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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
Below. Consequently. the industry is developing netting proposals to more accurately reflect net credit exposure. to $62 trillion. please see “The Credit Derivatives Market” on page 9.2% in total return. As of December 2007. Both banks have zero net default exposure ($10 million – $10 million = zero). even though net credit exposure will be unchanged. if an institution makes a mistake on a trade. credit derivatives have become a subject of significant market and regulatory attention. causing CDS market size to increase. the systemic risk of credit derivatives is far less than the headline $62 trillion notional. and high yield 1. their market value as of December 2007 was $96. not net. In cash market terminology. 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. if an investor buys protection in an index and sells protection in each of the underlying constituents. please see “The $62 Trillion Question” on page 11. Similarly. The goal is that. The International Swaps and Derivatives Association.50. 2008 35 Introduction As this publication goes to press. although the exact impact is unclear. compared 1 with about $14 trillion in corporate bond notional.Credit Strategy Research May 27. and a different trader at Bank A sells $10 million protection to Bank B. if trades were implemented at $100.7559 . Since that time. reported CDS notional will grow. First. credit exposure. A week later. the size of the CDS market may grow without any change in overall risk. The main theme is that rapid growth involves risks. we address these topics in more detail. along with the current state of the market.5%. Second. Of this. Inc. who buys $10 million protection from Bank B.855. gross market value would increase. investment grade credit has lost about 1. There are two issues. In 2005. To be clear. that suggests a current gross market value in credit 2 derivatives of $3 trillion.’s (ISDA) 2007 yearend market survey estimates that credit derivatives notional grew 81% in 2007. under many circumstances. the Bank of International Settlements (BIS) estimates that the gross market value of credit derivatives contracts was 3. this is a back-of-the-envelope estimate: If spreads were to widen further. the CDS market is subject to double-counting of risk. spreads widen. In this light. because two different traders transacted. The CDS market’s $62 trillion headline size is drastically larger than its overall economic impact Yet. CDS Market Size Considerable concern has been raised over rapid growth in the credit derivatives market. the majority 1 2 For more details. approximately $20 trillion is single-name CDS (globally). For example. For more details. particularly in a volatile trading environment. with a total notional of $20 million. But. CDS operational efficiency has improved substantially in recent years. 4 Credit Default Swap Primer Glen Taksler 646. that error should be quickly discovered and corrected. regardless of the reason. headline market size estimates are drastically larger than the overall economic impact of the CDS market.5%. Throughout this Credit Default Swap Primer. CDS market surveys focus on gross. we comment on some “hot topic” issues. typically. Consider a trader at Bank A. Roughly speaking. Through the ISDA trade association. the institution will record two separate trades.
Counterparty Risk As an unfunded market. the CDS market began work on a clearinghouse to guarantee selected trades.org. not just credit derivatives. Credit Default Swap Primer Glen Taksler 646.3 trillion in each of 2006 and 2005. This resulted in a trade backlog. For example. with quarterly coupon payments reconciled by the manual exchange of spreadsheets. the benefits of a highly functioning CDS market outweigh potential losses on To mitigate potential risks associated with rapid growth. ISDA estimates that there was approximately $2. through the Depository Trust & Clearing Corporation (DTCC). as of year-end 2007. the market continues to develop a series of voluntary solutions. please see the section “Counterparty Risk and Leverage” on page 68. this proposal may take effect for a small number of trades. 90% of total trades) settle 3 electronically. they still face challenges in a growing market. called “protocols. Although credit derivatives face challenges. about 95% of credit default swaps are eligible for electronic settlement. and the other suffers. Now. the CDS market requires parties to post collateral (margin). up from $1.markit. CDS Contract Language Standard CDS contracts are governed by the 2003 ISDA Credit Derivatives Definitions. Of those eligible trades. 6 ISDA Margin Survey 2008.9x in 2006.” When agreeing to a protocol.isda. investors would face the clearinghouse.9x for interest rate derivatives and 13. CDS market participants promise to exchange cash flows following a potential Credit Event. 7 For more details. according to Markit Group Ltd. trades would be netted across parties. Yet. The 2007 estimate 4 compares with 9. available from http://www. from 4.org. all remaining members would be responsible for a proportionate share of trades. In its early stages. Recently. they fare favorably to other derivatives produts from an operations perspective However. ISDA estimates that 90% of electronic confirmations are normally sent by T+1. if a clearinghouse member were to default. available from http://www. To preserve the spirit of CDS contracts. called “protocols” 3 4 http://www. To manage Counterparty risk. the CDS market has increased collateral requirements and is working on a clearinghouse to guarantee selected trades Recognizing this risk. creating an issue of Counterparty risk. Although no one knows exactly how much collateral is required to effectively manage Counterparty risk. where unsigned confirmations—those trades executed but not yet confirmed—piled up in back and middle offices. while credit derivatives fare favorably to other product areas from an operations 5 perspective. As such. To reduce outstanding notional.3x for equity derivatives.6x the daily volume of new trades in 2007. the immediate effect is that one party benefits. There are no hard assets set aside to guarantee payment. Effectively. and ISDA 2007 Operations Benchmarking Survey. most investors seem to recognize that. toward the end of 2008. among a small number of 7 parties. please see “Goals for CDS Operations Management” on page 67. if a protocol results in a lower recovery rate.html Preliminary results of ISDA 2008 Operations Benchmarking Survey.1 trillion in collateral in circulation. For year-end 2007.. 5 For more details. Rather than face banks or broker-dealers as Counterparties.isda. the CDS market continues to develop a series of voluntary solutions. Now five years old. for their overall portfolio. ISDA also estimates that unsigned credit derivatives confirmations rose to 6. the protection Buyer benefits.7559 5 .Credit Strategy Research May 27.855. 2008 35 of CDS trades were confirmed by facsimile. 6 These numbers are across all derivatives transactions.com/information/products/metrics. these Definitions did not fully anticipate the extent of CDS market expansion and current market conditions. another nearly 95% (i.e.
