strategy profitable. as bonds would benefit from step-ups while CDS would not. CDS should widen to reflect the capital structure of the new LBO’d entity. the telecommunications sector saw multiple Succession Events driven by accounting considerations: trying to keep spin-offs tax free. Normally.Credit Strategy Research May 27.855. Such a downgrade would be likely to cause bonds to outperform CDS. Temple Inland added step-up provisions to new issue bonds. CDS widened by far more than cash. on LBO news. bondholders receive a 25-bp step-up per one notch downgrade by either Moody’s or S&P. but CSC debt contained a negative pledge provision. there will be no Deliverable Obligation into CDS contracts and CDS will become near-worthless. Covenants and Indentures Covenants and indentures affect bonds only. in December 2005. 1 June 2005 – 1 December 2005 CSC 5% 2013 Interpolated CDS 225 200 175 Spread (bps) 150 125 100 75 50 25 0 1-Jun 1-Jul 1-Aug 1-Sep 1-Oct 1-Nov 1-Dec Source: Banc of America Securities LLC estimates. 2008 35 Unless the operating company issues new debt. Computer Sciences Corp Cash versus CDS. This led to a belief that the company would either securitize existing bondholders or launch a tender offer. If the company is downgraded to high yield. (Spreads on both bonds and protection later tightened as LBO concerns dissipated.) Figure 117. making a buy protection. not protection CDS investors should understand that covenants and indentures affect bonds only. Similarly.7559 141 . By contrast. The company was prohibited from issuing liens or other securitized assets in excess of 15% (for 2009 bonds) or 20% (for other bonds) of consolidated net tangible assets. In turn. (In particular. in October 2005. such LBO activity would send bond spreads wider. which Credit Default Swap Primer Glen Taksler 646. Consider Alltel. as illustrated in Figure 117. post-LBO entity. up to a maximum of 200 bps. effectively giving investors a cushion should the company later be LBO’d. reports of private equity firms trying to buy Computer Sciences Corp (CSC) sent the stock price up from the mid-$40s to the high$50s.) Accounting Considerations (Tax-Free Spinoffs) Accounting considerations may cause CDS contracts to split In 2006. For example.
NA.6 06/11. Example For example. As such. Had Windstream simply paid Alltel $3. each with a new trade number. partially or completely unwind. Operational Issues Surrounding Succession Events How Succession Events affect single-name and index trades Single-name trades that are effective on or before the Effective Date of a Succession Event will split.9 billion in cash. the CDX IG6 was the on-the-run investment grade index. a Succession Event occurred on July 17.4%. The $1. As a debt-for-debt exchange. $10 million Alltel CDS notional split into $5 million Alltel and $5 million Windstream. As CDS trades normally are effective T+1. which had an original weight of 0. 2006 (effective July 17. index trades in CDX IG6 always split.855. Although the Calculation Agent will update its internal systems to reflect the new position. also with a weight of 0. 2006) to split. the Calculation Agent will terminate the original trade in DTCC and book two new trades. SpinCo issued a roughly $2. At the time. which caused trades to split 50% Alltel Corporation / 50% Windstream Corporation.5 billion was not taxable to Alltel. regardless of the trade date. regardless of the trade date. Single-Name Trades A single-name trade in Alltel Corporation must have occurred on or prior to July 16. or assign—then at that time. 142 Credit Default Swap Primer Glen Taksler 646. Alltel Corporation.5 billion in Alltel debt. SpinCo then merged with Valor Communications Group. SpinCo exchanged approximately $1. and will not be rebooked by the Calculation Agent.8% = 0. just above the 25% threshold. An investor would now have two trades. the $1. will now have an effective weight of 50% x 0.IG. for half of the original notional.4 billion special dividend to Alltel. Instead. the trade will not immediately be rebooked in DTCC. the trade typically must occur no later than one Business Day before the Effective Date. both with the original fixed coupon.7559 . Index Trades However. As such. indices that were effective on or prior to the date of a Succession Event will split. The original trade will retain its original trade number.Credit Strategy Research May 27. CDX IG6—even though 84 the weightings in the index change.4%. Index trades are effective as of the inception date of the index and settle with accrued interest.9 billion wireline business to Windstream. which represented Alltel’s tax basis.2% of the Relevant Obligations of Alltel. This is because the Index Name is unchanged—for example. The new trades would reflect the new position in each of Alltel and Windstream. 84 The formal Index Name for five-year CDX IG6 is DOW JONES CDX. In addition. of which Alltel Corporation was a member. Windstream Corporation will effectively be added to the index. 2006 in Alltel Corporation. Alltel created a temporary spinoff company (SpinCo). The merged entity then was renamed Windstream. Should the investor later wish to modify the trade—for example. The investor would reference the original trade with its original trade number.8% (1 / 125 Reference Entities).5 billion exchange represented 26. the transaction would have triggered a capital gain for Alltel. 2008 35 spun-off its $3.
prespecified list of Deliverable Obligations. approximately 15 dealers submit a market on $10 million bonds. no one is required to accept the settlement protocol because standard documentation is currently written for physical settlement. which provide incentive for the submission of reasonable quotes. The exact minimum depends on how widely traded the relevant Reference Entity is. Figure 118 shows the dealer markets submitted in the 2005 Delphi CDS settlement protocol: 85 Fifteen dealers is an expectation. The methodology should be similar for a Failure to Pay. should a Modified Restructuring occur. as of January 2008. with a maximum 2 point bidoffer spread As a first step. Dealers commit to providing a baseline level of liquidity in the auction.” for details).creditfixings. Basic CDS Settlement Auction Mechanics As a first step. dealers may deliver bonds from a publicly disclosed. the protocol would need some changes. as discussed on page 158 in this Chapter. The cash settlement price is determined through an auction process. Credit Default Swap Primer Glen Taksler 646.. administer the process. CDS Settlement protocols have been used only for Bankruptcy Credit Events. The names of participating dealers. and tranche credit derivatives trades. Markit and Creditex. Similarly. the mechanics of which resemble a Treasury auction.7559 143 . CDS Settlement Protocols The most recent version of the CDS Settlement protocol This section discusses the most recent version of the CDS Settlement protocol. Even though the standard would be to cash settle. almost all counterparties have consented.Credit Strategy Research May 27. approximately 15 dealers submit a market on $10 million bonds. including dealers. 8) submit markets. are publicly released on the website http://www. The process requires that a minimum number of dealers (e. This should result in dealers quoting the cheapest-to-deliver obligation. in recent protocols.com. just like in CDS physical settlement. Any market participant. Thirdparties. and their respective markets. In addition. may opt to provide additional liquidity. To be clear. These markets represent a sample of the broader market for a particular Reference Entity. index. Dealers may be required to trade bonds at their submitted levels. However. 2008 35 The Alltel Corporation weight in CDX IG7 and later series will not split. Moreover. However. All cash-settled trades receive the same recovery rate. as discussed on page 160. because the indices started trading (were effective) after the Succession Event occurred. investors would retain the ability to request physical settlement.855. For example.g. This protocol is expected to be used to settle most single-name. For any required trades. Such requests would be filled to the extent that another market participant was willing to take the opposite position. depending on the Reference Entity. the $10 million x $10 million market size may change. dealers may be required to pay a penalty for markets that are inconsistent with those of other dealers (see the section “Incentive for Dealers to Accurately Portray Markets. with a 85 maximum 2 point bid-offer spread. there are special issues pertaining to potential CDS Settlement Protocols for monoline insurers.
Figure 119 uses the dealer markets submitted to settle Delphi. Banc of America Securities LLC estimates. this figure uses data from the 2005 Delphi CDS cash settlement protocol. Dealer $10mm x $10mm Markets Submitted into CDS Settlement Auction Dealer May be Required to Buy $10mm Bonds at its Bid. Sources: ISDA. CreditEx. This level is an indication from dealers regarding the fair value of the cheapest-to-deliver obligation for the relevant Reference Entity.7559 . 2008 35 Figure 118. to illustrate the calculation of the inside market midpoint. Inside Market Midpoint An indication from dealers regarding fair value forms a baseline for determining the final cash settlement price The “inside market midpoint” forms a baseline for determining the final cash settlement price. or Sell $10mm Bonds at its Offer For example.Credit Strategy Research May 27.855. There are three parts: 144 Credit Default Swap Primer Glen Taksler 646. “Dealer 1” submitted a 67/69 market Offer (As Submitted by Dealer) 70 69 68 67 66 65 64 63 62 0 1 2 3 4 5 Bid (As Submitted By Dealer) Price ($) 6 7 8 9 10 11 12 13 14 15 Dealer Number For illustration.
$67. 86 86 If there is an odd number of non-tradeable markets. These markets are excluded from the calculation of the inside market midpoint. and offers $66. $65. $66.” and the worst 5 form the “worst half.” The remaining non-tradeable markets are divided into two halves. and $64. 2008 35 Figure 119. Specifically.50. pay a penalty to ISDA. The average of all these bids and offers forms the inside market midpoint.855.” 87 $66 is the average of bids $65. Average of bids and offers in the best half. A “tradeable market” is a market submitted by one dealer that is inconsistent with that submitted by another dealer. Sources: ISDA. rounded to the nearest eighth. as described in the section “Incentive for Dealers to Accurately Portray Markets. $67. rounded up. For illustration. The best 6 form the “best half. No penalty.50. The “worst half” of non-tradeable markets (the far right portion of Figure 119) is the set of highest offers and lowest bids submitted. Banc of America Securities LLC estimates. Credit Default Swap Primer Glen Taksler 646. but there is no penalty. the best half is the average. These markets are excluded from the calculation of the inside market midpoint and may be subject to a penalty. $65. the auction settles here. Some dealers who submitted these markets If there is no demand to physically settle contracts. $65. The “best half” is the lowest half of sorted offers and the highest half of sorted bids. the inside market 87 midpoint is $66. there are 11 non-tradeable markets. Price ($) Worst Half: Excluded from calculation of inside market midpoint.50. In Figure 119.Credit Strategy Research May 27. this figure uses data from the 2005 Delphi CDS cash settlement protocol. and $67. $65. $67. a dealer whose bid is above another dealer’s offer is considered inconsistent: the bidder may have been trying to drive the price above fair value.50. while the offerer may have been trying to drive the price below fair value.50.7559 145 . In Figure 119. Calculation of Inside Market Midpoint Inside Market Midpoint Serves as a Baseline for Determining the Final Cash Settlement Price Sorted Bids (Descending Order) Sorted Offers (Ascending Order) 70 69 68 67 66 65 64 63 62 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Size ($ MM) Best Half of Non-Tradeable Markets: Tradeable Markets: Excluded from calculation Inside Market Midpoint = $66 of inside market midpoint. CreditEx.
which is simply recovery. and short $5 million of the same credit in the CDX indices. in most cases there will be at least some investors who wish to physically settle. the final cash settlement price is the inside market midpoint How to Physically Settle a Trade When a protection Buyer wishes to physically settle a transaction. $10mm Cash Investor Protection Seller $10mm Bonds $10mm Protection Protection Buyer In the cash portion. a dealer enters an order to sell bonds. less recovery. Since the dealer entered an order to sell bonds. For example. then the final cash settlement price is the inside market midpoint. The settlement process may be broken down into two portions. Source: Banc of America Securities LLC estimates. which the dealer will need to buy. Figure 120 and Figure 121 illustrate how a protection Buyer physically settles a transaction under the protocol. if an investor is long $20 million of a credit in single-name CDS.7559 . The client wishes to receive bonds from the trade. the protection Seller pays the protection Buyer the notional of the trade. Figure 121.Credit Strategy Research May 27. In the physical portion. Net Cash Flows are the Same as Physical Settlement Protection Buyer Delivers Bonds. that investor may request 146 Credit Default Swap Primer Glen Taksler 646. the investor also receives those proceeds. Any investor may enter a request to physically settle. These net cash flows are the same as those exchanged in physical settlement.855. and now wish to deliver those bonds to physically settle CDS. However. In such cases.Recovery Rate ) Dealer Physically Settled Portion: $10mm Bonds $10mm x Recovery Rate Source: Banc of America Securities LLC estimates. a traditional investor may have bought protection as a hedge against an existing bond position. and Receives $10mm Cash Protection Buyer’s Recovery Rate is the Price at Which He Bought Bonds Cash Settled Portion: $10mm x ( 1 . the protection Buyer delivers bonds. For example. Net. which the dealer then needs to sell. up to his net notional position in CDS. 2008 35 If there is no demand from market participants to physically settle any CDS trades. Which are then Sold In the Auction. The client will deliver bonds into the trade. If there is no demand from market participants to physically settle any CDS trades. a dealer enters an order to buy bonds. How a Trade is Physically Settled Under the Protocol Protection Buyer Wishes to Physically Settle a $10mm Trade Protection Buyer Delivers Bonds. when a protection Seller wishes to physically settle a transaction. the protection Buyer delivers bonds and receives the notional of the trade. Similarly. cash and physical: Figure 120. the final cash settlement price will be adjusted to reflect the net demand of market participants to physically settle.
Similarly. Additionally. A limit order is an order that will be filled only if needed to clear the net open interest. 88 Dealers are required to accept a request for physical settlement that reflects the CDS position of a client with that dealer. if an investor believes that ultimate cash bond recovery will be 70%. the auction may be cancelled for that day. on which he ultimately expects to earn at least 5 points profit (70% ultimate recovery minus maximum $65 90 purchase price). The net open interest is released roughly 30 minutes after dealers submit their $10mm x $10mm markets. Net Open Interest and Direction of Price Changes The net desire of the market to buy or sell bonds as a result of the Credit Event is called “net open interest. For example. Dealers may. Credit Default Swap Primer Glen Taksler 646. including new $10mm x $10mm markets. if more protection Sellers than protection Buyers want to physically settle. if the market has a net open interest to sell $100mm in bonds. the investor would expect to earn 7 point profit (70% ultimate recovery minus $63 purchase price). resulting in a short squeeze. This is in contrast to recent Credit Events. The open interest is released approximately 2 hours to 3 hours before the collection of limit orders so the market knows the overall demand to buy or sell bonds in advance. to the extent 88 that some other market participant is willing to take the opposite position. and clients may enter limit orders through any dealer with whom they have a trading relationship. These requests are fulfilled. provided the client states that the order reflects his net position across dealers. would be repeated one business day later. it is possible that cash bond prices will move after the net open interest has been released. where the requirement to physically settle single-name CDS sent protection Buyers scrambling to buy bonds. it is less likely that bond prices will move in advance. For example. If the auction settles below $65. there will be net demand to buy bonds in the cash settlement protocol: the cash settlement price is likely to be higher than then-current cash bond prices. the dealers’ $10mm x $10mm markets provide a base level of 89 liquidity. Since the credit market (including dealers) does not know beforehand whether the net open interest will be to buy or sell bonds. the final price is the bid that clears $100mm in size.7559 147 . to accept a larger order.Credit Strategy Research May 27. if the final cash settlement price is. investors should be more likely to place a limit order because there is a greater chance of a price swing on the cash settlement 91 day. if there is an extreme open interest. The entire auction process. If the auction settles at $65. the investor may be partially filled on his $2mm order. the investor will receive the $2mm in bonds. he may enter a limit order to buy $2mm bonds at a price of $65. Dealers may enter limit orders directly. not just the “Best Half of Tradeable Markets” described in Figure 119. To clear the market. 91 Should there be a material event or news that may have a significant effect on the price of bonds between the time of the dealers’ $10mm x $10mm markets and the collection of limit orders. 89 All dealers’ $10mm x $10mm markets are used. $63.” The net desire of the market to buy or sell bonds as a result of the Credit Event is called “net open interest” If more protection Buyers than protection Sellers want to physically settle. any market participant may enter a “limit order” to buy or sell bonds at a specified price. Naturally. Determining the Final Price The final cash settlement price is that price which clears the net open interest The final cash settlement price is that price that clears the net open interest. 90 If the investor’s order is filled.855. but are not required. there will be net demand to sell bonds in the cash settlement protocol: the cash settlement price is likely to be lower than then-current cash bond prices. As such. For example. 2008 35 physical settlement on $15 million or less. then he will pay the final cash settlement price.
using data from the settlement of Delphi. Sources: ISDA.375 is partially filled. Bid ($) 25 50 75 100 125 Cash Settlement Price: Bid that clears the $99mm of bonds that CDS market participants wanted to sell as a result of the Credit Event. which then need to be sold in the auction: Figure 122. The participant who bid $63. more protection Buyers than Sellers wanted to physically settle.375.Credit Strategy Research May 27. Notice.7559 . Unused Bids: These orders are not filled. this figure uses data from the 2005 Delphi CDS cash settlement protocol. the final price is $63. There were additional (lower) bids that could have been used to fill demand beyond $175 million in size (the maximum on the horizontal axis shown here). In this example. and so on. Those protection Buyers deliver bonds. to the extent necessary to clear the net open interest. Banc of America Securities LLC estimates. in which there was $99mm of net open interest to sell bonds. the participant who bid $65 only pays $63. 2008 35 Figure 122 illustrates the calculation of the final price.. In this case.375).375). All orders that are filled are done so at the final price (i. the first four orders filled come from dealers’ $10mm x $10mm markets. $2mm of this final $5mm limit order is filled at the cash settlement price ($63. this figure omits that data for readability.855.e. Calculation of Final Price in the Cash Settlement Protocol Combination of Dealer 10mm x 10mm Markets and Limit Bids are Used to Determine the Final Price 68 67 66 65 64 63 62 61 60 0 Combination of Dealer 10mm x 10mm Markets and Limit Bids: These orders are filled at the cash settlement price ($63. 148 Credit Default Swap Primer Glen Taksler 646. For illustration. The final cash settlement price is the bid that clears the $99mm in net open interest.375). CreditEx. 150 175 Size ($ MM) All dealers’ $10mm x $10mm markets are used. not just the “Best Half of Tradeable Markets” described in Figure 119. The next two orders filled come from limit orders.