in 2005. A debate ensued as to whether this structure would cause some existing Verizon CDS notional to succeed. For example. As a result. Currently. If the protection Buyer cannot do so. Verizon spun off its directories business. 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. standard CDS contracts require the protection Buyer to deliver a bond or loan to the protection Seller. to Idearc. and then hedge the transaction with a new trade at par. tax-efficient corporate finance structures sometimes has created uncertainty as to how CDS contracts should be treated following a spin-off. If a credit default swap were. there are 8 plans to eventually hard-wire such provisions into CDS contracts. with its wider high yield spreads. the bank or broker-dealer will lose 15 points: 8 9 For more details. in 2006. an ISDA 9 working group has been formed to try to develop a solution. he may (eventually) forfeit the right to receive par from the protection Seller. While not guaranteed. While not guaranteed. merger. consider a protection Buyer who looks to profit 15 points. Similar uncertainty exists surrounding the effect on CDS contracts from a potential split of monoline insurers into separate municipal bond and structured finance businesses. A bank or broker-dealer that accepts this trade must pay the investor 15 points. please see “Succession—How Corporate Finance Affects Credit Derivatives” on page 132. few investors would be willing to buy protection in the future. please see “CDS Settlement Protocols” on page 143. In other words. 2008 35 individual trades. please see “Special Issues Pertaining to CDS on Monoline Insurers” on page 158. 6 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. Although the eventual outcome is unclear. the market to potentially cash settle to) any debt obligation directly wrapped by the monoline. or change Reference Entity. thus reducing short squeezes as protection Buyers no longer have to locate bonds. Changes in Corporate Finance Structure The development of new. As part of the transaction. Risk of a Short Squeeze Following a Bankruptcy. the vast majority of investors have voluntarily agreed to cash settle CDS contracts following recent bankruptcies. standard CDS contracts allow the protection Buyer to deliver (by extension. to recover par. say. For more details. causing potential market disintegration. the price of the CDS contract has fallen from par to $85 ($100 – $15).7559 . However. There is some potential that monoline CDS notional could be divided between the two businesses or move entirely to the municipal bond business. some protection Buyers have found it difficult to unwind singlename CDS trades and realize profits. Monoline Insurers For CDS referencing monoline insurers. there may be wide disparity in the price and liquidity of such obligations. making it particularly difficult to settle CDS contracts should a monoline Credit Event ever occur. 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. bond prices started to short squeeze considerably following bankruptcies—the price of Delphi bonds rose from $58 to $72 after the company declared bankruptcy. For example. 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. or acquisition. 10 For more details.855. 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).
Credit Strategy Research May 27. Credit Default Swap Primer Glen Taksler 646. with appendices on more advanced topics. Until the market develops a solution. such as rolling to on-the-run contracts and taking profits in small chunks. 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. 2008 35 Bank or broker-dealer buys protection from investor. “More on Jump to Default Risk – Take CDS Profit in Small Chunks“ on page 123 discusses strategies for managing unwind risk. For more current views on credit derivatives strategy. This primer is organized by chapter.855. please see our daily Situation Room and biweekly Credit Market Strategist publications. buying protection on unwind or assignment becomes less valuable to the bank or broker-dealer.7559 7 .
credit default swaps allow users to take unfunded.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. customized credit risk positions.855. are available. In this instance. 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. In addition. Figure 2 illustrates the mechanics of a credit default swap. etc. One party (the protection Buyer) agrees to pay another party (the protection Seller) periodic fixed payments. 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. represent inflexibly bundled market and credit risks. as such. 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. 8 Credit Default Swap Primer Glen Taksler 646. These cash market limitations are more accentuated when investors seek to express a bearish view. 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. Unlike other financial instruments. Traditional cash instruments are inherently funding vehicles and. Figure 2.7559 . investment in bonds or term loans can subject investors to either undesired interest rate risk or additional expense in hedging out this risk. one of the following takes place: Cash Settlement Par . 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. seniority. 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. 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.Credit Strategy Research May 27.
please see page 129. Figure 3 provides a sense of the growth in notional volume of credit default swaps (CDS) since 1997. Since credit derivatives have no such requirement. credit default swaps make the credit markets more accessible to investors who have higher funding costs. credit default swaps allow investors to separate the credit decision from the funding decision.Credit Strategy Research May 27. a credit default swap allows protection Buyers to fix protection costs for the life of the CDS. because it allows the transfer of risk from a single party—for example. reflects the credit rating of the particular Counterparty. including initial and variation margin. relative to the corporate bond market. The Credit Derivatives Market While the precise size of the credit derivatives market is not known. Inc. seniority and Credit Events. The total cost of funding. 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. but precise documentation remains the responsibility of the parties involved. As unfunded products. The Definitions provide a basic framework for documentation. a bank lending a large loan facility—to a wide group of investors. so to speak. In this sense. In May 2003. the documentation evidencing the transaction—is based on definitions set forth by the International Swaps and Derivatives Association. (ISDA). a trade association. These Definitions build on a substantial case history of the CDS market. a house. expanding and revising the 1999 Definitions and Supplements. Credit Default Swap Primer Glen Taksler 646. 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. because credit default swaps are bilateral contracts. Credit default swaps also provide flexibility in expressing credit risk views on maturities. the 2003 ISDA Credit Derivatives Definitions took effect. 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. it is clear that the market has grown and gained significant strength in recent years. This distinction is intentional. As such. For details.7559 9 . they are not considered insurance. the legal framework of CDS—that is. among two parties on a third entity—provide more flexibility for expressing investment views on credit risk. 2008 35 By contrast. without regard to the availability of a physical market instrument. With few exceptions. for example.855. credit default swaps—as side agreements.
to $62 trillion The International Swaps and Derivatives Association. compared with 32% during the second half of 11 2006.0 trillion in mid-year 2006.’s (ISDA) 2007 year-end market survey estimates that CDS notional grew 81% in 2007. Estimated Growth in Single-Name and Total CDS Notional.7559 $ Trillions . despite recent market conditions. 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.2 trillion in year-end 2007 vs. ISDA estimates that CDS notional grew 37% during the second half of 2007. Cash Notional—Estimates are for the total notional of the global corporate bond market.855. Total CDS Notional-Estimates are for total notional of the global credit derivatives market.5 trillion in mid-year 2007. please see the Chapter Appendix on page 23. but non-traditional products have grown rapidly: 11 $62. for a 32% growth rate. and $34.Credit Strategy Research May 27. ISDA estimates that CDS notional grew by 81% in 2007. Sources: Bank of International Settlements. $26. ISDA. For further details. 10 Credit Default Swap Primer Glen Taksler 646. to $62 trillion. Banc of America Securities LLC estimates. Moreover. Banc of America Securities LLC estimates. for a 37% growth rate. including synthetic CDOs and index products. 2008 35 Figure 3. Federal Reserve. Sources: ISDA. $45. British Bankers Association. Inc.4 trillion in year-end 2006 vs. Single-name CDS has the greatest market share by product.