Preventing Unexpected Results The auction also contains a provision to prevent extreme scenarios from a small net open interest. market participants should seriously consider placing limit orders to avoid a final zero or 100 settlement price Accordingly. 2008 35 Why Participants Should Consider Limit Orders Limit orders are important to the overall success of the CDS settlement auction Limit orders are important to the overall success of the cash settlement auction. in addition to the dealers’ $10mm x $10mm markets. as illustrated in Figure 123. if there is a significant open interest to buy bonds—more protection Sellers than Buyers want to physically settle—the auction also relies on limit orders. if there is a significant net open interest. If there are not enough limit orders.Credit Strategy Research May 27. market participants should seriously consider placing limit orders to avoid a final zero or 100 settlement price. there is a general expectation that the final auction price will be below the inside market midpoint. To guard against this scenario. with a relatively high bid. the final cash settlement price will be 100. But now suppose there were a very small net open interest to sell just $5 million in bonds. this is not a problem.7559 149 .855. resulting in an unexpectedly high recovery rate. will be filled. not enough market participants were willing to take the opposite side of the Counterparty requesting physical settlement. Provided there are enough limit orders. established in the dealers’ $10mm x $10mm markets. requests for physical settlement will be filled on a pro rata basis. However. if there are not enough limit orders. That is. if there is a net open interest to sell bonds. the maximum final price is capped at the inside market midpoint plus 1% of par. the final cash settlement price will be zero. For example. Consider the case where 15 dealers submit $10mm x $10mm markets. notice that an insufficient volume of limit orders means that participants who requested physical settlement will be unable to do so. Additionally. Similarly. That limit bid would normally become the final price. This provides baseline liquidity of $150mm. A provision to help prevent extreme scenarios Credit Default Swap Primer Glen Taksler 646. if there is a net open interest to sell bonds. If there is a significant open interest to sell bonds—more protection Buyers than Sellers want to physically settle—the auction relies on limit orders to fill any balance greater than the $150mm baseline. against dealer $10mm x $10mm and limit orders that were received. as illustrated in the example above (Figure 122). If there is a significant net open interest. Then. In this case. it is possible that just one limit order.
auction capped at $67 (Inside Market Midpoint + 1%) 25 50 75 100 Size ($ MM) 125 150 175 Hypothetical data. Similarly. or an amendment thereof. allows adherents to know which obligations will be deliverable.) An inter-dealer committee is working on a solution to potential disputes surrounding Deliverable Obligations. market participants would bind themselves to the protocol through the ISDA Master Agreement. there is an expectation that the final auction price will exceed the inside market midpoint. counterparties that trade “bonds” in the auction enter into a single-name CDS contract on the relevant Reference Entity and may settle that contract with any obligation that is on a publicly available. Deliverable Obligations Dealers are working on a permanent protocol that could be used to settle all Credit Events We have said that the auction is on “bonds. the cheapest-to-deliver obligation. the Final Price is Capped at Inside Market Midpoint + 1% If There is a Net Open Interest to Buy Bonds. if ever. 2008 35 Figure 123. they are rarely delivered. 92 The Buyer of bonds (Participating Bidder) enters into a contract to sell credit default protection. This means that a loan is rarely. a procedure for determining the Deliverable Obligations (and potential disputes) would need to be added to the protocol. before entering into the auction. 93 More accurately.Credit Strategy Research May 27. Source: Banc of America Securities LLC estimates. the Final Price is Floored at Inside Market Midpoint – 1% 70 68 Bid ($) 66 64 62 60 0 With a small open interest. As such. post-Credit Event. 150 Credit Default Swap Primer Glen Taksler 646. auction normally would settle at $70. if there is a net open interest to buy bonds. should a similar protocol be incorporated into standard CDS documentation. because loans usually trade at a much higher price than bonds post-Credit Event. There is a general expectation that the 92 cheapest-to-deliver obligation would be exchanged. Preventing Unexpected Results If There is a Net Open Interest to Sell Bonds. Should there be a very small open interest that would otherwise result in a significant price decline.” Technically.. the maximum final price will be floored at the inside market midpoint minus 1% of par.7559 .. as with any CDS contract. even though the list of 93 Deliverable Obligations would not be determined until after a Credit Event. we note that loans are also deliverable into credit default protection. But in practice. …But. pre-specified list of Deliverable Obligations. the recent (since 2005) process of arranging an ad hoc CDS settlement protocol.855. (It is impossible to determine the list of Deliverable Obligations at trade inception because a bond may be issued after that date that becomes deliverable into the CDS contract. Difference from Figure 122 is the level of limit bids and the size of the open interest. Longer term. This is because market participants would bind themselves to the protocol at trade inception. Additionally. and must deliver a Notice of Physical Settlement.
7559 151 . CreditEx. For example. Offering Dealer Would Pay the Penalty. Banc of America Securities LLC estimates. If Net Open Interest Were to Buy Bonds. if there is a net open interest to buy bonds. on $10mm ($100. This figure shows the calculation of the penalty under the current protocol. For illustration. The penalty is the difference between the relevant bid and the inside market midpoint. on $10mm ($100.Credit Strategy Research May 27.75 0 Bidding Dealer Pays 1 Point Penalty to ISDA. the dealers whose bids formed part of the tradeable markets are subject to a penalty. Sources: ISDA. Penalty is the Bid Minus the Inside Market Midpoint. then the offering dealer would pay no penalty. For example. Bidding Dealer Pays the Penalty.75 66. Determining the Dealer Penalty When Net Open Interest is to Sell Bonds. However. as illustrated in Figure 124. The logic is that the offering dealer may have attempted to drive the Credit Default Swap Primer Glen Taksler 646. and the bid minus the inside market midpoint were negative.00 65. Figure 124. Sorted Bids (Descending Order) 67. The logic is that the bidding dealers may have attempted to raise the price above fair value. if there were a net open interest to buy bonds.00 Price ($) 66. this figure uses data from the 2005 Delphi CDS cash settlement protocol. 2008 35 Incentive for Dealers to Accurately Portray Markets As mentioned earlier. These are dealers whose $10mm x $10mm markets are tradeable with another dealer—one dealer’s bid is above another dealer’s offer (recall Figure 119)—and who are on the opposite side of the net open interest. Similarly.25 66. on $10mm ($50. the method for calculating a penalty has since changed.000 Penalty) 1 Inside Market Midpoint 2 3 Markets Subject to a Penalty Bidding Dealer Pays 1/2 Point Penalty to ISDA. and the inside market midpoint minus the offer were negative.25 67.50 66. the offering dealer pays the penalty to ISDA. if there is a net open interest to sell bonds. then the bidding dealer would pay no penalty. some dealers who submit markets that are inconsistent with the markets of other dealers are required to pay a penalty.000 Penalty) 4 5 No Penalty Because Bid is Equal to (or Less Than) the Inside Market Midpoint A penalty is only paid if it is positive.000 Penalty) Bidding Dealer Pays 1 Point Penalty to ISDA. Penalty Would Be the Inside Market Midpoint Minus the Offer. Similarly.855. if there were a net open interest to sell bonds.
similar to the terminology used in the 2003 ISDA Credit Derivatives Definitions. Proceeds from the penalty are used to defray auction 94 costs. The penalty would be the difference between the inside market midpoint and the relevant offer. 152 Credit Default Swap Primer Glen Taksler 646. Europe (investment grade and high yield.855. and the inside market midpoint minus the offer were negative. particularly for Reference Entities that were downgraded from investment grade. Any one of these criteria causes a Restructuring Credit Event to occur. For this reason. the offering dealer would pay no penalty. a singlename CDS Credit Event. 2008 35 price below fair value. When discussing which obligations a protection buyer may deliver post-Credit Event. we present a detailed discussion of Modified Restructuring. Restructuring Criteria Bankruptcy and Restructuring The table below summarizes the five Restructuring criteria. the triggers for a Credit Event are the same. The North American high yield market also sometimes uses Modified Restructuring. For both Modified and Modified-Modified Restructuring. and the bid minus the inside market midpoint were negative. parties may begin the CDS settlement process. the bidding dealer would pay no penalty. if the net open interest were to sell bonds.Credit Strategy Research May 27. Modified and Modified-Modified Restructuring differ. For example. we simply write “Restructuring” below when describing triggers. Similarly. we will be more specific.7559 . primarily used by the North American investment grade market. Details Around Modified Restructuring In this section. single-name and iTraxx indices) uses Modified-Modified Restructuring. if the net open interest were to buy bonds. Once this happens. 94 Penalties are only due if they are positive. and in these cases.
Modified Restructuring. 2008 35 Figure 125. such as single-name high yield CDS.855. investment grade and high yield. plain vanilla Restructuring—sometimes called “Old 95 Restructuring”—has been rarely used since the Conseco Restructuring in 2000. some single-name rising-star CDS and the CDX indices. For other CDS contracts on US Reference Entities.7559 153 . please see page 169. Similarly. causing the Subordination of such Obligation to any other Obligation Any change in the currency or composition of any payment of interest or principal to any currency which is not a Permitted Currency Exceptions to these rules include: Administrative. The primary differences between Modified Restructuring and Modified-Modified Restructuring lie in the maturities and transferability of Deliverable Obligations. the market standard is Modified Restructuring. the standard is Modified-Modified Restructuring. accounting. Instead: For single-name CDS contracts on US investment grade and many fallen angel Reference Entities. Recently. and Modified-Modified Restructuring. by rising-star CDS.Credit Strategy Research May 27. Additionally. the standard has become 97 Old Restructuring.one or more of the following events A reduction in the rate or amount of interest payable or the amount of scheduled interest accruals A reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates A postponement or other deferral of a date or dates for either (a) the payment or accrual of interest or (b) the payment of principal or premium A change in the ranking in priority of payment of any Obligation. Restructuring Criteria 2003 ISDA Restructuring Definitions. For more details. In the US and Europe. 97 This is because European leveraged loan CDS limits Deliverable Obligations to the Reference Obligation(s) and other senior loans with the same security and the same or equivalent guarantees. note that Old Restructuring continues to be used for Reference Entities in emerging markets. With the universe of Deliverable Obligations already limited. For CDS contracts on European Reference Entities. the standard is No 96 Restructuring. we mean a Reference Entity that was investment grade when it originally started trading in CDS and subsequently was downgraded to high yield. it seemed unnecessary to include the additional maturity limitation of Modified-Modified Restructuring. Restructuring Alternatives The differences between various Restructuring Criteria There are four Restructuring alternatives from which the counterparties choose when setting up the CDS: No Restructuring. Credit Default Swap Primer Glen Taksler 646. Restructuring. for European leveraged loan CDS contracts. 96 By fallen angel CDS. we mean a Reference Entity that was high yield when it originally started trading in CDS and subsequently was upgraded to investment grade. as 95 Please see the Case Histories section on page 129 for details. tax or other technical adjustment occurring in the ordinary course of business Events that do not directly or indirectly result from a deterioration in the creditworthiness or financial condition of the Reference Entity Source: 2003 ISDA Credit Derivatives Definitions. single-name and index.
MHOs have at least 4 unaffiliated lenders. two-thirds of which consent to the Restructuring. it will not be deliverable. usually up to a maximum maturity of 30 years. either without consent. However. Modified and Modified-Modified Restructuring Guidelines.Credit Strategy Research May 27. 98 based on whether the protection Buyer or Seller declares a Credit Event: If the protection Buyer declares a Restructuring. 2008 35 illustrated in Figure 126. if the protection Seller declares a Restructuring. not to be unreasonably withheld. because the protection Seller forces the Buyer to settle. Modified Restructuring and Failure to Pay—the limitations of Modified Restructuring and Modified-Modified Restructuring do not apply. or the Scheduled Termination Date of the CDS contract. For the two-thirds consent. Multiple Holder Obligation Figure 127 and Figure 128 show two examples of which obligations may be delivered following a Restructuring. If the Reference Obligation fails to meet these criteria. Restructuring Credit Events are triggered only by Multiple Holder Obligations (MHOs). As such. the two-thirds consent is deemed automatically satisfied if the restructured obligation is a bond. For Modified-Modified Restructuring (Europe): The maximum maturity of the Deliverable Obligation submitted by the protection Buyer is 60 months (for restructured bonds or loans) or 30 months (for all other Deliverable Obligations) following the Restructuring Date. or with consent of the Reference Entity.855. For Modified-Modified Restructuring (Europe): The Deliverable Obligation must be transferable to any entity that regularly engages in loan and securities markets. if the Protection Buyer Declares a Credit Event If the Protection Seller Declares a Credit Event. Fully Transferable Obligation (North America) or Conditionally Transferable Obligation (Europe) For Modified Restructuring (North America): Obligation must be fully transferable to an eligible assignee.7559 . Essentially. the protection Seller is likely to prefer not to trigger a Restructuring Credit Event. the protection Buyer should have the option to deliver obligations across the credit curve. 99 Per the May 2003 Supplement to the 2003 ISDA Credit Derivatives Definitions. 154 Credit Default Swap Primer Glen Taksler 646. Notice that there is a difference in Deliverable Obligations. Modified Restructuring also essentially limits Deliverable Obligations to bonds only (not loans). Deliverable Obligations are the Same as for a Bankruptcy or Failure to Pay (See Figure 13 on page 20) Maturity Limitation Date For Modified Restructuring (North America): The maximum maturity of the Deliverable Obligation submitted by the protection Buyer is the later of the Scheduled Termination Date of the CDS contract. these limitations do not apply. 99 Source: 2003 ISDA Credit Derivatives Definitions. Figure 126. The protection Buyer may deliver the same obligations as for a Bankruptcy or Failure to pay. whichever is later. this limits Deliverable Obligations to bonds (not loans). each holder has one vote. even if affiliated with another holder. and the shorter of (i) 30 months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan. This prevents parties from profiting by triggering bilateral loans. The logic is that. then Modified and ModifiedModified Restructuring attempt to limit the cheapest-to-deliver obligation to the portion of the credit curve that was restructured. assuming that the protection Buyer declares a Credit Event: 98 If multiple Credit Events are declared—for example. What’s important here is that these are relatively short-term and thereby limit the cheapest-to-deliver option. For Reference Entities based in North America.