The single-name CDS market is estimated at $20 trillion for 2007 Based on the overall CDS market size shown in Figure 3. The index market expanded to an estimated $18 trillion in 2007. Tranches) 29% Synthetic CDOs 16% Sources: British Bankers Association. The next release is expected in 2008. under many circumstances. 2008 35 Figure 5. Both banks have zero net default exposure ($10 million – $10 million = zero). In cash market 12 Synthetic CDOs are debt obligations representing a pool of credit default swaps. (The CDX credit derivatives indices began trading in October 2003. CDS Product Usage. who buys $10 million protection from Bank B. Other includes total return swaps. even though net credit exposure will be unchanged. and equity linked products. the size of the single-name CDS market is pegged at $20 trillion for 2007. reported CDS notional will grow. Forecast 2008 Basket products 1% Options 3% Other 8% Single-name CDS 30% Figure 4. not net. First. we multiply the 2008 forecast market share from Figure 5 by the 2007 total CDS notional from Figure 3. Banc of America Securities LLC estimates. Synthetic CDO volume declined substantially in the second half of 2007. credit exposure.) The $62 Trillion Question Headline market size is drastically larger than the overall economic impact of the CDS market. typically. 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. from $319 billion in 2003. spreads widen.7559 11 .Credit Strategy Research May 27. compared to $2 trillion in 2003. A week later. CDS Product Usage. the institution will record two separate trades. Similarly. We emphasize that the 2008 forecast market share was made in 2006. if an investor buys protection in an index and sells protection in each of the underlying constituents. Synthetic CDO market notional was an estimated $10 trillion in 2007. the size of the CDS market may grow without any change in overall risk. causing CDS market size to increase. Banc of America Securities LLC estimates. Sources: British Bankers Association.5%. up from $570 12 billion in 2003. As of December 2007. because two different traders transacted. There are two issues. as discussed in “The Synthetic CDO Market” on page 166. To estimate the size of the synthetic CDO market. Second. the CDS market is subject to double-counting of risk. and a different trader at Bank A sells $10 million protection to Bank B. the industry is developing netting proposals to more accurately reflect net credit exposure. Through the ISDA trade association. No survey was released in 2007. the Bank of International Settlements (BIS) estimates that the gross market value of credit derivatives contracts was 3. Consider a trader at Bank A. with a total notional of $20 million.855. Credit Default Swap Primer Glen Taksler 646. CDS market surveys focus on gross. so this forecast is from before the onset of the credit crunch. But. 2003 Total return swaps 4% Credit linked notes 6% Tranched Index 2% Index (Excl. asset swaps. before the onset of the credit crunch. For example.
following British Bankers Association estimates from 2006. broker-dealers generally try to run more evenly balanced trading books. out of increased ROE focus and desire to diversify credit exposure. Add the BIS estimate of -3. so estimates are not available for 2007. Breakdown of Buyers and Sellers of Protection Banks and dealers are both Buyers and Sellers of protection To date.2% in total return. Since that time. and relative value between CDS and cash. The CDS market is working to improve netting of trades. 14 We emphasize that this is a back-of-the-envelope estimate.7559 . The next release is expected in 2008. hedge funds are typically total-return investors. Their overall position in the CDS market grew from about 15% in 2003 to 30% in 2006. investment grade credit has lost about 1. as discussed in the section “Counterparty Risk and Leverage” on page 68. would widen quotes—and therefore losses—drastically. A mass unwind of derivatives trades. and as Sellers. that suggests a current gross market value in credit 13 derivatives of $3 trillion. banks and dealers have been the dominant CDS players as both Buyers and Sellers of credit default protection. the systemic risk of 14 credit derivatives is far less than the headline $62 trillion notional. should such a scenario ever occur. Although the exact figure is unclear. Banks’ prominence as protection Buyers is in part a natural outgrowth of their desire to hedge their substantial credit exposure. and are now the fastest-growing participants in this rapidly expanding market. as of May 22.Credit Strategy Research May 27.3%. 12 Credit Default Swap Primer Glen Taksler 646. with a focus on the 15 riskiest parts of the capital structure. for an estimate of $3 trillion gross market value.855. we assume a 70% investment-grade and 30% high-yield market share. if trades were implemented at $100. As market makers. Netting agreements between counterparties.5% high yield return x 30% market share). and high yield 1. Multiply the result by $62 trillion notional. Hedge funds also have emerged as large Buyers and Sellers of protection. which are excluded from our analysis. Moreover. 2008 35 terminology. their market value as of December 2007 was $96. 2008 ( -1.7%. Hedge funds are the fastest-growing participants 13 Total return estimates based on the CDX IG and CDX HY indices.5% from December 2007.5%.50.2% investment grade return x 70% market share – 1. for a total CDS market value of -4. which are discussed in “CDX and iTraxx Indices” on page 48. leading to increased participation as Buyers of protection. would partially offset these losses. The total estimated CDS return is -1. Roughly speaking. Using these estimates. 15 The British Bankers Association releases surveys bi-annually. but are becoming more active in managing their portfolios of credit risk. contributing to a general perception that CDS has higher volatility than the corporate bond market. Hedge funds have two main motivations for participating in the CDS market: the opportunity to use higher leverage than other markets allow.
Banc of America Securities LLC estimates. According to Moody’s Investors Service. The next release is expected in 2008.” March 11.” However. accounting for 87% of market debt In high grade. Sources: British Bankers Association. Figure 8 shows a more detailed breakdown of high grade CDS issuer representation by sector: 16 In recent months. they represent approximately 87% of the market value of high grade debt. Owing to their high rating. Buyers of Protection. CDS Issuer Composition High Grade About 63% of high-grade issuers trade actively in the CDS market. provides a cushion for potential loss of 16 principal on the credit portfolio. 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. 2006 Pension funds Corps. Sources: British Bankers Association. The next release is expected in 2008. “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. Banc of America Securities LLC estimates. 1% Banks and Dealers (Trading Portfolios) 33% Corps. Sellers of Protection. Credit Derivative Product Companies (CDPCs) are a relatively new class of protection Sellers. “Credit Derivative Product Companies 2007 Sector Review and 2008 Outlook. because CDPCs do not post initial margin. The need for yield has led to participation in the credit derivatives market through selling protection on single-name and. to a lesser extent. 2% 5% Mutual funds 3% Hedge funds 31% Hedge funds 28% Loan Portfolios 7% Loan Portfolios 20% Insurers 18% No survey was released in 2007.7559 13 . some Counterparties have expressed concern about trading with CDPCs. 1% Banks and Dealers (Trading Portfolios) 39% Figure 6. in the form of common stock. CDPCs are triple-A rated investment vehicles that sell protection. Equity. CDPCs are exempt from initial margin requirements. Volume is greatest at a five-year maturity. 2006 Misc. but also trades for other maturities between one and ten years. the newly launched CDPCs hope to become broadly accepted as trading partners. primarily on investment grade credits. Since these issuers are concentrated in the larger. 2008. Moody’s also writes that. 2% Insurers 6% Mutual funds Pension funds 2% 2% Misc.Credit Strategy Research May 27.” Credit Default Swap Primer Glen Taksler 646. “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. and therefore in principle are able to use leverage to seek high returns. No survey was released in 2007. 2008 35 Figure 7. more liquid credits.855. we estimate that there is an active market for credit default swaps referencing about 63% of issuers. tranched CDS.
% 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. 14 Credit Default Swap Primer Glen Taksler 646. Banks. accounting for 44% of market debt In high yield. Diversified Finance. S&P. and Fitch.Credit Strategy Research May 27. High Grade Liquid CDS vs. these issuers represent approximately 44% of high yield market value. we estimate that there is an active market for credit default swaps referencing approximately 16% of issuers. High Grade Cash Issuers Estimate as of April 2008 Count Sector Basic Materials Capital Goods .855. Finance includes Finance. While not as large as in high grade. with cash bonds outstanding of at least $250 million. Figure 9 illustrates this point.Manufacturing Consumer Cyclical Consumer Non-Cyclical Energy Finance Gaming.7559 . and REITs. High Yield About 16% of high-yield issuers trade actively in the CDS market. Lodging & Leisure Health Care Insurance Media Technology Telecommunications Transportation Utilities Total Source: Banc of America Securities LLC Estimates. 2008 35 Figure 8.
Credit Strategy Research May 27. % 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. 17 For Reference Entities located in Europe. please see the Chapter Appendix on page 17. and Fitch. Modified Restructuring.” It is a circumstance that allows parties to trigger a CDS contract. 17 Failure to Pay. High Yield Cash Issuers Estimate as of April 2008 Count Sector Basic Materials Capital Goods . Credit Default Swap Primer Glen Taksler 646. Credit Events A Credit Event is the “default” in “credit default swap” A Credit Event is the “default” in “credit default swap. with cash bonds outstanding of at least $100 million.855. Lodging & Leisure Health Care Insurance Media Technology Telecommunications Transportation Utilities Total Source: Banc of America Securities LLC estimates. There are three types of Credit Events: Bankruptcy. please see the Chapter Appendix on page 17. the market uses a variant known as Modified-Modified Restructuring. and for some contracts. S&P. High Yield Liquid CDS vs.Manufacturing Consumer Cyclical Consumer Non-Cyclical Energy Finance Gaming. Figure 10 outlines the basics around each type of Credit Event. Below.7559 15 . For a more detailed explanation. we translate the most important points. For details. 2008 35 Figure 9.
Reference Obligation. Banc of America Securities LLC estimates. in exchange for the notional of the CDS contract (recall Figure 2 on page 8).855. Figure 11 shows how to often find the standard Reference Entity and Reference Obligation in Bloomberg: 16 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. The Reference Entity and Reference Obligation establish the Deliverable Obligations. and subordination to other obligations. are deliverable into the CDS contract. simply an obligation of equal or better seniority. the protection Buyer must deliver an obligation to the protection Seller. Only certain obligations. a Reference Obligation of that entity is chosen. or in some cases. Deliverable Obligations must be issued by. appropriately called Deliverable Obligations.7559 . Importantly. maturity extension. The Chapter Appendix on page 19 discusses further Deliverable Obligation requirements. 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. guaranteed by. and establishes the seniority of CDS within the capital structure. The Reference Obligation is typically a large and liquid bond issue. Reference Entity. A company changes outstanding obligations such that it adversly affects investors who own those securities. such as maturity limitations. After the Reference Entity is selected. the Reference Entity. 2008 35 Figure 10. Following a Credit Event. Examples include reduction in Modified Restructuring interest or principal. 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. A company's failure to make agreed upon payments on borrowed money. The Basics Around Credit Events For more details. x x Source: ISDA. the protection Buyer need not deliver the Reference Obligation.
bonds may be in technical default. Credit Events Credit Events include Bankruptcy. we provide more explicit definitions of important CDS terms. Modified Restructuring Importantly. but protection Buyers will be unable to trigger CDS contracts. and for selected credits. For example. CDS contracts do not protect against all defaults. agree on a Reference Entity and Reference Obligation with your Counterparty. if a Reference Entity violates covenants. Finding the Reference Entity and Reference Obligation in Bloomberg REDL <GO> REDL is not always correct.Credit Strategy Research May 27. Modified Restructuring. Banc of America Securities LLC estimates. not security. and for selected credits. Failure to Pay.7559 17 . Appendix I – The Basics of Credit Default Swaps Details around CDS Contract Terminology Below. Before entering into a trade. 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. 2008 35 Figure 11. CDS contracts protect against specific Credit Events. Search field in Bloomberg Reference Entity (Specific legal entity on which a CDS contract is written) Reference Obligation (Establishes required seniority. The Credit Default Swap Primer Glen Taksler 646.855. ISDA. Instead. of the Deliverable Obligation) Sources: Bloomberg. Failure to Pay.