Assume that a company’s bonds would trade at $70 post-Restructuring. If the protection Buyer declares a Restructuring. Protection Buyer May Choose When to Trigger a Restructuring Modified Restructuring resembles an American option An investor may think of Modified Restructuring as an American option. Maturity (All Deliverables) Max. Credit Default Swap Primer Glen Taksler 646. Sources: ISDA. Banc of America Securities LLC Estimates. For further details on maturity limitations and transferability. (1) Deliverable Obligations are essentially limited to bonds (not loans) and (2) 30m Maturity Limitation is the shorter of (i) 30 months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan. the protection Buyer may deliver an obligation with a maturity of up to 30 months after the Restructuring date Years 0 Maturity of CDS 1 30m Maturity Limitation 2 3 4 60m Maturity Limitation 5 North America (MR) Europe (MMR) Max. Example of Which Obligations May Be Delivered Following a Restructuring Remaining Maturity of CDS Contract is Four Years Under MR. For further details on maturity limitations and transferability. 2008 35 Figure 127. Figure 128.Credit Strategy Research May 27. Second Example of Which Obligations May Be Delivered Following a Restructuring Remaining Maturity of CDS Contract is One Year Under MR. please see Figure 126. please see Figure 126. Maturity (Restructured Deliverables) For North America. or $40 post-default. Sources: ISDA. (1) Deliverable Obligations are essentially limited to bonds (not loans) and (2) 30m Maturity Limitation is the shorter of (i) 30 months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan. he stops paying the CDS premium and receives 30 points (100% par – 70% post-Restructuring price).855.7559 155 . Banc of America Securities LLC Estimates. Maturity (All Deliverables) Max. the protection Buyer may deliver an obligation with a maturity of up to 4 years after the Restructuring date Years Post-Restructuring 0 1 30m Maturity Limitation 2 3 Maturity of CDS 4 60m Maturity Limitation 5 North America (MR) Europe (MMR) Max. Maturity (Non-Restructured Deliverables) Max. Maturity (Restructured Deliverables) For North America. Maturity (Non-Restructured Deliverables) Max.
These payoff scenarios are illustrated in Figure 129. the more likely the protection Buyer is to trigger Modified Restructuring immediately. when to declare a Credit Event. one should generally expect the protection Buyer to trigger a Modified 100 Technically. Provided that CDS matures later than the bond. the perceived value of Restructuring provisions has increased. the investor would expect to receive 60 points (100% par – 40% post-default price). the protection Buyer has a choice on when to trigger CDS--that is. the closer a CDS contract is to maturity. the value of Restructuring provisions in CDS contracts had declined from about 5%-10% (Modified Restructuring spreads wider than No Restructuring spreads) to about 2% for investment grade names. in part because of deterioration in the overall macroeconomic environment. Restructuring as an American Option Sample Discounted P&L from Perspective of Protection Buyer. Discounted by LIBOR. As such. If the protection Buyer believes that. Source: Banc of America Securities LLC Estimates. However. the timing option is essentially irrelevant following a Bankruptcy or Failure to Pay. More recently. To be clear. its probability of default rises 101 significantly. 156 Credit Default Swap Primer Glen Taksler 646. presumably the protection Seller will not trigger a Modified Restructuring. or 40% post-Bankruptcy. the bond will be deliverable under Modified Restructuring criteria. From about 2005 until summer 2007. where the protection Buyer already owns a bond. He may do so anytime from the date of the Modified 100 Restructuring up to and including 14 calendar days after CDS contract maturity. for a CDS with a Premium of 500 Bps Protection Buyer may trigger a Restructuring or continue to pay the CDS premium and hope to later trigger a Bankruptcy or Failure to Pay 60 P&L (Points) 40 20 0 0 Discounted Payoff from Triggering a Bankruptcy Discounted Payoff from Triggering a Restructuring Potential benefit of waiting to trigger CDS 1 2 3 4 5 Years Post-Restructuring That the Protection Buyer Waits to Trigger a Credit Event Assumes recovery rate of 70% post-Restructuring. it should be to one party’s advantage to immediately declare a Credit Event. because either the protection Buyer or Seller may trigger CDS and the Deliverable Obligations are the same regardless of who triggers. because following a Modified Restructuring.855. 2008 35 Alternatively. At that time. 101 Naturally. Figure 129. and thereby has locked in a recovery rate. once a company has restructured its debt. However. In this case. This creates a meaningful timing option for the protection Buyer.7559 . the protection Buyer may continue to pay the CDS premium and hope to trigger a Bankruptcy or Failure to Pay later in the life of the contract. Exception: CDS—Cash Basis Packages One exception is CDS—cash basis packages. the protection Seller will lose the advantage of the maturity limitation if he triggers. he is likely to wait to trigger CDS. the timing option also exists following Bankruptcy and Failure to Pay Credit Events.Credit Strategy Research May 27.
Such activity could invert the credit curve and decrease liquidity post-Restructuring. he will become concerned about the potential for a trigger. The appropriate duration depends on the difference in expected recovery rates between a Bankruptcy or Failure to Pay. suppose that a bond traded at $70. which changes post-Modified Restructuring. Absent a Restructuring. resulting in no loss. 2008 35 Restructuring immediately.855. he in turn can trigger the frontend contract. resulting in no loss. if the investor is not triggered on back-end protection. he will be naked long risk. the investor is notional neutral. CDS contracts (including the CDSW screen on Bloomberg) typically derive the implied probability of default. Different dealers may assign different recovery rates. if a Modified Restructuring occurs. versus a Modified Restructuring. or to buy front-end protection as a hedge. he in turn can trigger the backend contract. By contrast. the investor would receive par on CDS with a locked-in recovery rate of 70%. By contrast. if the investor is not triggered on front-end protection. Assuming CDS matures later than the bond. Accordingly. The low dollar price of the cash bond would make a buy CDS—buy bond trade look attractive. However. Using the methodology in the “Implied Probability of Default” section on page 100. Practical Trading Considerations Following a Restructuring Example 1: Curve Trades Consider an investor who sold front-end protection and bought back-end protection. Absent a Restructuring. in which an investor sold back-end protection and hedged by buying front-end protection. but CDS traded at par (all running spread. But he will lose money if the recovery rate drops between the date he settles front-end CDS and the date he eventually settles backend CDS. the investor is notional neutral. which could occur at any time until contract maturity. Alternatively. to a one-year horizon. the investor’s position becomes unclear: If the investor is triggered on front-end protection. In practice. then once the front-end contract matures. which could be triggered at any time until contract maturity. this could particularly result in triggers for 102 credits where bonds traded at a deep discount but CDS traded at par. Presumably. because of the option to trigger the CDS contract at any time until maturity.7559 157 . Post-Credit Event. as follows: Expected Gain = Expected Loss Spread = [ Probability of Default ] x [ 1 – Recovery] + [ 1 – Probability of Default ] x Zero [ Probability of Default ] = Spread / [ 1 – Recovery ] Credit Default Swap Primer Glen Taksler 646. However. he will be forced to either hold on to the back-end position. as opposed to points upfront). 102 For example. the investor could deliver the bond following a Modified Restructuring.Credit Strategy Research May 27. if the investor is not triggered on back-end protection. However. resulting in a 30 point profit. he still can trigger the front-end contract. if a Modified Restructuring occurs: If the investor is triggered on back-end protection. duration should shrink. Example 2: Hedging Risk Consider the reverse situation. Example 3: Mark-to-Market Risk Suppose that an investor bought protection but does not want to trigger immediately post-Modified Restructuring. spreads widen and the investor would like to record mark-to-market gains of the spread change multiplied by the duration. 103 CDS contracts discount at LIBOR plus the implied probability of default. resulting in 103 unclear mark-to-market profits and reduced liquidity.
we apply these criteria to hypothetical scenarios for monoline insurers. We emphasize that our analysis is incomplete. we discuss potential issues in settling monoline CDS contracts. a further discussion of Bankruptcy criteria is relevant.Credit Strategy Research May 27. Special Issues Pertaining to CDS on Monoline Insurers We discuss special issues pertaining to CDS on monoline insurers.7559 . the above formula changes to (letting “default” mean a Bankruptcy or Failure to Pay Credit Event): Expected Gain = Expected Loss Spread = [ Probability of Default ] x [ 1 – Recovery post-default ] + [ 1 – Probability of Default ] x [ 1 – Recovery post-Modified Restructuring ] Probability of Default = [ Spread + Recovery post-Modified Restructuring – 1 ] / [ Recovery post-Modified Restructuring – Recovery post-default ] Post-Modified Restructuring. we discuss how rarely used criteria in CDS Bankruptcy definitions could (or could not) result in a Credit Event for monolines. For monolines in particular. should a Credit Event be determined. because it enters a gray area in CDS language. But post-Modified Restructuring. we address the implications of a proposed “good bank” / “bad bank” split on monoline CDS contracts. have been used only for Bankruptcy Credit Events. In this section. any one of which is sufficient to trigger a Credit Event. But Figure 130 shows that several other criteria meet the definition of Bankruptcy in CDS contracts. particularly based on additional information available at the time of a potential event. Defining a Monoline Credit Event CDS Bankruptcy criteria contain more triggers than an actual bankruptcy filing. Accordingly. we discuss special issues pertaining to CDS on monoline insurers. ISDA is looking into Modified Restructuring cash settlement solutions through a working group. 2008 35 CDS Settlement Protocols Recent CDS (so-called “cash”) settlement protocols. 158 Credit Default Swap Primer Glen Taksler 646. Should a Modified Restructuring occur in the future. any one of which is sufficient to trigger a Credit Event. In the section “Credit Events. and (2) the option to trigger immediately post-Modified Restructuring or at any time up to and including 14 calendar days after maturity. the protection Seller’s minimum expected Loss rises from zero to [ 1 – Recovery post-Modified Restructuring ]. Next. Currently. investors think of Bankruptcy as an actual bankruptcy filing. Generally.855. It may be possible to obtain different—or even opposite—interpretations. CDS mark-to-market profits and trade unwinds should use LIBOR plus this new implied probability of default. Finally. the CDS Settlement Protocol methodology would probably need to be revised to account for (1) different Deliverable Obligations based on the maturity of different CDS contracts. discussed in the section “CDS Settlement Protocols“ on page 143. we discussed the various criteria that may trigger CDS contracts. Second. First.” beginning on page 17.
855. stayed or restrained in each case within thirty calendar days of the institution or presentation threreof has a resolution passed for its winding-up. attachment. amalgamation. clause d). clause b). because the monoline has not become subject to the appointment of an administrator for all or substantially all its assets (Figure 130. Hypothetical Scenarios for Monoline Insurers (Based on Limited Information—Actual Results May Differ) A state regulator prevents a monoline from writing new business Not a Credit Event. (e) (f) (g) or (h) Source: 2003 ISDA Credit Derivatives Definitions. such proceeding or petition (i) results in a judgment of insolvency or bankruptcy or the entry of a order for relief or the making of an order for its winding-up or liquidation or (ii) is not dismissed. and. Criteria for a Bankruptcy Credit Event Any one of these criteria is sufficient to trigger CDS Contracts A Reference Entity: (a) (b) (c) (d) is dissolved (other than pursuant to a consolidation. 2008 35 Figure 130. in the case of any such proceeding or petition instituted or presented against it. receiver. regulatory or administrative proceeding or filing its inability generally to pay its debt as they become due makes a general assignment. enforced or sued on or against all or substantially all its assets and such secured party maintains possession. stayed or restrained. Monoline admits in writing in a regulatory filing that it is generally unable to pay debts as they becomes due Bankruptcy Credit Event at the monoline (Figure 130.Credit Strategy Research May 27. clause f). or any such process is not dismissed. clause f). arrangement or composition with or for the benefit of its creditors institutes or has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors’ rights. official management or liquidation (other than pursuant to a consolidation. has an analogous effect to any of the events specified in clauses (a) to (g) (inclusive). execution. provisional liquidator. A state regulator seizes control of a monoline. in each case within thirty calendar days thereafter causes or is subject to any event with respect to it which. under the applicable laws of any jurisdiction. custodian or other similar official for it or for all or substantially all its assets has a secured party take possession of all or substantially all its assets or has a distress. trustee. discharged. Monoline obtains a judgment of insolvency or bankruptcy Bankruptcy Credit Event at the monoline (Figure 130.7559 159 . or merger) becomes insolvent or is unable to pay its debts or fails or admits in writing in a judicial. discharged. sequestration or other legal process levied. Credit Default Swap Primer Glen Taksler 646. amalgamation or merger) seeks or becomes subject to the appointment of an administrator. for all or substantially all its assets Bankruptcy Credit Event at the monoline (Figure 130. conservator. or a petition is presented for its winding-up or liquidation.
wrapped (guaranteed) CDO super seniors typically are not eligible for delivery. the tranche) is Borrowed Money. Failure to Pay Credit Event at the holding company. Should an investor want to deliver a CDO tranche.. Should an investor want to deliver a CDO tranche—for example. These Deliverable Obligations are in addition to the direct debt of a Reference Entity—i. In this structure. whereas they are accustomed to trading CDS. in addition to bonds and loans. More importantly. monolines issued a financial guarantee on CDS on CDO tranches. whereas our understanding is that financial guarantees need not be re-marked unless they become impaired—namely.e. in exchange for a financial guarantee on the CDS. Usually applies to Borrowed Money. a broader category than simply Bonds and Loans.7559 . Figure 131 shows a sample structure that would allow for effective insurance from a monoline but would not be deliverable into CDS contracts. we discuss potential issues in settling monoline CDS contracts. Ultimate contract payoffs depend crucially on the type of instrument delivered. dealers were not in the business of marking and trading financial guarantees. owing to their structural characteristics. The protection Buyer may deliver debt that is wrapped by the monoline. a bank owns a CDO tranche. CDS is typically marked-to-market daily. Monoline CDS contracts are governed by the usual 2003 ISDA Credit Derivatives Definitions plus a 2005 Monoline Supplement. Quoting from the ISDA 2005 Monoline Supplement (emphasis added): “Qualifying Policy” means a financial guaranty insurance policy or similar financial guarantee pursuant to which a Reference Entity irrevocably guarantees or insures all Instrument Payments … of an instrument that constitutes Borrowed Money … for which another party … is the obligor . This supplement allows the protection Buyer to deliver debt that is wrapped by the monoline insurer. 2008 35 A state regulator prohibits a monoline from dividending any payments up to its holding company. First. a premium is paid to the monoline. This was done for two main reasons. At the same time. In exchange. 160 Credit Default Swap Primer Glen Taksler 646. which prevents the holding company from making a coupon payment Not a Credit Event at the monoline.—and usually sets a minimum threshold of USD 1 million.. First. a super senior—that tranche must be guaranteed directly by the monoline. not the underlying super senior tranche. not the underlying tranche. such as a municipal bond or super senior CDO tranche. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days in the U. so that the insured instrument (i. it must be guaranteed directly by the monoline. should a Credit Event occur. monolines issued a financial guarantee (wrap) on CDS on super senior tranches. Settling a Monoline Credit Event Settlement of monoline CDS contracts Settlement of monoline CDS contracts.. the bank receives CDS protection from the SPV.Credit Strategy Research May 27. The bank is thus protected against lost of principal and interest payments. We then discuss recent steps taken by ISDA to potentially reach a solution..855. Typically. may prove problematic due to vast dispersion in the recovery rates of potential Deliverable Obligations. unless the tranche suffers a loss of principal. bond or loan—that is deliverable under standard CDS contract language. 104 A Failure to Pay is a Reference Entity’s failure to make due payments.S.e. Notably. CDS was more attractive than a direct financial guarantee. after the expiry of any grace period in the relevant holding company bond 104 indenture.” Typically. Since dealers owned the underlying CDO tranche and wanted to be able to offset potential (now actual) mark-to-market losses. The bank buys protection from a special purpose vehicle (SPV).
and incomplete. it is consolidated in the financial statements of the Company on the basis that substantially all risks and rewards are borne by MBIA. Not on the Tranche Itself Bank. MBIA Insurance Corp. the CDO tranche would not be deliverable into CDS contracts referencing the monoline insurer. MBIA’s guarantees of synthetic CDOs are typically executed through LaCrosse. Frequently Asked Question “What is LaCrosse Financial Products?” in Category “Derivatives & Mark-to-Market. currently. If a monoline were to suffer a Credit Event. approximately 15 dealers submit a market on. not a requirement. Challenges with Cash Settlement for Monolines We think it would be difficult. While MBIA does not have a direct ownership interest in LaCrosse. description of CDS (so-called “cash”) settlement protocols. investors have come to generally expect an option to cash settle of CDS contracts. As we discussed in the section “Risk of a Short Squeeze” on page 22. LLC (LaCrosse) was created in December 1999 to act as a counterparty for structured derivative products. cash settlement is only an expectation. through a financial guarantee policy. with a 2 point bid-offer spread.com/investor/investor_inquiries_faqs. which owns CDO tranche CDS Premium SPV CDS Protection Financial Guarantee Premium Monoline insurer Financial Guarantee on CDS Source: Banc of America Securities LLC estimates. because the wrap is not the CDO tranche itself. which provides incentive for 106 the submission of reasonable quotes. which enters into a credit default swap with the counterparty. though not necessarily impossible. For further details.” 106 This is only an approximate.mbia. the mechanics of which resemble a Treasury auction..Credit Strategy Research May 27. primarily pooled credit default swaps. Credit Default Swap Primer Glen Taksler 646. $10 million bonds.7559 161 . Dealers may be required to trade bonds at their submitted levels.html. we think it would be very difficult to cash settle.855. then 105 guarantees the obligations of LaCrosse under the credit default swap. CDS settlement protocols (commonly called “cash settlement”) are actually an auction. please see “CDS Settlement Protocols” on page 143. as we discussed on page 143 in this Chapter. However. say. 2008 35 MBIA provides this description of the process: LaCrosse Financial Products. to cash settle a monoline. The reason is that. Roughly speaking. 105 http://www. Figure 131. Example of CDO Tranche Which Would Not Be Deliverable into Monoline CDS Monoline Financial Guarantee is on CDS Written by the SPV on the Tranche. However.
where only bonds and loans are deliverable Moreover.50% May 2009. in our view. the CDS settlement auction would be likely to result in a cash settlement price in the $10-$20 range. because each dealer would recognize that he may receive the lowest price Deliverable Obligation.isda. we see the potential for CDS contracts to rally massively. For example. these figures are just an example.55% June 2006.” and is not intended to be definitive. The purpose of the list is simply to “gather and disseminate information as to the range of obligations that market participants believe may be delivered upon the occurrence of a credit 107 event.org. Similar to CDS. not on assets. a list of Deliverable Obligations is established.125% May 2009 all were Deliverable Obligations. Should such a proposal be enacted. one referencing municipal bonds and the other referencing structured finance On February 14. 107 For details. the auction could result in a very low cash settlement price To address these issues. one referencing municipal bonds and the other referencing structured finance.855. please see http://www. 2. the 6. Before the beginning of the auction. MBIA Insurance Corp). New York Insurance Department Superintendent Eric Dinallo suggested the potential for monoline insurers to be split into two divisions. 2008 35 Before the beginning of the auction. CDS Succession refers to the potential change of entity that a CDS contract references (for example. ISDA subsequently published a list of obligations that dealers viewed as potentially likely to be delivered into monoline CDS contracts. That is far more straightforward for non-monolines. As such. To clarify. using the to-date methodology. 6. As discussed on page 132 in this Chapter. a CDS settlement protocol. 6. This is possible but timeconsuming. 2008. 162 Credit Default Swap Primer Glen Taksler 646. and any of those obligations may be delivered/received if a dealer is required to trade.Credit Strategy Research May 27. Recovery Rate Risk Moreover. would have a substantial risk of realizing a very low recovery rate. Potential Solutions To address these issues. if even a small portion of Deliverable Obligations have a very low recovery rate. ISDA assembled a working group in February 2008. suppose that the bulk of Deliverable Obligations have a price of $60 to $80. which could impede on the 30 calendar days within which parties normally settle credit default swaps. Succession is based solely on the transfer of debt. dealers participating in the auction quote markets assuming they will exchange the cheapest-todeliver. or splitting 50% / 50% notional between the municipals and structured finance businesses.7559 . ISDA has assembled a working group Monoline Succession: The “Good Bank” / “Bad Bank” Split The potential for monoline insurers to be split into two divisions. ISDA also is working with dealers to develop potential changes to the CDS auction (so-called “cash” settlement) methodology to accommodate the wide range of potential recovery rates across deliverables. but a few Deliverable Obligations have a price of $10-$20. either entirely succeeding (changing Reference Entity) to the municipals division. in the Delphi auction. Each dealer then would have to value each Deliverable Obligation to determine the cheapest-to-deliver obligation. The dealer community would have to agree that the each proposed Deliverable Obligation is indeed deliverable into CDS contracts. and 7.50% August 2013. a list of Deliverable Obligations is established. Then. not a recovery value estimate. should a Credit Event occur. This would be a time-consuming and difficult process. Deliverable Obligation Challenges To assemble a list of Deliverable Obligations for a monoline: 1.
Similarly. Credit Default Swap Primer Glen Taksler 646. prepared by our insurance analyst Michael Barry. if between 25% and 75% of financial-guaranteed obligations are transferred to a new division. because many of these products would neither be deliverable into CDS contracts nor counted for Succession 108 purposes. which also would not be counted for Succession purposes. a $10 million notional contract referencing MBIA Insurance Corp. existing CDS contracts would split 50% / 50% notional between the original and the new entity. but would be counted for Succession purposes.. For a monoline. the original monoline Reference Entity would be deleted entirely and replaced with the new division. in our early view. a subordinated bond would not be deliverable into a senior unsecured CDS contract. However. we exclude CDOs entirely. At the extreme. the 25% and 75% thresholds are not clear-cut for monolines. The table divides CDS deliverables into two groups: those based on financial guarantees to municipal bonds and those based on financial guarantees to structured finance. In reality. then existing CDS contracts would split 50% / 50% 108 There are circumstances in which obligations may not be deliverable into CDS contracts but would be considered for Succession purposes. but would be considered for Succession purposes. For example. These Succession rules include financial-guaranteed obligations. if between 25% and 75% of financial-guaranteed obligations are transferred to a new division. For these early estimates.855. if 75% or more of financial-guaranteed obligations are transferred to a new division. CDOs with a direct financial guarantee but a maturity greater than 30 years would not be deliverable.7559 163 . some portion of CDOs should be included and some portion excluded. although not applicable for monolines. 2008 35 For a monoline. but we do not yet have a sense of this proportion. unlike Succession rules for non-monoline Reference Entities. as one might imagine. We also exclude international financial guarantees because many of these products were written as reinsurance.Credit Strategy Research May 27. would split into two contracts of $5 million notional each. Figure 132 shows pertinent statistics. one referencing the municipals division and one referencing the structured finance division. For example.
Scenarios for CDS Succession in Monolines Should Be Viewed in the Context of Preliminary Estimates Assumes that no CDOs have a direct financial guarantee from monoline insurers. This assumption is inaccurate. Banc of America Securities LLC estimates. (*) For FGIC.Credit Strategy Research May 27.905 117.870 44.973 20.855. but not deliverable into CDS contracts.% Would CDS Succeed to Municipals Division? Based on Preliminary Information and Data ABK 556. but because we do not know which CDOs have direct financial guarantees. we assume that all existing financial guarantees relevant to a particular division (municipals or structured finance) would be transferred.% Total Structured Credit. CDOs with a direct financial guarantee but a maturity greater than 30 years would be considered for Succession purposes.100 (*) Not Available MBIA 672. we assume it to be zero. We believe that results have not changed materially since then. 2008 35 Figure 132. Actual results would depend on the universe of Relevant Obligations (Bonds and Loans with a direct financial guarantee) as of one day prior to the potential Succession event—in this case.247 84% 16% 472.896 83. we omit them entirely.956 425. It is entirely possible that the transaction would be constructed in a different way.731 159.347 47.950 66% 34% 50% / 50% Split Full Succession Full Succession 50% / 50% Split But Borderline (*) Estimates as of September 30.518 71.331 72. so for our preliminary purposes.164 59.016 18. Net Par of CDS Relevant Obligations for Succession (Total Net Par ex-CDOs and ex-Int’l): There are circumstances in which obligations may be considered for Succession purposes. Actual results would depend on obligations outstanding as of one day prior to the potential Succession event Figure 132 suggests the following implications for monoline CDS.467 28.569 70.814 224. To be clear.027 176.549 SCA 154.298 130. these results are borderline—we estimate that 70% of obligations considered for CDS 164 Credit Default Swap Primer Glen Taksler 646. $ Millions Total Net Par Outstanding Total Municipals Total Structured Credit Total International CDOs (US + International) US CDOs International CDOs Est.7559 . 2007. ex-CDOs .527 FGIC 314.725 23.934 395. Moreover. these results are simply preliminary estimates based on financial guarantee disclosures by the monolines.682 70% 30% 268. For example.344 3.173 300.300 40. A determination of the actual exposure may result in different implications for CDS. Sources: Company reports. “Est. Net Par of CDS Relevant Obligations for Succession (Total Net Par ex-CDOs and ex-Int'l) Total Municipals . for the time being.100 28. making our estimates invalid. the international portion of CDOs is not available. but would not be deliverable following a potential Credit Event. likely one day prior to the Dinallo “good bank” / “bad bank” plan going through—so the final result may differ substantially. Particularly for Ambac.628 79. Ambac and SCA Our preliminary estimates suggest that existing notional on CDS would split 50% / 50% between the municipals and structured finance divisions.500 50.289 84% 16% 89.
we have assumed that all CDOs are US exposure because of lack of information. for FGIC. some portion of CDOs is deliverable into monoline CDS and counted for Succession purposes. Additionally. Credit Default Swap Primer Glen Taksler 646. FGIC and MBIA Our preliminary estimates suggest that existing CDS notional would succeed entirely to the municipals division with corresponding spread tightening.855.Credit Strategy Research May 27. In reality. CDS would succeed entirely to the municipals division. A determination of this number could result in a 50% / 50% split. but if the actual number turned out to be at least 75%. 2008 35 Succession purposes would travel with the municipals. we again caution that Figure 132 excludes CDOs entirely.7559 165 . rather than a full succession. However. Determination of the international portion of CDOs may change the denominator in the CDS Succession calculation.
See Figure 133. 2008 35 Chapter VII – Other Credit Derivatives Products This section discusses products in the credit derivatives market other than single-name and index CDS referencing corporate unsecured bonds. shrinking the cushion that had prevented credit default swap spreads from moving wider. By contrast. either the best bid wins a particular trade or the flow desk bidding the best overall wins the entire list. Such products include synthetic CDOs. 166 Credit Default Swap Primer Glen Taksler 646. or a super senior notation in Credit Flux data. and CDS on asset-backed securities. Higher credit-risk tranches. during 2007. such as equity and mezzanine structures. please see the Chapter Appendix on page 179. Correlation desks’ until-then persistent demand to sell protection dried up. Banc of America Securities LLC estimates. CDS on leveraged loans. CDS spreads could move notably wider. correlation desks (groups responsible for managing structured credit risk and banks and broker-dealers) often use lists known as “Bid Wanted in Competition (BWIC). Figure 133. leveraged structures known as synthetic CDOs provided a constant source of demand for credit risk that was often sourced through single-name CDS from 2005 until early 2007. Identifiable super seniors defined as transactions with an attachment point higher than 20%. should such structures ever unwind en masse. For a further introduction to the structured credit market. particularly at popular seven. Potentially. Sources: CreditFlux. 109 To sell single-name protection on a large number of Reference Entities in different notionals. In the synthetic CDO market. Investment Grade Synthetic CDO Issuance January 2003—December 2007 IG Synthetic CDO Issuance ($ Billion) 25 20 15 10 5 May-03 May-04 May-05 May-06 May-07 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Distributed tranches excluding identifiable super seniors. losses in subprime mortgages and traditional cash CDOs caused synthetic CDO volumes to plummet.” Each recipient of the BWIC is responsible for entering a bid on trades in which it is interested. had greater leverage. Typically. an OWIC is an Offer Wanted in Competition and signals the desire to buy single-name protection. an exhaustion point of at least 50%.7559 . dealers typically sold credit risk to the end investor through one particular tranche. However.and ten-year maturities. resulting in 109 tighter CDS spreads. Dealers hedged their short credit-risk exposure by selling protection in the single-name (secondary) CDS market.Credit Strategy Research May 27.855. The Synthetic CDO Market Strong synthetic demand was a catalyst toward tighter spreads from 2005—early 2007 Whereas the new issue market for cash bonds provides a constant source of supply.
• Relevant Obligations are Bonds and Loans - Sources: ISDA. Bank loan portfolios may sell protection to add exposure to issuers with underutilized credit lines. buying LCDS protection provides a more accurate hedge for loan portfolios than senior unsecured CDS. 2006.5 MM • Bankruptcy • Failure to Pay Senior Unsecured CDS • 2MM . Credit Events If an issuer defaults on just Bonds (not Loans). Similarly.and single-B high yield universe. these Credit Events may occur anywhere within Borrowed Money. See Main Text for Major Differences in Europe. Figure 134 compares key features of LCDS with senior unsecured CDS: Figure 134. September 28. 2008 35 Leveraged Loan CDS (“LCDS”) For more information on Leveraged Loan CDS.Credit Strategy Research May 27. Banc of America Securities LLC.10 Years • Physical (Cash Settlement Protocols Developing) Cancelability Deliverable Obligations Tenors Settlement • • • • • Successor Language Additional If syndicated secured facility no longer exists Loans Revolvers 3 Years and 5 Years Cash (Recovery rate determined through an through an auction process).7559 167 . Focused on the double. First Lien) Designated Priority is a trading (not a legal) standard. Leveraged investors may buy LCDS protection to short credit risk without the need for a repo market. LCDS trades actively on 25 to 40 Reference Entities and is quoted for about 80 entities. often with lower funding costs than a total-return swap on par loans. Sellers of protection include hedge funds. who seek quick access to leveraged loan exposure. regardless of where a trade Is executed Loan CDS Size Credit Events • 2 MM . Senior Unsecured CDS For North American Contracts.10MM • Bankruptcy • Failure to Pay • Modified Restructuring (Selected Credits in SingleName CDS) • None • Bonds • Loans • 1 Year . please see our Guide to Leveraged Loan CDS.g. “North America” and “Europe” refer to the location of the Reference Entity. provided that another market participant is willing to take the opposite position.855. Importantly. • Ability to physically settle. Leveraged loan CDS (“LCDS”) allows investors to reference secured loans in standardized credit derivative contracts. there is a Credit Event in LCDS LCDS Credit Events are Bankruptcy and Failure to Pay. Overview of Loan CDS vs. LSTA.. which includes Loans and Credit Default Swap Primer Glen Taksler 646. • Relevant Obligations are Syndicated Secured • Designated Priority (e.
After that day. Accordingly. Succession language refers to potential changes in CDS contracts if the Reference Entity is merged.Credit Strategy Research May 27. LCDS Succession language is based on Syndicated Secured Loans 110 111 Succession Language Like senior unsecured CDS. Early Termination (Cancelability) LCDS may be terminated if a Syndicated Secured facility is canceled and not replaced For North American Reference Entities. for a credit that has rallied. much like senior unsecured CDS in the late 1990s and early 2000s. A Syndicated Secured List helps determine Deliverable Obligations into LCDS contracts. higher recovery rates reduce expected profit. in senior unsecured CDS. Settlement Unlike senior unsecured CDS. As long as investors can come to the same conclusion regarding cash flows (dollar price). 85% versus a more commonly used 75%. a haircut should be applied to the unwind payment. we point out some practical trading considerations. rip up) the trade. Practical Issues in Trading LCDS As a young market. Investors need not agree on haircuts and recovery rates. the LCDX index (Chapter III – CDX and iTraxx Indices page 48) may offer greater liquidity both because of its diversification and because LCDX trades in dollar price. However. using an auction process that resembles recent protocols for senior unsecured CDS settlement. For example. LCDS cash settles.855. because a Counterparty may argue that the recovery rate may be relatively high—for example. leveraged loan CDS cash settles using an auction process Unlike senior unsecured CDS trades. Therefore. the unwind payment 110 declines. Succession criteria are Post-Credit Event. particularly for single names. the likelihood of prepaying a Syndicated Secured facility rises. In other words.7559 . Similarly. That process is described in Chapter VI – CDS Case Studies and Legal Issues on page 143. either party may deliver an Optional Early Termination Notice to terminate (effectively. or undergoes some other change to its corporate structure. senior unsecured CDS uses a 40% recovery rate for almost all Reference Entities (autos and neardistressed credits are exceptions). For LCDS in the interim. some protection Sellers find it difficult to unwind profitable single-name LCDS trades. reducing the protection Seller’s profit. there still will be a Credit Event in LCDS. it does not matter how they reach that conclusion. First. LCDS is evolving toward standardized trading protocols. if an issuer defaults on just its Bonds (not Loans). This is because the Counterparty may argue that. The protection Buyer is required to pay accrued interest up to and including the termination date. which facilitates consistent trading and liquidity. the protection Buyer’s expected profit is par – recovery. 2008 35 Bonds. 168 Credit Default Swap Primer Glen Taksler 646. The list is based on dealer polls and is administered by Markit Group Ltd. Since a higher recovery rate would cause the protection Buyer to make less following a potential Credit Event. Additionally. Investors who wish to physically settle may do so through the settlement process. provided that 111 another market participant is willing to take the opposite position. as the market tries to learn the fair value of early termination options. an LCDS contract may be terminated if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. reducing the protection Buyer’s profit. When marking LCDS. some protection Buyers find it difficult to unwind profitable trades. parties should take these issues into account. acquired.