For details. Restructuring does not constitute a Credit Event). or maturity extension.e. or currency is changed to a non-permitted currency (G7 plus OECD members with a triple-A local currency long-term debt rating). please see “The Transition from Spread to Points Upfront” on page 108. a change in the priority of payment of an obligation.. plus an up-front payment. 18 Upfront payments typically apply only to indices and Reference Entities with five-year CDS wider than approximately 700 bps. obligations may become capable of being declared due earlier than normal as a result of default. the investor does not have protection. To prevent parties from profiting by triggering bilateral loans. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. Cash flows are settled at T+3 days. Restructuring criteria may also be triggered if the date for payment or accrual of interest is extended. The protection Seller receives only the accrued periodic payment up to and including the Event Determination Date (effectively. the protection Buyer receives a compensating payment depending on the settlement of the contract (discussed below). 18 Credit Default Swap Primer Glen Taksler 646. the date a Credit Event occurs). Failure to Pay A Reference Entity’s failure to make due payments. 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. Conversely. The market standard is for CDS protection to begin at T+1 days. Figure 12 shows 2003 ISDA Defintions of Credit Events: Figure 12. Credit Event Definitions Credit Event Bankruptcy Description A corporation’s insolvency or inability to pay its debts. Not relevant to sovereign issuers. Modified and Modified-Modified Restructuring generally limit the maturity of Deliverable Obligations to the front-end of the curve. The CDX indices use No Restructuring. single-name and iTraxx indices) uses Modified-Modified Restructuring. Obligation Acceleration is subject to a minimum dollar threshold amount. a broader category than simply bonds and loans. No longer used in G7 corporate contracts. the obligation triggering the Restructuring must have at least 4 unaffiliated lenders. Repudiation/Moratorium: A Reference Entity’s rejection or challenge of the validity of its obligations. The US investment grade market generally uses Modified Restructuring.—and usually sets a minimum threshold of USD 1 million. Obligation Default: Although rarely used. 2008 35 European corporate market uses Bankruptcy.855. the protection Seller keeps the periodic payment (quarterly payments calculated by notional x coupon x actual/360. if a Credit Event occurs on the same day that a trade is executed. and Modified-Modified Restructuring. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days in the U. two-thirds of which consent to the Restructuring. For details. which causes the subordination of such obligation to any other obligation. The US high yield market generally uses No Restructuring (i. Source: 2003 ISDA Credit Derivatives Definitions. but credits that were downgraded from investment grade usually continue to use Modified Restructuring. if applicable) in compensation for assuming 18 credit risk on the Reference Entity. Usually applies to borrowed money. These criteria are discussed in Chapter VI – CDS Case Studies and Legal Issues on page 158. Failure to Pay. A reduction of interest or principal. should a Credit Event occur during the life of the transaction. Sample Credit Event documentation appears on page 86. No longer used in G7 corporate contracts. So. Usually applies to borrowed money. and sets a minimum threshold of USD 10 million. and have been of particular concern to monoline insurers. Restructuring If no pre-specified Credit Event occurs during the life of the transaction.S.7559 . Must result from a deterioration in the creditworthiness or financial condition of the Reference Entity. Additional criteria that do not involve an actual bankruptcy filing may trigger a Bankruptcy Credit Event. Or. a broader category than simply bonds and loans. Europe (investment grade and high yield.Credit Strategy Research May 27. 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.
If the Reference Obligation matures or is otherwise redeemed. For example.Credit Strategy Research May 27. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. not the security. which was later than 11:59pm GMT. It is important to note that the protection Buyer does not have to deliver the Reference Obligation. After the Reference Entity is selected. For example. 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. there was no Credit Event. Calpine filed for Bankruptcy at 10:57pm New York time on December 20. the protection Buyer may deliver a senior unsecured bond. Reference Obligation. Following a Bankruptcy or Failure to Pay Credit Event. 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. following a Credit Event. The Reference Obligation is typically a large and liquid bond issue.855. of the Deliverable Obligation. its original seniority 20 continues to set the seniority of CDS. For details. a Reference Obligation of that entity is chosen. for holders of CDS contract with a December 20. 20 By “original seniority. if the Reference Obligation is a senior secured bond. For plain-vanilla CDS trades without a Reference Obligation. 2005. 2005 maturity. As such. and its selection establishes the seniority of the CDS within the capital structure. the priority is considered senior unsecured. While there are some exceptions. up to a 30-year maturity. 19 There are additional restrictions surrounding Deliverable Obligations following a Restructuring. the market standard for Reference Entities and Reference Obligations is often found on the REDL screen in Bloomberg. Reference Entity.7559 19 .” we mean the seniority as of the later of the CDS trade date and the Reference Obligation issue date. Credit Default Swap Primer Glen Taksler 646. the protection Buyer may deliver a bond or loan that is pari passu in seniority with the Reference 19 Obligation. The Reference Obligation determines only the required seniority.
CAD. defaults to senior unsecured. Not Contingent. 2008 35 Figure 13. Maximum Maturity: 30 years. etc. Complicated by mergers. EUR.Credit Strategy Research May 27. ISDA Definitions technically provide for additional Credit Event triggers. Consequently. Parties retain the option to physically settle. See Figure 14. please see Chapter VI – CDS Case Studies and Legal Issues on page 152. Banc of America Securities LLC estimates. Protection Seller buys Deliverable Obligation from protection Buyer at par upon occurrence of a Credit Event. protection Seller pays protection Buyer the difference between the par and market values of a Reference Obligation. Specified Currency (typically. Consent Required Loan (if applicable). Additionally. that operating company’s debt is deliverable into CDS on the holding company. the financial and risk profiles of different entities that fall under the same organizational umbrella are not always the same. 20 Credit Default Swap Primer Glen Taksler 646. and Not Bearer. Transferable. The Reference Obligation determines only the required seniority. If no Reference Obligation is chosen. Standard CDS documentation specifies Physical Settlement. Guarantees Under certain circumstances. Note: For senior unsecured CDS. for CDS on an operating company. The guarantee must be unconditional and irrevocable. There are two Credit Events currently used across CDS products (see Figure 12). Please see Chapter VI – CDS Case Studies and Legal Issues on page 143 for details. or JPY). restructurings. CDS Essential Vocabulary List Reference Entity Credit Event The legal entity (not the instrument) on which a contract is written. Bankruptcy and Failure to Pay. debt from a subsidiary may be deliverable into CDS on a parent company Naturally. Upstream guarantees (from subsidiary to parent) are not taken into account for Reference Entities located in North America. Single-name and index CDS contracts on European Reference Entities (investment grade and high yield) typically include Modified-Modified Restructuring. Important because different entities within the same company or organization may have different risk profiles and expected recoveries. under no circumstance is holding company debt deliverable. the protection Buyer may deliver a senior unsecured bond following a Credit Event. However. where the holding company owns a majority of the operating company. Please see the section “Secured CDS” on page 169. if the Reference Obligation is a senior secured bond.or Modified-Modified Restructuring.7559 . for details. For example. 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.855. Sources: ISDA. not the security. Settlement Can be Physical or Cash Settlement. if a holding company (parent) guarantees an operating company (subsidiary). Assignable Loan (if applicable). provided that another market participant is willing to take the opposite position. the recovery values on instruments of those different entities potentially will be very different following a Credit Event. described in Figure 12. An event that triggers the contingent payment on a credit default swap. Deliverable Obligations typically are Bonds and Loans that meet the following criteria: Not Subordinated. parties to a credit default swap should recognize that. In practice. debt from a subsidiary may be deliverable into CDS on a parent company. market expectations are in the process of moving from Physical Settlement to Cash Settlement. For details. up to a 30-year maturity (typically shorter for a Modifiedor Modified-Modified Restructuring). For Reference Entities located in North America. Reference Obligation and Reference Obligation is cited in the CDS term sheet. That is. In Cash Settlement. under certain circumstances. Maturity limitation is typically more restrictive following a Modified. USD. CHF. GBP. of the Deliverable Obligation. Special language must be included for investors who wish to restrict the security of the Deliverable Obligation. single-name CDS contracts on US investment grade and fallen-angel Reference Entities typically include Modified Restructuring.