Only LCDS contracts will succeed. if for some reason there is no LCDS (commonly called cash settlement) auction. Secured CDS Secured CDS seeks to limit Deliverable Obligations to those bonds that contain particular security Secured CDS seeks to limit Deliverable Obligations to debt (usually bonds) that contain particular security. it seemed unnecessary to include the additional maturity limitation of Modified-Modified Restructuring. the market introduced secured CDS contracts on HCA. Successor provisions depend on all Loans of the Reference Entity. unsecured debt may be deliverable. In Europe. we note some general differences for Reference Entities based in Europe: In Europe. Credit Default Swap Primer Glen Taksler 646. in 2006.g.7559 169 . first lien). the Reference Obligation determines only the seniority. physical settlement is the standard. Successor provisions depend on the Reference Obligation and its corresponding credit agreement.855. Under some circumstances. For example. the protection Buyer may deliver a senior unsecured bond. In Europe. or the auction fails to result in a final price. of the Deliverable Obligation. rather than the Modified-Modified Restructuring (MMR) used for European senior unsecured CDS. please see Chapter VI – CDS Case Studies and Legal Issues on page 132. ELCDS Deliverable Obligations are limited to the Reference Obligation(s) or other senior loans with the same security and the same or equivalent guarantees. suppose all Syndicated Secured Loans succeed to a new entity. with a settlement price determined through a market-wide auction. if the Reference Obligation is a senior secured bond. trades may revert to physical settlement. Below. the protection Buyer) rather than a market-wide cash settlement price.. A group is working on the development of ELCDS marketwide cash settlement mechanics..” or plain vanilla. 2008 35 based on all Bonds and Loans outstanding.g. For example. not the security. With the universe of Deliverable Obligations already limited. The reason for secured CDS language is that. In North America. Restructuring. currently. Early Termination depends on all Loans of the Designated Priority (e. in senior unsecured CDS. with the intention that the only Deliverable Obligation would be second lien HCA bonds. In Europe. a Deliverable Obligation may have different 112 security.Credit Strategy Research May 27. European LCDS (ELCDS) European LCDS uses different standards The above discussion focuses on Reference Entities based in North America. For more details on Succession language. Senior unsecured CDS trades will remain with the original Reference Entity. Early Termination depends specifically on the Reference Obligation and assets securing it. ELCDS uses “old. first lien) based on a trading standard. In North America. cash settlement is possible under some circumstances but is based on an auction conducted by the Calculation Agent (in some cases. cash settlement is 113 the standard. For example. In North America. but this represents 25% or less of all Bonds and Loans outstanding at the Reference Entity. In Europe. In Europe. In North America. LCDS Succession language is based solely on Syndicated Secured Loans outstanding. 112 113 The North American Deliverable Obligation still must be a loan of the Designated Priority (e. following a Credit Event. In North America.
Figure 135 illustrates that the investor’s mark117 to-market profit is $440. “secured” is added to the list of Deliverable Obligation Characteristics. But the market’s expectation for recovery increases to 60% and the spread remains constant.Credit Strategy Research May 27. We note that. an opposite result occurs if the security goes away. sometimes called recovery swaps. In this case. should there be a Credit Event. The protection Buyer would be required to continue to pay the CDS coupon but would not be entitled to receive anything from the protection Seller. suppose an investor buys a recovery lock at 50% and a Credit Event does not occur. the Reference Obligation is changed to a secured bond from a senior unsecured bond.” 115 We say near-worthless because. the investor profits 10 points.” ISDA. 170 Credit Default Swap Primer Glen Taksler 646. a clause “Substitute Failure Termination Date: Applicable” is inserted into a confirm. through a tender offer--then secured CDS would become near-worthless.399 per $10 million notional. should such an obligation be issued before contract maturity. Recovery Locks Recovery locks. the Deliverable Obligation Characteristic “Secured” would no longer apply. Similar to senior unsecured CDS. A regular senior unsecured CDS bond would become deliverable. Relevant CDS confirms specify. which essentially causes the trade to be ripped up. 2008 35 Secured CDS therefore makes two changes from senior unsecured contracts. suppose the secured Reference Obligation were to be refinanced and the collateral package simultaneously released. First. should all Deliverable Obligations cease to exist—for example. 117 A wide bid-offer spread makes it difficult to realize mark-to-market gains on recovery swaps. allow an investor to take a view on recovery rates rather than outright default risk. if an investor buys a recovery lock at 50% and realized recovery is 60% post-Credit Event. that obligation would immediately become deliverable. a secured CDS trade would revert to senior unsecured CDS By contrast. the trade would revert to senior unsecured 116 CDS.855. should there be no Deliverable Obligation. Mark-to-market profits are based on the change in recovery rate relative to the implied probability of default. This characteristic is based on ISDA language published in June 2006 and requires that the Deliverable Obligation be secured with at least all of the assets that secure the 114 Reference Obligation.7559 . 116 Formally. For example. 2006. For example. 114 “Additional Provisions for a Secured Deliverable Obligation Characteristic. “Secured Deliverable Obligation Characteristic: Applicable. If the security were to be released. in some nonstandard CDS trades. Second. should there later be a Credit 115 Event. For example. June 16.
Current Spread Notional 5y CDS Original Recovery Rate and Current Spread (Better to use full credit curve) Recovery Swap Buyer Current Profit $440. This is because a wider spread implies that a Credit Event is more likely. Both Deal Spread and Par CDS Spread equal the current market spread. Banc of America Securities LLC estimates. Current Market Recovery Rate Figure 136 illustrates an investor’s mark-to-market gain on his long recovery lock position if the market spread widens from 500 bps to 750 bps and the market recovery rate increases from 50% to 60%. the chance that the investor realizes the 10 point differential between the fixed recovery rate (50%) and the market recovery rate (60%) increases. Notice that the mark-to-market is higher than in Figure 135.399 Sources: Bloomberg. Calculating Mark-to-Market on Recovery Locks with Unchanged CDS Spread Investor Buys a Recovery Lock at 50% and Market’s Recovery Expectation Increases to 60% Recovery Set Curve Recovery to False. Credit Default Swap Primer Glen Taksler 646. Input original (“strike”) recovery rate on left side.855. 2008 35 Figure 135.7559 171 . Input current recovery rate in bottom-right corner. As the probability of default increases.Credit Strategy Research May 27.
in the section. Input current recovery rate in bottom-right corner. Input original (“strike”) recovery rate on left side. illustrated in Figure 137. the protection Seller must make the Buyer whole for any write-downs or shortfalls. The protection Buyer pays a premium with the same frequency as an underlying Reference Obligation (denoted by a specific CUSIP in the term sheet). 2008 35 Figure 136. the protection Buyer continues to pay the protection premium. if the CDS notional was $10 million Credit Default Swap Primer Glen Taksler 646. CDS on ABS CDS on ABS was decimated in price during 2007 CDS on ABS is primarily designed for “soft” Credit Events. Current Spread Notional 5y CDS Original Recovery Rate and Current Spread (Better to use full credit curve) Recovery Swap Buyer Current Profit $576. typically monthly. such as write-downs and shortfalls. such as write-downs and shortfalls The protection Seller must make the Buyer whole for any soft Credit Event Following a soft Credit Event. with interest compounded at LIBOR. the protection Buyer reimburses the Seller.7559 . Current Market Recovery Rate Generally. CDS on ABS is primarily designed for “soft” Credit Events. For example.928 Sources: Bloomberg. Should the underlying Reference Obligation later repay a shortfall. Banc of America Securities LLC estimates.” we will discuss 2007-early 2008 performance. recovery locks are far less liquid than single-name CDS. including Credit Events and mechanics as compared with CDS on corporate Reference Entities. the protection Buyer continues to pay the protection premium. Calculating Mark-to-Market on Recovery Locks with Widening CDS Spread Set Curve Recovery to False. But first we provide an overview of CDS on ABS more generally. In turn. Below. Instead of focusing on outright default risk. but on a reduced notional 172 Credit default swaps on asset-backed securities (CDS on ABS) became popular in 2006 before being decimated in price during 2007.Credit Strategy Research May 27. “The Decline of ABX. Both Deal Spread and Par CDS Spread equal the current market spread. The resulting structure. but on a reduced notional. Following a soft Credit Event.855. is called “Pay as You Go (PAUG)” CDS.
5 million notional ($10 million – $500. 2008 35 and an interest shortfall amounted to 5%. as the underlying Reference Obligation in ABS is often not sufficiently liquid in large quantity. the protection Buyer has the option to force Physical Settlement Alternatively. the protection Buyer delivers an ABS bond (the specific Reference Obligation noted on the term sheet) and the protection Seller pays the notional amount of protection. as illustrated in Figure 138. Similar to CDS on corporate credit. Pay As You Go (PAUG) CDS Figure 139 compares key features of CDS on corporate credit with CDS on ABS: Credit Default Swap Primer Glen Taksler 646. Figure 137. following any soft Credit Event. Alternatively. we note that it may be difficult to execute. Pay As You Go (PAUG) CDS Seller Provides Protection for “Soft” Credit Events Figure 138.7559 173 . Because Hard to Get the Bond Premium Buyer Write Downs Interest Shortfalls Seller Deliver ABS Bond Buyer Par Amount Seller Shortfall Reimbursement See Figure 139 for details on Credit Events. typically monthly.000). Source: Banc of America Securities LLC estimates.000 ($10 million x 5%). Growth in the CDS on ABS market during 2006 brought the market to a more Pay As You Go-focused system. Source: Banc of America Securities LLC estimates. Although the ability to physically settle technically exists. Optional Physical Settlement Difficult to Execute. the protection Buyer would receive $500. the protection Buyer has the option to force Physical Settlement.855. Payments are made with the same frequency as the underlying Reference Obligation. The protection Buyer then would pay a coupon going forward on $9.Credit Strategy Research May 27.
the protection Seller pays the Buyer only 150 bps. While a fixed cap limits liability to the annual protection premium.7559 . This is because the Interest Shortfall is less than the annual protection premium. because liability is capped at the annual premium. Otherwise.50%. Fixed vs.Credit Strategy Research May 27. LIBOR is typically set at a one-month maturity. Variable Caps Pay As You Go CDS has a cap to limit the liability of the protection Seller Following a Soft Credit Event. Pay as You Go CDS has a cap to limit the liability of the Seller of protection. the protection Seller pays the Buyer the full 200 bps.) 174 Credit Default Swap Primer Glen Taksler 646. the protection Buyer pays 150 bps and the Seller pays nothing. Under a variable cap. 2008 35 Figure 139. Comparison of CDS on Corporate Credit. fixed and variable. (We assume that LIBOR is at least 0. should there be an Interest Shortfall of 200 bps. the protection Seller would pay the Buyer LIBOR + 150 bps. the Seller pays the Buyer 100 bps for both types of cap. the market appears to be evolving toward a fixed cap. Comparison of Fixed and Variable Caps Based on a Premium of 150 Bps Per Annum In a Fixed Cap.855. Otherwise. Protection Seller’s Liability is Capped at LIBOR + Premium Fixed Cap CDS Buyer No Credit Event Interest shortfall of 100 bps Interest shortfall of 200 bps Source: Banc of America Securities LLC estimates. Variable Cap CDS Seller Pays 0 bps CDS Buyer Pays 150 bps Pays 150 bps Pays 150 bps CDS Seller Pays 0 bps Pays 100 bps Pays 200 bps Pays 150 bps Pays 150 bps Pays 150 bps Pays 100 bps Pays 150 bps Variable cap interest shortfall of 200 bps scenario assumes that LIBOR is at least 0. There are two types of caps. A fixed cap limits liability to the annual protection premium. In the case of No Credit Event.50%. A variable cap limits liability to LIBOR plus the annual protection premium. the CDS Seller’s liability would be capped at LIBOR + 150 bps. a variable cap limits liability to LIBOR plus the annual protection premium However. versus CDS on ABS (Pay as You Go) PAUG CDS Generally Provides Protection for “Soft” Credit Events Unsecured CDS (Corporates) Reference Obligation Reference Notional Credit Events • Any Bond or Loan issued by the Reference Entity • Fixed over the life of the trade • Bankruptcy • Failure to Pay • Modified Restructuring (Selected Credits in SingleName CDS) • Cash or Physical • Not Applicable CDS of ABS (PAUG) • Unique issuance specified by a CUSIP • Amortizing • Failure to Pay Principal • Writedown • Distressed Ratings Downgrade • Maturity Extension • Optional Physical • Interest Shortfall • Principal Shortfall • Writedown • Legal Final Of Reference Obligation Settlements Soft Credit Events Maturity • Stated Source: Banc of America Securities LLC estimates. Following an Interest Shortfall of 100 bps. Protection Seller’s Liability is Capped at the Premium In a Variable Cap. Figure 140 compares the two caps: Figure 140. Currently.
There are six indices. in 2006. A. The index is cash 118 settled. The BBB and BBB. the “Buyer” of the index is like the protection Seller. The ABX index uses a fixed cap equal to the coupon rate (recall Figure 140) and is intended to roll twice annually. The ABX indices also have served as a gauge for overall performance of securities backed by subprime mortgages. The lesser of the two ratings applies. Credit Events are soft and include Interest Shortfall. The Decline of ABX th The ABX indices served as a gauge for performance of securities backed by subprime mortgages Since February 2007. and Writedown. to single digits in some cases.tranches dominated volume until late 2007. BBB. especially for participants in other markets who are less familiar with ABS and RMBS securities.855. Key Features of ABX Indices A dealer consortium selects 20 deals among the 25 largest issuers as ranked by subprime home equity issuance. the protection Buyer does not have the option to force physical settlement following a soft Credit Event. Principal Shortfall. and BBB. The “Seller” of the index is like the protection Buyer. A. ABX is quoted in dollar price. AA. See Figure 141. record weak performance in subprime mortgages has driven ABX prices down. around January 19 and July 19. Credit Default Swap Primer Glen Taksler 646. based upon the rating of the Reference Obligations: Penultimate AAA (secondto-last AAA cash flow). with a fixed coupon. Like the CDX HY index. called ABX.7559 175 . 118 Unlike single-name CDS of ABS. and BBB-. Unlike the CDX and iTraxx indices. As such. there is no overlap between various series of the ABX index. and a AAA index with an average life longer than 5 years Must be rated by Moody’s and S&P. the market introduced a series of indices on Home Equity Loans.indices with a weighted average life longer than 4 years.Credit Strategy Research May 27. AAA (last AAA cash flow). BBB. when severe expected losses pushed volume up the capital structure. 2008 35 ABX and CMBX Indices ABX is an index of Home Equity Loans To provide relatively liquid access to the CDS of ABS market. Deals must meet the following criteria: No more than four deals with loans from the same originator No more than six deals with the same master servicer Issued within the prior six months Offering size of at least $500 million At least 90% of deal’s assets in first lien mortgages Weighted average FICO score of less than 660 Pays on the 25 of each month Pays interest at a floating rate benchmark of one-month LIBOR Has AA.
7559 . Similar to ABX. that is. which roll approximately every April and October 25. not enough reference deals were issued in the second half of 2007 to create the ABX 08-1 (first series of 2008) index under current rules. However. CMBX is quoted in spread. unlike ABX. and 119 BB. CMBX is an index of commercial mortgage-backed securities Similarly. AAA A BBB- Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 Owing to the collapse in subprime securities. the CMBX index references 25 commercial mortgage-backed securities. not price. there are six separate indices by rating: AAA.855. Dealers decided to postpone the creation of a new index until more securities become available as opposed to changing the criteria for inclusion in the index. Banc of America Securities LLC estimates. the second CMBX series issued in 2006. Key Features of CMBX Indices Similarly. Covering Deals Issued in the Second Half of 2006 120 100 Index Price ($) 80 60 40 20 0 Jan-07 Mar-07 May-07 Sources: Markit. 176 Credit Default Swap Primer Glen Taksler 646. BBB-.0 119 The BB index began with the 06-2 series. AA. Reference Obligations must meet the following criteria: Must be a debt or pass-through security referencing a pool of fixed-rated securities Must be secured by obligations from at least 50 separate mortgages among at least 10 unaffiliated borrowers Issued within the prior two years Offering size of at least $700 million No more than 40% of underlying obligations from the same state No more than 60% of underlying obligations of the same property type Factor of 1.Credit Strategy Research May 27. BBB. 2008 35 Figure 141. ABX 07-1 Price Performance “07-1” Means First ABX Series Issued in 2007.