Sources: ISDA. Succession Succession refers to changes in a CDS contract after a Reference Entity is merged. and replaced with the Successor Reference Entity. then parent (or subsidiary) debt is deliverable into third-party CDS. For example. an orphaned CDS situation may occur when a company’s debt is tendered for in connection with an LBO. or some other change is made with respect to its corporate structure? This issue is one referred to as Succession in CDS terms. debt delivered must be pari passu or better than the Reference Obligation in seniority. The notional for each contract will be the original notional. acquired.7559 21 . The original Reference Entity will be deleted from the contract. Banc of America Securities LLC estimates. or undergoes some other change in its corporate structure What happens if a Reference Entity is merged.” For example. acquired. a broader class of guarantees applies to CDS contracts. If a third-party guarantees the parent (or subsidiary). for Europe only. 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. divided equally by the number of Successors. and CDS will become near-worthless. each such entity and the original Reference Entity will be a Successor. Also of note: If the parent (or subsidiary) guarantees a third-party. for Europe only. Effect of Guarantees on CDS Contracts. and that company subsequently becomes an operating company within the post-LBO entity. and a $5 million Reference Entity in the Successor Reference Entity. that entity will be the sole Successor. 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. there will be no Deliverable Obligation into CDS contracts. regardless of security. Globally Based on Location of Reference Entity. then third-party debt is deliverable into parent (or subsidiary) CDS. 2008 35 Figure 14. an investor with a $10 million CDS contract may now have a $5 million CDS contract in the original Reference Entity. Credit Default Swap Primer Glen Taksler 646. Unless the operating company issues new debt. as illustrated in Figure 14. If one or more entities succeeds to more than 25% but less than 75% of the Relevant Obligations.Credit Strategy Research May 27.855. Orphaned CDS (Lack of Deliverable Obligations) A CDS contract on a company that has no Deliverable Obligation is sometimes called “orphaned CDS. Regardless of Where Trade Is Executed Globally. For Reference Entities located in Europe.
$10 million) if he delivers a bond or loan to the Seller. Information and Confidentiality Provisions Although credit default swaps usually are traded on the public side of the information wall. indices. according to standard confirms. Additionally. Protocols originally allowed investors to cash settle only index and index tranche transactions. the standard is Physical Settlement. please see Chapter VI – CDS Case Studies and Legal Issues on page 143. although single-name CDS notional for Dura Operating Corp. In regular CDS contracts. with an option to cash settle. For example. provided that another market participant 22 is willing to take the opposite position. the CDS market has voluntarily adopted settlement protocols following all Credit Events since 2005. it is the burden of the protection Buyer to find a deliverable bond or loan Standard confirms for flow CDS products (single-name. cash settlement protocols have asked banks and broker-dealers to quote the cheapest-to-deliver bond on a defaulted credit. Generally. with an option to physically settle. That is. As a partial solution to the risk of a short squeeze. and tranches) state that Credit Events are physically settled. With rapid growth in the CDS market. there has been a significant need for Buyers of protection to buy bonds post-Bankruptcy. the CDS market has voluntarily adopted settlement protocols 21 22 2003 ISDA Credit Derivatives Definitions.1(b)(iv)–(v). For Delphi. please see Chapter VI – CDS Case Studies and Legal Issues on pages 129 and 132. 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. This has driven the price of bonds artificially high following a Credit Event..7559 . the 2003 ISDA Credit Derivatives Definitions contain representations surrounding information. the protocol helped to bring 23 bonds down from a peak of $72 to a cash settlement price of $63. For more details on Succession. 2008 35 If no one entity succeeds to more than 25% of the Relevant Obligations. 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). and the Reference Entity continues to exist. was relatively low. have allowed investors to cash settle single-name transactions as well.Credit Strategy Research May 27. including case studies on issues that have created recent market uncertainty. just another participant in the settlement protocol.g. Section 9. the protocol settles near an average of the dealer prices. The other participant need not be the original Counterparty. Specifically. the notional value of protection now exceeds the notional of Deliverable Obligations for many Reference Entities. it is the burden of the protection Buyer to find a deliverable bond or loan. 23 Roughly speaking. parties are not 21 subject to any obligation of confidentiality. the protection Buyer (generally) is only entitled to receive the notional value of protection (e.” Moreover. The Reference Entity will not change. provided that both parties consent. historically. but since the Dura Bankruptcy in October 2006. unless otherwise agreed. on little fundamental news. For more on CDS settlement protocols. This may drive the price of bonds artificially high following a Credit Event As a partial solution. the settlement protocol set a precedent for including singlename CDS transactions. The settlement protocols change the standard to Cash Settlement. As such. in Delphi. bonds traded up from $58 immediately post-default to a high of $72 three weeks later. Risk of a Short Squeeze Generally.375. 22 Credit Default Swap Primer Glen Taksler 646. there will be no Successor.855. After applying a filtering mechanism to eliminate off-market quotes.