7559 177 .tranche of the ABX 06-1 Series had an Interest Shortfall of $117. Must be rated by at least two of Moody’s. and hedge funds. meaning obligations that: Are subordinated to other debt obligations.151 regular payment – $117. and Fitch. 2006. In practice. On the next monthly coupon date. times 29 actual / 360 total days in the coupon period.855. Protection Buyers include dealers. technically. and BBBindices may reference publicly or privately issued securities. the AAA index must reference bonds with a weighted average life of 8-12 years. CDS on CLOs CDS on CLOs also focuses on soft Credit Events Traditionally.032. This comes from a coupon of 267 bps per annum. “06-1” means the first ABX series issued in 2006. principal finance groups. AAA index must reference publicly issued securities. based on 0% constant prepayment yield at issuance and an initial issuance size of at least $100 million. Protection Sellers include CLO asset managers. December 25. CDS on CLOs largely focuses on recent vintage single-A to double-B tranches. Preferred CDS (“PCDS”) Preferred CDS adds a Credit Event called “Deferral of Payment. risk exposure on CLOs was limited to long positions. Credit Default Swap Primer Glen Taksler 646. Note that.86 interest shortfall.97 ($2. hedge funds. to hedge new issue origination and pipeline risk. 2008 35 AAA index references the bond from each deal that is composed of the most credit 120 enhanced tranche. 2006. the BBB. To monetize the Interest Shortfall.83 per $1 million of index notional.150. principal finance groups. AA. with the longest average life. and trading desks. and In addition. A. CDS on CLOs allows an investor to take an unfunded long or short position and focuses on soft. by either holding a cash position or using a total return swap. S&P. to hedge tranche-specific risk. BBB. and Provide for deferral of interest or other scheduled payments on an optional or mandatory basis. multiplied by a factor of one. The weakest of all ratings applies. they are netted in one payment. the Seller of the index (effectively. Going forward. the protection Buyer) normally would pay $2. The notional and factor are not affected by an Interest Shortfall. This shortfall resulted from losses on the M9 bond of Structured Asset Investment Loan Trust 2005-HE3 and the M9 bond of Long Beach Mortgage Loan Trust 2005-WL2. the protection Buyer will continue to pay a coupon of 267 bps per annum (paid monthly) on a notional of $1 million. Should the shortfall later be repaid. and trading desks.” which affords protection against missed dividend payments 120 Preferred CDS references Preferred Securities. the coupon date and the Interest Shortfall reimbursement are two separate cash flows. multiplied by a factor of one. multiplied by a factor of one).86 per $1 million of index notional. the protection Buyer must reimburse the Seller. with interest compounded at LIBOR.Credit Strategy Research May 27. traditional cash CLO buyers. Soft Credit Event Example: Interest Shortfall Example of a soft Credit Event On November 27. the Seller of the index will pay just $2. Pay As You Go Credit Events.
7559 . that period must be breached before Preferred CDS triggers a Credit Event. or Otherwise defers a scheduled dividend or other distribution. the protection Seller islikely to prefer not to trigger a Deferral of Payment Credit Event. Accounts Receivable CDS allows the protection Buyer to assign Accounts Receivable to the protection Seller. PCDS Succession criteria are limited to Preferred Securities outstanding rather than the Bonds and Loans used in senior unsecured CDS. the protection Buyer should have the option to deliver obligations across the capital structure (Preferred Securities. because the protection Seller forces the Buyer to settle. and Loans). rather than deliver a Bond or Loan Standard CDS contracts require that the protection Buyer deliver a Bond or Loan. Trust Preferred (TruP) and recently issued hybrid securities typically allow the issuer to miss 20 dividend payments before the issuer is deemed to be in default. Failure to Pay. 122 Assuming the protection Buyer triggers the contract and the only Credit Event is a Deferral of Payment. As such. Deliverable Obligations are Preferred Securities. the PCDS protection Buyer has a benefit not afforded by 121 the underlying security. Bonds. “Deferral of Payment” means that. after any applicable Grace Period expires. By contrast. In this case.Credit Strategy Research May 27. or other equity interests. or Modified Restructuring. and Deferral of Payment. versus Accounts Receivable. Failure to Pay. Not surprisingly. Modified Restructuring (for selected Reference Entities). The protection Buyer pays quarterly coupons in exchange for protection against hard Credit Events. please see Chapter VI – CDS Case Studies and Legal Issues on page 132. Deferral of Payment applies only to Preferred Securities but occurs regardless of whether any terms of the securities permit them to transpire. For a Bankruptcy. who are more concerned about the recovery rate on Accounts Receivable. only Preferred Securities are deliverable. and Loans. For more details on Succession language. this limitation does not apply. The reason is that only the price of Preferred Securities (not senior unsecured bonds. in whole or in part. To this end. This process effectively eliminates basis risk between the recovery rate on a Bond or Loan. if the indenture specifies a Grace Period. Preferred CDS triggers a Credit Event three Business Days after the first missed dividend payment. 2008 35 Receive at least partial treatment as equity from at least one U. if the protection Seller triggers the contract. Accounts Receivable CDS typically matures after three months – two years and may involve running coupons or a single up-front payment. in whole or in part. which include Bankruptcy.S. for example) should be affected by a Deferral of Payment. However. For example. Preferred CDS triggers a Credit Event three Business Days after the first missed dividend payment. at a predetermined price. or Fails to pay a dividend or other distribution in cash. For a Deferral of Payment. using the recovery rate on the inventory. While extremely useful to the overall financial market. but instead pays the dividend in additional Preferred Securities.855. these contracts may be less useful to suppliers of physical goods (inventory). Deliverable 122 Obligations are Preferred Securities only. because the issuer is allowed to miss them. For example. The logic is that. 121 Indentures for Preferred Securities typically do not specify a Grace Period for missed dividend payments. Bonds. As such. the suppler of inventory to a grocer may wish to protect against a potential Credit Event at that grocer. 178 Credit Default Swap Primer Glen Taksler 646. the Reference Entity or any Related Trust Preferred Issuer: Fails to pay a dividend or other distribution. However. The terms of these contracts are customized. Accounts Receivable CDS Accounts Receivable CDS allows the protection Buyer to assign Accounts Receivable. nationally recognized ratings agency. common stock. primarily to help suppliers to maintain shipments during periods of financial stress or alleviate concentration risk.
and may use Physical Settlement. Credit Events are Bankruptcy and Failure to Pay. then a poll is conducted across three secondary traders. 125 After delivery of a Notice of Physical Settlement. If the Protection Buyer does not deliver a Bond or Loan. in which the protection Seller and Buyer alternate every 10 Business Days as being the party responsible for locating a Bond or Loan. The Settlement mechanism is chosen at trade inception. If neither party has located a Bond or Loan by this time. 2008 35 Private Institutional CDS Private Institutional CDS allows investors to obtain exposure to companies that issue private placement. with a recovery rate pre-determined at trade inception. Credit Default Swap Primer Glen Taksler 646. 124 Under specific circumstances. Private Institutional CDS typically matures in three to seven years. rather than publicly traded. please see our Guide to Single-Tranche CDOs: Correlation Products in Plain English. In a single-tranche CDO. Fixed Recovery Settlement. such as a Succession Event. This debt may be rated or unrated. with the exact details negotiated at the time of the trade. in case the Counterparties are unable to locate a Bond or a Loan to deliver into 125 the trade. the protection Seller may be able to terminate a trade. which states that transactions by an issuer that do not involve any public offering are exempt from SEC registration requirements. December 21. with Cash Settlement as a backup. the protection Buyer has 30 Business Days to deliver a Bond or Loan.7559 179 .Credit Strategy Research May 27. If fewer than two quotes are obtained. debt. 123 Specifically. secured or unsecured. rather than publicly traded. Modified Physical settlement refers to Physical Settlement. or Modified Physical Settlement. then protection becomes worthless. investors buy or sell protection on a pool of credit default swaps instead of single names. by the protection 124 Buyer. Fixed Recovery settlement is similar to cash settlement. 2004. Private Institutional CDS affords protection against debt that falls under section 4(2) of the Securities Act of 1933. Single-Tranche CDOs (STCDOs) Perhaps the most prominent product in structured credit is the single-tranche CDO. For a more detailed explanation of correlation products. Unlike standard CDS. debt Private Institutional CDS allows investors to obtain exposure to companies that issue 123 private placement. The average of at least two quotes is used as a Cash Settlement price. Private Institutional CDS is typically callable. Figure 142 shows the liquid tranches of the CDX IG index. That pool is then “tranched” in a way similar to ABS securities and cash CDOs so an investor has subordination before suffering a potential loss of principal. a 60 Business Day flip-flop procedure begins. Appendix VII – Other Credit Derivatives Products Structured Credit Market Basics This section provides an overview of the structured credit market.855.
Assuming an equally-weighted portfolio and 40% recovery rate.Credit Strategy Research May 27. the 7%-10% CDX IG tranche will be wiped out. 60% loss rate is par – 40% recovery rate. Tranches on CDX IG. In structured credit lingo. 180 Credit Default Swap Primer Glen Taksler 646.3% (First Loss) 3% .30% (Senior) 30% . or More Generally.7559 .855. 126 7% subordination / 60% loss rate per Credit Event.7% (Jr Mezzanine) 7% . An investor who sells protection on the 7%–10% CDX IG tranche has 7% subordination. 2008 35 Figure 142. 7% is known as the “attachment” point and 10% is known as the “detachment” or “exhaustion” point.66% of Reference Entities in the underlying portfolio would need to suffer a Credit Event before the 7%-10% tranche 126 investor lost principal. STCDOs Senior Tranches Selected Tranche Standardized CDX IG Tranches 0% .15% (Senior) 15% . See Figure 143. If the CDX IG index loses 10% of principal.100% (Senior) CDX IG Subordinated Tranches Source: Banc of America Securities LLC estimates. He suffers no loss of principal until 7% of the underlying CDX IG index is wiped out.10% (Mezzanine) 10% . 7% subordination implies that 11.
even as spreads in the underlying portfolio widened. mezzanine-hedged equity strategies (long equity risk. The Correlation Crisis of May 2005 Mezzanine-hedged equity strategies backfired in May 2005 The mismatch began with an increase in fundamental risk to the equity tranche. A forced unwind followed.7559 181 . Dollar Losses on CDX IG Assumes Notional of $100 million CDX IG Index CDX IG 7% . Spreads on equity tranches widened greater than model estimates.Credit Strategy Research May 27. By contrast. almost all this increase in idiosyncratic risk hit the equity tranche. 2008 35 Figure 143. while those with lower risk appetites may prefer higher levels of subordination. Investors with a high risk appetite and desire for yield may prefer tranches with little or no subordination. hold-to-maturity investors such as insurers are large protection sellers. How CDX IG 7%–10% Tranche Principal Losses Compare with CDX IG Principal Losses Dollar Losses on 7% − 10% Tranche vs. Higher levels of subordination decrease the likelihood of principal loss. the credit default indices. Market Participants At senior level attachment points. as illustrated in Figure 144: Credit Default Swap Primer Glen Taksler 646.855. As the first loss investor. as idiosyncratic risk—that is. Equity tranche investors may hedge risk by buying protection on single-name CDS. The mismatch in the mezzanine-hedged equity strategy began with an increase in fundamental risk to the equity tranche. as idiosyncratic risk increased In May 2005. significant individual issuer spread risk—increased. longer-term. prompting a second leg lower. and correspondingly. short mezzanine risk) backfired. at the equity (first loss) level. or more senior tranches.10% Tranche 100 Loss ($ Millions) 80 60 40 20 0 0 10 20 30 40 50 60 70 LCDX Index Loss ($ Millions) 80 90 100 Source: Banc of America Securities LLC estimates. while mezzanine tranche spreads actually tightened. spread. hedge funds are large protection sellers.
from LBOs.Credit Strategy Research May 27.7559 . The total spread change across the tranches must add up back to the index level. more and more of the overall index spread widening was allocated to the equity portion of the tranche structure. Opening Marks 0-3 Hedged with Index -200 P&L (000) -700 -1200 -1700 -2200 1-Apr-05 Initial leg lower reflected risk of significant single-credit spread widening.855. Index-Hedged Equity P&L Delta-Hedged with the Index (Red Line) or Mezzanine (3% – 7%) Tranche (Gray Line) 1 Apr 05—10 May 05. The amount of spread available to other tranches declined. consider the following chart: 182 Credit Default Swap Primer Glen Taksler 646. In reality. autos. Spillover to the Broader Credit Market We also saw clear spillover to the credit index markets. and auto parts 0-3 Hedged with IG 3-7 Forced unwind accelerates losses in mezzanine-hedged equity 10-Apr-05 19-Apr-05 28-Apr-05 7-May-05 Source: Banc of America Securities LLC estimates. allowing mezzanine tranche spreads to actually tighten. Mezzanine-Hedged vs. the amount of spread available to other tranches declined. 2008 35 Figure 144. Hence. the move toward tighter mezzanine tranches in the face of wider index spreads probably reflected the unwind of existing correlation trades that were long equity risk and short mezzanine risk. allowing mezzanine tranche spreads to actually tighten One way to think of spread movements across the tranches is as follows. To see this impact. With the dramatic move lower in equity.
Credit Strategy Research May 27. it turned out that rather than being 2. hold-to-maturity investors such as insurers.25x the risk of the index. but it was the wrong sign However. Hence. the 7%–10% tranche tightened as spreads widened. Typically. 2005 the expected spread widening in the 7%–10% tranche was 54 bps (from 55 bps to 109 bps). they also lost money on the hedge position. To offset their risk. and the broken line illustrates the underlying investment grade index spread. from March 16. not only was the hedge ratio off (too high). As a source of positive carry. At the extreme.855. The 7%–10% tranche tightened. creating negative leverage. The thick gray line indicates the actual 7%–10% tranche spread. at an anticipated model leverage of 2. causing hedge mismatches on correlation books.25x.5 million of index protection for every $10 million in senior (7%–10%) tranche exposure.7559 183 . Actual Spread Widening in 7% – 10% Tranche Investment Grade (CDX IG) Indices Dealers and hedge funds rehedged to reduce the mismatch between expected and actual Expected or Actual Spread (bps) 110 100 90 80 70 60 50 40 16-Mar-05 Expected Spread: IG 7-10 Hedged With Index Actual Spread: IG 7-10 IG Index Spread 26-Mar-05 5-Apr-05 15-Apr-05 25-Apr-05 5-May-05 IG index spread reflects on-the-run five-year index (Series 3 until 20 Mar 05. During the same time period. Now look at what actually occurred. For simplicity. The corresponding short position is typically held by dealers and hedge funds. not only did dealers and hedge funds lose money on the short position in the tranche. there is a mixture of index and single-name hedging. it was the wrong sign. long positions in higher-quality (senior) portions of the tranche market are held by longer-term. For example. not only was the hedge ratio off (too high). Model Error: Model Forecasted vs. Credit Default Swap Primer Glen Taksler 646. implying an expected leverage of about 2. 2005 to May 10. the underlying investment grade index widened 24 bps. The thin red line indicates the model forecasted spread change for the 7%–10% (indicative AAA) tranche. Series 4 beginning 21 Mar 05). 2008 35 Figure 145. 127 In reality. On days when the overall market moved wider. Based on model estimates. See Figure 146. a highly unexpected result. At the extreme. this position was naturally attractive to the dealer and hedge fund community. senior tranches widened less than expected.25 times (54 bps divided by 24 bps). dealers 127 (or hedge funds) typically sell protection on the CDX index. we focus on CDX index hedging. Source: Banc of America Securities LLC estimates. dealers sold protection on about $22.
caused traditional investors to search for yield without hurting the ratings quality of their portfolio. High Grade Corporates Offered Limited Spread… 10y Sector Figure 148. Figure 148 illustrates that structured credit appeared to offer that opportunity.Mar. the hedge ratio needed to be reduced.7559 . dealers examined the strategies that led to losses.30% Empirical Model-predicted leverage shown as of April 1. Banc of America Securities High Grade Broad Market Index Source: Banc of America Securities LLC estimates.7%) Senior (7% 10%) 10% . Some dealers turned their attention to traditional. illustrated in Figure 147. 2008 35 Figure 146.Sep. Dealers and hedge funds needed to reduce their long position in the index. hold-to-maturity investors and more conservative hedging strategies. Source: Banc of America Securities LLC estimates. …Sending Investors to Structured Credit 10y CDX IG Index Indicative Rating: BBB+ 10y CDX IG 7%-10% Tranche Indicative Rating: A- 700 600 500 400 300 200 100 0 Mar. which led to significant buying of protection.Sep05 05 06 06 07 07 Cash Spread to Swaps (bps) 700 600 10y Spread (bps) 10y CDX IG Index 10y CDX IG 7%-10% Tranche Structured Credit Offers Yield Pick Up 500 400 300 200 100 0 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Source: Banc of America Securities LLC estimates. That is. 2005. which led to significant buying of protection To adjust for the mishedge.Credit Strategy Research May 27.855. The Hedging Mismatch Model-Predicted versus Empirical Leverage 1 Apr 05 – 25 May 05 Model-Predicted 40 35 30 25 20 15 10 5 0 -5 -10 Equity (0% 3%) Mezzanine (3% . This is why we saw investment grade spreads move wider. Leveraging Credit Following the May 2005 correlation crisis.15% 15% .Sep. dealers and hedge funds needed to reduce their long position in the index. The then-extremely tight credit spread environment. Leverage (x) Figure 147.Mar. 184 Credit Default Swap Primer Glen Taksler 646.