We focus on three CDS market size surveys: the International Swaps and Derivatives Association (ISDA). Credit Default Swap Primer Glen Taksler 646. and the Bank of International Settlements We agree that the CDS market is growing rapidly but believe that under many circumstances. the adjustment factor should bring the reported growth in the CDS market back to $10 million. reported CDS notional will grow. emphasizing differences between market size and overall risk exposure.855. the size of the CDS market may grow without any change in overall risk exposure. This result accurately reflects net credit risk.7559 23 . This section provides more details on the methodology of popular CDS and corporate bond market surveys. 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. similar to an unwind. the British Bankers’ Association (BBA). and immediately unwinds with the same dealer: Reported size of the CDS market is unchanged An investor sells $10 million protection. International Swaps and Derivatives Association (ISDA) Survey ISDA conducts two surveys per year of its primary members. 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. As described below. if an investor buys protection in an index and sells protection in underlying intrinsics.Credit Strategy Research May 27. This is because the original dealer is likely to consolidate the two trades. each dealer will report a $10 million trade with another dealer. In principle. the British Bankers’ Association. The adjustment factor estimates the extent of this double-counting. We then explain our methodology to estimate the size of the global corporate bond market. even though net credit exposure will be unchanged. 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). leading to double-counting. For example. and assigns the trade to another dealer: Reported size of the CDS market grows $20 million ($10 million initial trade + $10 million assignment). 2008 35 CDS and Corporate Bond Market Surveys We look at CDS surveys from ISDA. reported size of the CDS market is likely to be unchanged ($10 million in initial trade – $10 million offset). ISDA attempts to adjust for potential double-counting. We show several examples that illustrate the methodology. ISDA attempts to adjust for the error by multiplying the $20 million by a BISestimated adjustment factor for dealer-to-dealer trades. That is. in which the trades of two survey respondents offset each other. to show a net zero position. This is an overstatement. and then aggregates the results to obtain an overall estimate of market size. ISDA asks each institution to estimate the size of its credit derivatives notional. An investor sells $10 million in protection. and the Bank of International Settlements (BIS).
unhedged: Reported size of the CDS market grows $10 million. an investor partially offsets an off-the-run CDS contract with an onthe-run CDS contract. Unlike an assignment. reported CDS notional increases. As such. 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).Credit Strategy Research May 27. if the offset is with the original dealer but has a different maturity date (for instance. the reported size of the CDS market grows $20 million ($10 million in initial trade + $10 million in offset).” BBA then reports the average of these estimates.7559 . 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. the last time in June 2007. 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). British Bankers’ Association (BBA) Survey The bi-annual BBA survey does not use a standardized methodology to estimate the size of the CDS market. Every third year. the survey is conducted across approximately 1. rather than another dealer. 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.855. Even though the offset causes net credit risk to substantially decline. across approximately 60 institutions in the G10 countries and Switzerland. 24 Credit Default Swap Primer Glen Taksler 646. Bank of International Settlements (BIS) Survey The Bank of International Settlements (BIS) conducts a semiannual survey on the derivatives markets. regardless of maturity date. The result is the same if the investor hedges with single-name CDS or an index. the reported size of the CDS market grows $10 million Structured Credit (Correlation) An investor sells $10 million of 20x leveraged equity tranche protection. However.500 institutions worldwide. Index vs. reported size of the CDS market grows $20 million ($10 million in initial trade + $10 million in offset). Even though there is no net credit exposure. each dealer faces the client. but keeps the tail risk between the maturity dates). 2008 35 However. there is no adjustment for the offsetting position. An investor sells $10 million of 20x leveraged equity tranche protection. 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. Instead.
7559 25 . 2008 35 In addition to credit. For the numerator. We then multiply the results in step one by this adjustment factor. the survey includes data on derivative contracts in foreign exchange. international and domestic. as well as non-financial institutions. credit default swap reporting began in December 2004. banks. residents through U. entities.S. which are purchased by U. market. Otherwise. based on Federal Reserve Flow of Funds data. 2. insurance and financial firms. BIS surveys dealers. relative to the U.S. we look at the U. equities.S. anywhere in the world. Corporate Bond Market Size We use the following methodology to estimate global corporate bond market size: 1. corporations.S. residents. we look at the global market. market. dealers are asked to report both their total notional and their notional with other dealers. These estimates include bonds issued by U. We look at BIS estimates of debt securities for corporate and financial issuers.. While the survey began in June 1998.S. BIS’ methodology is similar to the ISDA survey. For the denominator.S. In recent years.S.S. minus one-half the sum of contracts bought and sold between reporting dealers. plus bonds issued by non-U. and commodities. interest rates. this methodology suggests that the global market is approximately twice the size of the U.855. Adjust these estimates to reflect the approximate size of the global. Estimate the size of the portion of the global corporate bond market held by U. corporate bond market. Credit Default Swap Primer Glen Taksler 646. dealers.Credit Strategy Research May 27. The BIS then calculates total notional amount outstanding as the sum of contracts bought and sold. To reduce double-counting.
CDS payments in most instances are tied to the underlying cash instrument through no-arbitrage relationships. The quoted spread will be 380 bps. often provides a good indication—but not an exact metric—of credit default swap levels. not LIBOR + 380 bps. For details. In this sense. because of the inclusion of LIBOR in the discount factor. discussed below. credit default swaps have some exposure to interest rates. Consider a single-name CDS trade at 380 bps.7559 . a bond’s spread to LIBOR.000 per annum ($95. the offered side in the CDS market reflects the fixed payment CDS dealers demand to provide protection. Investor’s Economic Position: Although relatively small. The bid side in the CDS market reflects what CDS dealers will pay for protection. for the protection Buyer to pay 380 bps 26 Credit Default Swap Primer Glen Taksler 646. Notice the payment is 380 bps. 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. While investment-grade cash bonds are typically quoted as a spread to Treasury. or the fixed payment an investor must pay to purchase protection: meaning. Source: Banc of America Securities LLC. 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. in CDS. or the fixed payment an investor would receive for providing protection: meaning going long credit risk. credit default swaps are thought of as a spread to LIBOR. the bid side in the cash market reflects what cash dealers will pay for an asset.000 per quarter) to the protection Seller. we summarize various ways to compare relative value between CDS and corporate bonds. The reason has to do with the cost of funding. the Buyer is assumed to fund at LIBOR. The Chapter Appendix on page 34 provides more complete details. However. Figure 15.855. on a $10 million notional. and the protection Buyer will pay $380.Credit Strategy Research May 27. The ABCs of Credit Spreads Below. the offered side in the cash market reflects the price at which cash dealers will sell an asset. In contrast. to short credit risk. please see Interest Rate Sensitivity on page 111. Though the form of CDS fixed payment quotations may be unfamiliar to some cash market participants. In contrast. That is. 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. so that the investor would be long credit risk. Similarly. While investment grade cash bonds are typically quoted as a spread to Treasury. so that the investor would be short credit risk.