These products tended to mitigate default risk and increase mark-to-market risk by adding leverage. 2008 35 The search for yield while maintaining (then-) ratings led to the development of new products. Default risk works the same as the typical tranche subordination structure—for example. and leveraged super seniors. Leveraged Super Senior A leveraged super senior breaks down risk into two components. the tranche begins to lose principal after 15% of the underlying portfolio has suffered losses. the leveraged super senior (15%–30%) tranche suffers losses due to default risk at 15% and exhausts all notional at 30% of the underlying portfolio. the leveraged super senior has a mark-to-market trigger identified by the downward-sloping line. either the trade is terminated at mark-to-market levels or the investor increases cash collateral. Mark-to-market risk is based on the weighted averaged spread of the underlying portfolio. losses begin at 7% of the underlying portfolio and all tranche notional is exhausted after losses in 10% of the underlying portfolio. Mark-to-market trigger shown at trade inception. If in the first year there are no losses in the underlying portfolio and the weighted average spread exceeds 320 bps.Credit Strategy Research May 27. The triggers are set so that the overall mark-to-market loss on the portfolio is roughly constant throughout. 7% . the investor loses principal.7559 185 . Similarly.10% Already Lost All Notional. if losses are 4% in the first year. Figure 149 shows a sample structure: Figure 149. default risk and mark-to-market risk Underlying Portfolio Spread (bps) 400 350 300 250 200 150 100 50 0 0 Loss to Leveraged Super-Senior Only Loss to Both Structure s Mark-toMarket Trigger Loss to Leveraged Super Senior. Canadian conduits issued commercial paper and used the proceeds to buy then-highly rated assets like triple-A CMBS. In addition. Loss to 7% Original Portfolio Spread 10% Only 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Loss Rate (%) Sample portfolio structure. the investor gets back the extra collateral. The mark-to-market trigger is typically set so that the overall structure has a triple-A rating.855. the investor loses principal if the weightedaverage spread exceeds 250 bps. Similarly. Two such important products are the leveraged super senior and Constant Proportion Debt Obligation (CPDO). Particularly between 2005 and early 2007. How a Senior Tranche Compares to a Leveraged Super Senior Tranche Leveraged Super Senior Has Both Loss Rate and Mark-to-Market Triggers Initial underlying portfolio spread is 80 bps A leveraged super senior breaks down risk into two components. If the underlying portfolio spread reaches a predetermined threshold. Source: Banc of America Securities LLC estimates. If spreads then tighten back through the mark-tomarket trigger. cash CDOs. In the senior (7%–10%) tranche. The commercial paper’s interest cost was less than the Credit Default Swap Primer Glen Taksler 646. default risk and markto-market risk.
The CPDO investor always has the five-year on-the-run index even though the structure has a ten-year maturity date. the investor may have to post more collateral 80 10y CDX IG 30%-100% Tranche 10y CDX IG 30% . At 15 times leverage. CPDOs offered a triple-A rated spread of approximately Euribor+200 bps. Figure 150. For example. Now subtract a coupon of Euribor+200 bps and fees of roughly 20 128 There were also costs associated with creating and servicing the conduit. In the first round of issuance (2H06).Credit Strategy Research May 27. Figure 150 illustrates the underperformance of the CDX IG super senior (30% -100%) tranche during the credit crunch. Additionally. every six months. … Causing Leveraged Super Seniors to Approach Market Value Triggers If the Leveraged Super Senior trips a market value trigger. any credit that suffers a downgrade to high yield (split-rated or worse) would be dropped out of the index and therefore dropped out of the structure. This product often has 15 times initial leverage with a ten-year maturity. 2007 with 10x leverage. We estimate the tranche P&L by using the on-the-run 10y CDX IG index 30%-100% tranche spread. 186 Credit Default Swap Primer Glen Taksler 646.7559 . CPDOs achieved their high credit rating through the expected accumulation of reserves (the excess of coupon income earned over coupons paid out). actual triggers vary by deal. the average spread for five-year IG and iTraxx was roughly 30 bps. Source: Banc of America Securities LLC estimates.100% Tranche Spread (bps) 70 60 50 40 30 20 10 170 10y CDX IG Index 10y CDX IG Index Spread (bps) 150 130 110 90 70 100 Estimated Leveraged Super Senior NAV ($) 90 80 70 60 Leveraged Super Senior Price Market Value Trigger 50 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 On-the-run CDX IG series. in late 2006. the funded structure therefore earned three-month Euribor+450 bps.855. 50 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Example leveraged super senior product beginning March 22. This resulted in an S&P triple-A rating on the logic that the main risk was that an investment grade-rated credit could default within a six-month interval. Super Senior Spreads Widen Significantly… Figure 151. Constant Proportion Debt Obligations (CPDOs) A CPDO is a rolling five-year combination of the US and European investment grade CDS indices (CDX IG and iTraxx Main). In other words. The underperformance of the senior portion of the tranche capital strucucture caused some leveraged super seniors to breach or renegotiate unwind triggers. 2008 35 spread paid by the assets held in the conduit. with the difference taken as a fee for the 128 conduit sponsor. Source: Banc of America Securities LLC estimates. Market value trigger is an example.
Historical 5y CDX IG. Figure 153 shows that the significant widening in IG and iTraxx caused CPDOs to approach and. 2008 Figure 153. but that during the wides in March of 2008.7559 Blended 5y Index Spread (bps) 187 5y CDX IG Blended Spread 5y iTraxx NAV Unwind Trigger Blended Spread .855. their forced unwind triggers. 2007 to April 15 . Reserves were made available for potential losses from future defaults. which were set to an NAV of $10. in some cases even breach.Credit Strategy Research May 27. Figure 152 shows the historical 5 year CDX IG. Figure 152. 2008 35 bps. the blended spread was around 30 bps. However. spreads were closer to 175 bps. When CPDOs were initially issued. iTraxx and Blended CDX IG and iTraxx Spread CPDOs performance based on the blended spread of CDX IG and iTraxx From October 2. CPDOs Approached Unwind Levels 250 5y CDS Spread (bps) 200 150 100 50 120 100 CPDO NAV ($) 80 60 40 20 200 150 100 50 0 0 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Source: Banc of America Securities LLC estimates. Credit Default Swap Primer Glen Taksler 646. for net income (reserves) of approximately 230 bps. 0 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Source: Banc of America Securities LLC estimates. 5 year iTraxx and the blended spread between the two indices.
see Fully Transferable Obligation. The Clearing Corporation (page 72) – A clearinghouse that is working with CDS market participants to potentially act as a centralized Counterparty and guarantor of selected CDS trades. the ability to terminate an LCDS contract early. either without consent or with consent of the Reference Entity. XO (35 crossover). For Europe. not required by standard CDS documentation. parties typically post variation margin and may be required to post initial margin. Correlation desk (page 166) – The division of a bank or broker-dealer responsible for managing synthetic CDO risk. Includes IG (125 investment grade). To reduce risk. HY (100 high yield). if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. the trade continues between the original Counterparty and the new party. Asset Swap Spread (page 36) – Spread over LIBOR that an investor earns to swap a fixed-rate corporate bond to LIBORbased floating payments. Bankruptcy (page 18) – Typically a Reference Entity’s insolvency or inability to pay its debts.855. BWIC (page 166) – Bid wanted in competition.. at which a tranche begins to suffer principal losses. Also see Par CDS Equivalent Spread. Z-Spread. the trade is terminated. depends on the Reference Obligation and assets securing it. toward the end of 2008. Cheapest-to-Deliver (page 47) – The lowest-price obligation that the protection Buyer may deliver following a Credit Event. Defines the level of subordination in a synthetic CDO. and LCDX (100 leveraged loans). Assignment (page 110) – A trade transferred by an investor to another party. market expectations are in the process of moving to cash settlement. Parties retain the option to physically settle.7559 . Conditionally Transferable Obligation (page 154) – Only applies when the protection Buyer triggers a ModifiedModified Restructuring Credit Event (primarily for European-based Reference Entities). among a small number of counterparties.e. 188 Credit Default Swap Primer Glen Taksler 646. Signals tighter spreads. Cancelability (Early Termination) (page 168) – For North American Reference Entities. Typically attached to trade recaps. Attachment Point (page 179) – The level of cumulative losses in an underlying portfolio. May take effect for a small number of trades. provided that another market participant is willing to take the opposite position. 2008 35 Chapter VIII – Glossary ABX (page 175) – Index of credit default swaps on asset backed securities. Discounts the premium or discount portion of cash flows at LIBOR flat. the protection Seller pays the protection Buyer the difference between par and the market value of the cheapest-to-deliver obligation. i. Standard CDS documentation requires physical settlement. From the investor’s perspective. HVOL (30 high volatility investment grade). Counterparty Risk (page 68) – The risk that an investor’s counterparty may not pay cash flows when due. CDS Settlement Protocol (page 143) – Market procedure of allowing parties to cash settle a CDS contract approximately 30 calendar days following a Credit Event. Often used by correlation desks to sell protection. CDX (page 48) – Indices of credit default swaps referencing North American corporate issuers. For North America. CMBX (page 175) – Index of credit default swaps on commercial mortgage-backed securities. and I-Spread. CDSW (page 93) – Screen in Bloomberg to value a credit default swap. Also see Prepayment Event. but in practice. Adoption of a protocol is voluntary. Same as novation. Also see OWIC. Also see CDS Settlement Protocol. In reality. Requires that the protection Buyer deliver an obligation that is transferable to any entity that regularly engages in loan and securities markets. not to be unreasonably withheld. which allows parties to trigger a Credit Event.Credit Strategy Research May 27. Cash Settlement (page 8) – Approximately 30 calendar days following a Credit Event.
Also see Prepayment Event. Typically within two business days of a Credit Event. Modified Restructuring. and threshold amounts). Fixed Cap (page 174) – Limits the protection Seller’s liability in Pay As You Go CDS to the annual protection premium. Early Termination (Cancelability) (page 168) – For North American Reference Entities. and ModifiedModified Restructuring. Credit Default Swap Primer Glen Taksler 646. and for selected Reference Entities. single-name trades switch to a long coupon (first coupon due in four months. Failure to Pay. DV01 (page 103) – Sensitivity of the present value of a credit default swap to a 1 bp change in spread. ELCDS (page 169) – CDS on European leveraged loans. By market convention.g. Discount Factor (page 102) – LIBOR plus the implied probability of default. the ability to terminate an LCDS contract early. can be served by protection Buyer or protection Seller no later than 14 calendar days after the Scheduled Termination Date (maturity) of the CDS contract. Usually.. One party (the protection Buyer) agrees to pay another party (the protection Seller) periodic fixed payments in exchange for becoming entitled to a payment should a third party (the Reference Entity) or its obligations suffer one or more pre-agreed adverse Credit Events over a pre-agreed time period. usually includes Bankruptcy. margin requirements are due (initial margin. June. Credit Event (page 17) – A pre-agreed circumstance that allows parties to settle a credit default swap.. usually includes Bankruptcy. that the protection Buyer may deliver (or cash settle to) following a Credit Event.855. approximately equal to LIBOR plus ( spread / [ 1 – assumed recovery rate ] ).Credit Strategy Research May 27. Same as exhaustion point. Credit Event Notice (page 86) – Notice served to argue that a Credit Event has occurred. Day Count (page 93) – ACT/360 for standard credit default swaps. depends on the Reference Obligation and assets securing it. the final coupon payment includes the maturity date (e. Event Determination Date (page 86) – The official date of a Credit Event for CDS purposes and the last date on which the protection Buyer is responsible for paying accrued interest. Deal Spread (page 103) – Same as coupon and strike. Delta (page 181) – The hedge ratio for a duration-neutral trade. 2003 ISDA Credit Derivatives Definitions (page 9) – Standardized rules for CDS trades. For example. Credit Support Annex (page 65) – An optional document that pre-determines when. Same as detachment point. Depository Trust and Clearing Corp (DTCC) (page 66) – System used to electronically confirm credit derivatives trades. At a one-year horizon. September. March) through the 19 th of the current roll month (e. 2008 35 th Coupon Frequency (page 78) – Quarterly for corporate credit default swaps.g. on the 20 each of March. Failure to Pay. and in what increments. Failure to Pay (page 18) – A Reference Entity’s failure to pay interest or principal beyond any grace period specified in the relevant indenture. Credit Default Swap (page 8) – Bilateral contracts used to transfer credit risk among market participants. rather than one coupon due in one month and a second coupon due in three months). if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. an investor that buys $10 million protection on a 3x leveraged synthetic CDO may hedge by selling $30 million single-name protection on the underlying constituents. and December. June). typically a bond or loan. However. Typically allows parties to trigger a Credit Event. For Europe. June 20 ).7559 189 . For European corporate Reference Entities. one month before a quarterly CDS roll. Deliverable Obligation (page 19) – Obligation. For North American corporate Reference Entities. the protection Buyer must pay the premium from the 20 of the last roll month (e. Usually delivered at the same time as a Notice of Publicly Available Information. Exhaustion Point (page 179) – Loss level in an underlying portfolio for which the remaining tranche principal is zero. On a th th coupon date. Detachment Point (page 179) – Loss level in an underlying portfolio for which the remaining tranche principal is zero. variation margin.g.
Smaller impact that spread duration (DV01). broker-dealers. Inc. see Conditionally Transferable Obligation. Requires prime brokerage service. For Reference Entities located in Europe. who then faces the Counterparty in a separate CDS trade. that operating company’s debt is deliverable into CDS on the holding company. HVOL (30 high volatility investment grade). Jump to Default Risk (page 123) – Profit or loss resulting from a wide spread move or a Credit Event. based on CDS and an assumed recovery rate. Members include banks. LCDS (page 167) – CDS on leveraged loans. 2008 35 Fully Transferable Obligation (page 154) – Only applies when the protection Buyer triggers a Modified Restructuring Credit Event. limits Deliverable Obligation to bonds (not loans). Also see Par CDS Equivalent Spread. a broader class of guarantees applies. A trade association that represents participants in the derivatives industry. but may be shorter for a Modified or Modified-Modified Restructuring. Implicitly incorporates liquidity and mark-to-market risk. For example. Implied Forward Spread (page 105) – The market’s expectation of future spreads. Funding Cost (page 33) – The price an investor pays to borrow capital and the appropriate metric for CDS—cash relative value. Inside Market Midpoint (page 144) – An indication from banks and broker-dealers regarding the fair value of the cheapest-to-deliver obligation for a Reference Entity. where the holding company owns a majority of the operating company. Used to form a baseline for the final price in a CDS Settlement Protocol. IR01 (page 111) – The impact of interest rates on the present value of CDS. Give Up (page 67) – Allows a Counterparty to trade CDS without an ISDA Master Agreement. lower interest rates increase the present value of the gain. financials (25 senior or 25 subordinated). an investor who funds at LIBOR+50 bps should compare CDS to the cash bond spread to LIBOR+50 bps. Often agreed in a Credit Support Annex. XO (50 high yield). based on the current (spot) credit curve. A bank or broker-dealer faces the Counterparty’s prime broker. and investors. 190 Credit Default Swap Primer Glen Taksler 646. ISDA (page 9) – International Swaps and Derivatives Association. Includes iTraxx Main (125 investment grade). ISDA Master Agreement (page 65) – A governing document usually signed during the approval process for derivatives trading. Based solely on the yield and maturity of a bond. Initial Margin (page 68) – Requirement that a Counterparty post collateral at trade inception. not cash flows. rather than LIBOR flat.7559 . Limit Order (page 147) – An order to buy or sell bonds at a specified price. Usually applies to hedge funds that sell protection (at any spread) or buy protection at wide spreads. Requires that the protection Buyer deliver an obligation that is fully transferable to an eligible assignee. Essentially. iTraxx (page 48) – Indices of credit default swaps referencing European corporate issuers. lower interest rates increase the present value of the loss. and therefore usually overstates Credit Event risk.855. For investors with a mark-to-market loss. For investors with a mark-to-market gain. Used to clear net open interest in CDS Settlement Protocols. Z-Spread. Index Abitrage (page 51) – Strategy to trade the difference between an index and its underlying intrinsics. I-Spread (page 35) – Yield difference between a cash corporate bond and a matched-maturity swap yield. Additional series exist for Asia. For Europe. Guarantees (page 138) – For Reference Entities located in North America. Often results in a haircut for protection Buyers who want to unwind or assign trades with significant profits. and LevX (75 senior or 45 subordinated leveraged loan). The guarantee must be unconditional and irrevocable. Typically 30 years for a Bankruptcy or Failure to Pay. Implied Probability of Default (page 100) – The implied probability that a Reference Entity suffers a Credit Event. and Asset Swap Spread. Maturity Limitation Date (pages 77 and 154) – The maximum maturity of the obligation that a protection Buyer may deliver following a Credit Event. if a holding company (parent) guarantees an operating company (subsidiary).Credit Strategy Research May 27.
Standard CDS documentation requires physical settlement.Credit Strategy Research May 27. OAS to LIBOR is the same as Z-spread. Assumes a recovery rate to keep total credit risk equal between the cash and CDS markets. and I-Spread. Referenced in standard CDS confirmations. Allows the protection Buyer to deliver debt that is wrapped (guaranteed) by the monoline insurer. Negative Basis Trade (page 30) – Trade in which an investor buys protection and buys a cash bond of the underlying Reference Entity. as a result of a Credit Event. Also see Z-Spread. Notice of Physical Settlement (page 86) – Details of the Deliverable Obligations that the protection Buyer will deliver to the protection Seller for physical settlement. without an assumption of zero volatility. in the location of the investor. For bullet bonds. PCDS (page 177) – CDS on preferred securities.. distressed ratings downgrade. Deliverable Obligation Characteristics. OAS to LIBOR (page 40) – Option-adjusted spread to LIBOR. two-thirds of which consent to the Restructuring. in addition to the direct debt of a Reference Entity— i. Also see CDS Settlement Protocol.e. Same as assignment. Also see Multiple Holder Obligation.855. and maturity extension. Usually delivered at the same time as a Credit Event Notice. To execute an assignment. the protection Buyer delivers a bond or loan to the protection Seller. typically from two internationally recognized. In reality. Net Open Interest (page 147) – The net desire of the CDS market to buy or sell bonds. and similar features of CDS contracts. but in practice. the investor must receive consent from the original Counterparty by 6pm. 2005 Monoline Supplement (page 160) – Standardized rules for CDS on monoline insurers. on the day an assignment is agreed to. the trade is terminated. Used in CDS on ABS. Used in CDS Settlement Protocols. From the investor’s perspective. Restructured obligation must have at least 4 unaffiliated lenders. Also see Multiple Holder Obligation. Asset Swap Spread. Modified-Modified Restructuring (page 152) – Primarily used for European corporate Reference Entities. Physical Settlement (page 8) – Approximately 30 calendar days following a Credit Event. market expectations are in the process of moving to cash settlement. Credit Default Swap Primer Glen Taksler 646. Limits the maturity and transferability of obligations that a protection Buyer may deliver following a Restructuring Credit Event. Physical Settlement Matrix (page 77) – Document to clarify Credit Events. Limits the maturity and transferability of obligations that a protection Buyer may deliver following a Restructuring Credit Event. the trade continues between the original Counterparty and the new party. bond or loan—that is deliverable under standard CDS contract language. Notice of Publicly Available Information (page 86) – Contains proof of a Credit Event.7559 191 . with a spread pickup. 2008 35 Modified Restructuring (page 152) – Primarily used in single-name CDS for North American corporate Reference Entities. If the investor does not receive consent by 6pm. OWIC (page 166) – Offer wanted in competition. Must be delivered within 30 calendar days of the Event Determination Date. Orhpaned CDS (page 138) – A CDS contract on a Reference Entity that has no Deliverable Obligation. Signals wider spreads. published or electronically displayed news sources. which were rated investment grade when they began trading in the CDS market. Novation (page 110) – A trade transferred by an investor to another party. the assignment will instead be booked as a new trade. Not suitable for callable or putable bonds. Also see BWIC. Multiple Holder Obligation (page 154) – Requirement to trigger a Modified or Modified-Modified Restructuring Credit Event. Pay as You Go (PAUG) (page 172) – CDS contracts focusing on Soft Credit Events such as failure to pay principal. 2005 Novation Protocol (page 83) – Market procedure to reduce risk surrounding assignments. and receives par. Par CDS Equivalent Spread (page 41) – Spread to LIBOR for a cash bond that makes an investor indifferent between choosing the cash bond and CDS. writedown.
of the trade. not the security. May allow parties. REDL (page 17) – Screen in Bloomberg that often shows the market standard for Reference Entities and Reference Obligations. 192 Credit Default Swap Primer Glen Taksler 646. the event that causes Early Termination to occur. found on the REDL screen in Bloomberg. Remaining Party (page 83) – In an assignment. Roll (page 94) – The process of changing the on-the-run maturity date for CDS contracts. Typically a large and liquid bond issue.855. 2008 35 Points Upfront (page 108) – A convention whereby the protection Buyer pays a fixed 500-bp coupon in single-name CDS and settles the present value of any spread difference upfront. times the trade notional. Recovery Lock (page 170) – CDS contracts that allow an investor to take a view on recovery rates rather than outright Credit Event risk. Relevant Obligation (page 132) – Obligations considered for CDS Succession purposes. Also see Protection Seller. and December) and semiannual for indices. Protection Buyer profits (protection Seller loses) 100% minus the recovery rate. may occur if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. CDX and iTraxx indices use points upfront with different coupons. the party that originally faced the Transferor but now faces the Transferee as Counterparty. to trigger a Credit Event. Before entering into a trade. September. Reference Obligation (page 19) – An obligation that establishes the seniority of CDS within the capital structure.7559 .Credit Strategy Research May 27. Recovery Rate (page 45) – Roughly speaking. Prepayment Event (page 168) – In LCDS. Used in CDS Settlement Protocols. June. For Europe. should a third party (the Reference Entity) or its obligations suffer one or more pre-agreed adverse Credit Events over a pre-agreed time period. See Physical Settlement. establishes only the seniority. Single-Tranche CDO (page 179) – A slice of risk on a pool of securities. particularly the protection Buyer. or change in the priority of payment of an obligation that causes the subordination of such obligation to any other obligation. should a third party (the Reference Entity) or its obligations suffer one or more pre-agreed adverse Credit Events over a pre-agreed time period. Usually takes effect once five-year CDS approaches the 700bp range. Also see Protection Seller. Also see Early Termination (Cancelability). Restructuring (page 152) – Usually refers to a reduction of interest or principal. Usually involves subordination (attachment point) and a detachment point. Often the same as Deliverable Obligations but without a maturity limitation. Request for Physical Settlement (page 146) – The desire of a bank or broker-dealer and any CDS market participants it represents to buy or sell bonds as a result of a Credit Event. Quarterly for corporate singleth name (the 20 each of March. In plain-vanilla corporate CDS. agree on a Reference Entity and Reference Obligation with your Counterparty. For North American Reference Entities. Settlement (page 8) – The process of exchanging cash flows after a Credit Event. depends on the Reference Obligation and assets securing it. Other criteria also exist. Protection Buyer (page 8) – The party that makes periodic fixed payments in exchange for being able to receive a payment. See Modified Restructuring (North America) and Modified-Modified Restructuring (Europe). Note: REDL is not always correct. Protection Seller (page 8) – The party that receives periodic fixed payments in exchange for being required to make a payment. maturity extension. Also see Succession. Cash Settlement. and CDS Settlement Protocol. the mark-to-market on the cheapest-to-deliver obligation approximately 30 calendar days following a Credit Event. Secured CDS (page 169) – CDS contracts that require the Deliverable Obligation to be secured with at least all of the assets that secure the Reference Obligation. Reference Entity (page 19) – The legal entity on which a CDS contract is written.
Also see Transferee and Remaining Party. Often agreed in a Credit Support Annex. Synthetic CDO (page 179) – A collateralized debt obligation referencing a pool of credit default swaps. Settled in present value terms. discount. Also see Transferor and Remaining Party. Transferor (page 83) – In an assignment. but ignores the different recovery rates of par. Soft Credit Events include failure to pay principal. distressed ratings downgrade. 2008 35 Soft Credit Events (page 172) – Credit Events designed to reflect a change in cash flows for an underlying Reference Obligation rather than default risk. Also see Par CDS Equivalent Spread. Succession (page 132) – Changes to a CDS contract that may occur when a Reference Entity is merged. Unwind (page 109) – The termination of an existing trade with the original Counterparty. and maturity extension. Z-Spread (page 38) – Option-adjusted spread to LIBOR under an assumption of zero volatility.855. Subordination (page 179) – The percent of a CDO capital structure that must be wiped out before a tranche begins to suffer principal losses.Credit Strategy Research May 27. Incorporates the shape of the yield curve and the timing of cash flows. Credit Default Swap Primer Glen Taksler 646. Usually involves subordination (attachment point) and a detachment point. Strike (page 103) – Same as coupon and deal spread. Asset Swap Spread. Threshold Amount (page 71) – The level of mark-to-market profits beyond which Counterparties are required to exchange variation margin. writedown. Often exchanged daily and agreed in a Credit Support Annex.7559 193 . or undergoes some other change to its corporate structure. acquired. Termination Event (page 72) – Criteria specified in an ISDA Master Agreement that may allow a party to force an unwind of all existing trades with a Counterparty. Tranche (page 179) – A slice of risk on a pool of securities. and I-Spread. the party that transfers a trade. and premium bonds. Also see Relevant Obligations. Underlying Portfolio (page 179) – The pool of credit default swaps referenced in a synthetic CDO. Variable Cap (page 174) – Limits the protection Seller’s liability in Pay As You Go CDS to LIBOR plus the annual protection premium Variation Margin (page 71) – Requirement that Counterparties exchange mark-to-market profits beyond a pre-established threshold amount. the party to whom a trade is transferred. Also see Synthetic CDO. Also see SingleTranche CDO. Not suitable for callable or putable bonds. Used in CDS of ABS. Transferee (page 83) – In an assignment. Used in both synthetic CDOs and cash structured products.
Materials prepared by BAS and affiliate research personnel are based on public information. over the next six months. Such persons may own diversified mutual funds. 2006. namely the BAS BMI. 2008 35 REG AC — ANALYST AND FIRM CERTIFICATION The research analyst whose name appears on the front page of this research report certifies that: (1) all of the views expressed in this research report accurately reflect his or her personal views about any and all of the subject securities or issuers. company. BAS and affiliate policy prohibits research personnel from disclosing a rating. dated November 24. is or will be. As of 05/01/2008. over the next six months. the company has improving credit fundamentals and/or it is trading at a notable spread concession relative to bonds of comparable risk within the sector. BAS and its affiliates are regular issuers of traded financial instruments linked to securities that are mentioned in this report. their fixed income department and each security asset class is generated by investment banking business. but does not have any impact on the analyst’s “Buy. BANC OF AMERICA SECURITIES RATINGS DISCLOSURES BAS High Grade and High Yield Research employ a Buy/Neutral/Sell rating system. 194 Credit Default Swap Primer Glen Taksler 646. “Hold” is equivalent to our “Neutral” rating. (ii) the profitability of the fixed income department of BAS and its affiliates and (iii) the profitability of BAS and its affiliates from the fixed income security asset class covered by the analyst or associate. their associates and members of their households from maintaining a financial interest in the securities or options of any company that the analyst covers except in limited circumstances as permitted by BAS and affiliate policy. related to the views or results produced by the Credit OAS quantitative model. therefore going long credit risk. Market Weight: The sector is expected to perform in line with excess spread returns of High Grade corporate indices.” or “Neutral” rating (which is based on a 6month investment horizon). directly or indirectly. Neutral: Spreads and / or total returns are likely to perform equal to or near sector averages over the next six months. To the extent that any of the views expressed in this report have been produced as a result of the application of the Credit OAS quantitative proprietary model. Buy: Spreads and / or total returns are likely to outperform sector averages over the next six months. namely the BAS Broad Market Index (BAS BMI). The sector recommendation time horizon is determined by the expected performance over the next six months. Buy: We recommend that investors buy protection in CDS. recommendation or investment thesis for review by an issuer prior to the publication of a research report containing such rating.” “Sell. 37 46 17 Investment Banking Clients Buy Hold Sell Recommendations 101 139 54 Pct. Any such direct securities ownership by the analyst(s) preparing this report is disclosed above. and these recommendations carry a time horizon of six months. Underweight: The sector is expected to underperform excess spread returns of High Grade corporate indices. the company may have weakening credit fundamentals and/or it is trading at a notable spread premium relative to bonds of comparable risk within the sector. This report may contain a trading call which highlights a specific identified near-term catalyst or event impacting a security. Portfolio Analytics and Data Analysis. the company generally has solid credit fundamentals and/or it is trading in line relative to bonds of comparable risk within the sector. BAS and its affiliates prohibit analysts. Overweight: The sector is expected to outperform excess spread returns of High Grade corporate indices. Trading calls may differ directionally from the analyst’s rating on a security or company because they reflect the impact of a nearterm catalyst or event. is. over the next six months. Sell: Spreads and / or total returns are likely to underperform sector averages over the next six months.855. using Overweight/Market Weight/Underweight. Banc of America Securities LLC (BAS) and its affiliates certify that (1) the views expressed in this report accurately reflect the Credit OAS quantitative model as to the securities and companies mentioned in the report and (2) no part of the firm’s compensation from any company mentioned in this report was.Credit Strategy Research May 27. These include (i) the overall profitability of BAS and its affiliates. industry sector or the market generally that presents a transaction opportunity. High Grade and High Yield Research use the following rating system with respect to Credit Default Swaps (CDS).** 39 43 47 * For the purposes of this Rating Distribution. For a description of the Credit OAS proprietary credit evaluation model. Research analysts and associates do not receive compensation based upon revenues generated from any specific investment banking transaction. A portion of the profitability of BAS and its affiliates. High Grade Research also employs a formal structure to define sector performance. Sell: We recommend that investors sell protection in CDS. or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research report. please see Introduction to Lighthouse: Credit Option Adjusted Spread. ** Percentage of recommendations in each rating group that are investment banking clients. and (2) no part of the research analyst’s compensation was. Neutral: We are neutral on CDS and expect performance in line with sector performance.7559 . Rating Distribution* Coverage Universe Buy Hold Sell Recommendations 262 321 116 Pct. namely the BAS BMI. but sector recommendation changes may occur at any time based upon sector analysis and relative value. Further information on any security or financial instrument mentioned herein is available upon request. including the data input into the model. recommendation or investment thesis. IMPORTANT CONFLICT OF INTEREST DISCLOSURES The analyst and associates responsible for preparing this research report receive compensation that is based upon various factors. The absence of any such disclosure means that the analyst(s) preparing this report does(do) not have any such direct securities ownership in his or her covered companies mentioned in this report. therefore going short credit risk.
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