Should the Counterparty fail to make a coupon payment (or appropriate payments following a Credit Event). the investor has no recourse against the Reference Entity. they would issue a bond at about the Treasury rate + swap spread. major CDS Counterparties fund at approximately LIBOR. While a bank or broker-dealer Counterparty may facilitate that trade by locating the bonds. payment for that transaction is solely a matter between the investor and Verizon.855. 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. For example. Typically.Credit Strategy Research May 27. only against the CDS Counterparty However. the investor has no further exposure to the bank or broker-dealer. If a cash bond investor purchases a Verizon bond. effectively creating a spread of 24 LIBOR + 380 bps. he must borrow that money at LIBOR. Hedge funds are a natural exception. 2008 35 annually. and they view CDS as a LIBOR + funding spread market. the investor has no recourse against Verizon.7559 27 . a protection Buyer who funds at LIBOR + 3/8 should view the same credit spread as LIBOR + 3/8 + 380 bps. in a credit default swap. Credit Default Swap Primer Glen Taksler 646. Hence. spread to LIBOR may be thought of as compensation for Counterparty risk. payment for the transaction also depends on the creditworthiness of the Counterparty. the market generally views CDS as a LIBORbased market. only against the CDS Counterparty. once the bonds have been delivered. not just LIBOR + 380 bps. Alternatively. that is. Should the Counterparty fail to make a payment.
the same as the credit 26 default swap spread. leaving them exposed only to the credit spread component of risk. we assume a semiannual coupon and 30/360 day count for both the corporate bond and CDS. 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. For a five-year credit default swap trading at 380 bps. a yield of 7.855. In reality.582% is also the comparable cash 25 bond coupon. while US corporate bonds pay a semiannual coupon and have a 30/360 day count.7-bp spread to Treasury and the 380-bp CDS spread is the five-year swap spread (83 bps). Banc of America Securities LLC estimates. To reconstruct a cash bond out of a Credit Default Swap. The “Z-spread. CDS trades with a quarterly coupon and ACT/360 day count. Since single-name CDS trades usually begin at par. 7. This yields the investor LIBOR (from buying the bond) plus the CDS spread (from selling protection).7 bps over the five-year Treasury.7559 .Credit Strategy Research May 27. is 380 bps. See the section. the relevant comparison is a corporate bond trading at five-year LIBOR + 380 bps. buy a AAArated bond that yields roughly LIBOR and sell CDS protection 25 In practice. 26 For simplicity.” one of the spread to LIBOR measures we will discuss in this section. “The Transition from Spread to Points Upfront” on page 108 for details. while relaxing the day count assumption would tighten the Z-spread by approximately 3. these trades often begin away from par. However. The equivalent cash bond spread is 463. single-name CDS trades often begin away from par for wide-spread Reference Entities. 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. 2008 35 Figure 16. In addition. Relaxing the coupon assumption would widen the Z-spread by approximately 3 bps. investors do not often replicate cash bonds out of CDS contracts.582%. in this case. Since the credit default indices trade with a fixed coupon.5 bps. 28 Credit Default Swap Primer Glen Taksler 646. Sources: Bloomberg. This is because most corporate bond buyers hedge with Treasuries. The difference between the 463. A quarterly CDS coupon (still with a semiannual corporate bond coupon) would widen the Z-spread by approximately 3 bps.
The economics of I-Spread for a par bond are identical to those of CDS Spread. Par CDS equivalent spread more accurately reflects compensation for credit risk. not cash flows. making it particularly appropriate for high yield bonds. For bonds trading away from par. The Chapter Appendix on page 34 provides more details. 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 bullet bonds. If the yield curve is completely flat. I-spread. we summarize popular spread to LIBOR measures. understate the actual level of spread when the cash bond is trading at a discount. asset swap spread. Zspread does not adjust for the dollar difference in recovery between cash bonds and credit default swaps. except that there is no funding requirement under the credit default swap contract. Preferred Spread to LIBOR Measure for Non-Bullet Bonds OAS to LIBOR is the option-adjusted spread to LIBOR. Z-Spread is the option-adjusted spread to LIBOR under an assumption of zero volatility. This measure estimates the value of call or put provisions. If there is a Credit Event during the life of the transaction. Par CDS equivalent spread assumes a recovery value to keep total credit risk equal between the cash and CDS markets. For non-bullet bonds. but does not take into account that single-name CDS trades at par. For a coupon bond. or interpolated spread to swap. while cash may trade 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. is the yield difference between a cash corporate bond and a matched-maturity swap yield. Other Popular Spread to LIBOR Measures I-Spread.7559 29 . discussed below. 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). It incorporates the shape of the yield curve in its calculation and uses the timing of cash flows of the bond. assuming an upward sloping yield curve. For par asset swaps. without an assumption of zero volatility. It is a percentage of the notional amount (expressed in terms of bps) that the investor is paid per annum. Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. and Z-spread. Z-spread is the same as I-spread. 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. OAS to LIBOR is an approximate relative value measure. any premium or discount is settled upfront in cash. this payment stops and the investor pays the Buyer of protection a onetime credit loss equal to par minus recovery.855. OAS to LIBOR is the same as Z-spread. which uses a higher discount factor to more accurately reflect credit risk. It is calculated by discounting the premium or discount portion of cash flows at LIBOR flat. the Z-spread is higher than the I-spread. Par CDS equivalent spread does not adjust for optionality and therefore should be used only for bullet bonds. I-spread is based solely on the yield and maturity of a bond. 2008 35 Which Spread to LIBOR? Below. unlike Z-spread.
2013 Par CDS .Z-Spread (bps) 250 Par CDS . Positive basis trades require either having the bond in inventory (and available for sale).875 % July April 15. tightening of the cash spread. between October 2003 and April 2008. this relationship is nonlinear. or both. …Be Careful About Your Spread Measure Par CDS – Z-Spread.Z-Spread (bps) 200 150 100 50 0 Par CDS . widening of the cash spread. The further the bond moves away from par. the investor profits from widening of CDS. This is due to a no-arbitrage relationship: If CDS trades tighter than cash (a “negative basis”). 2008 35 Example: Z-Spread vs.875% July April 15. If a Credit Event occurs.7559 .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. Provided that the basis widens. versus Price TOY 7. 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. Source: Banc of America Securities LLC estimates. versus Price TOY 7. the investor profits from tightening of CDS. the investor may deliver the cash bond to settle the CDS contract. or borrowing the bond in the repo market. By contrast. Inc. 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. an investor may consider buying protection and buying the cash bond After converting a cash bond to spread to LIBOR. and receive par. or both. The Credit Default Swap Basis If CDS trades tighter than cash (a “negative basis”).875 % of 2013. an investor may consider selling protection and selling the cash bond 30 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. Z-spread understated Par CDS equivalent spread by about 45 bps (Figure 18). If CDS trades wider than cash (a “positive basis”). when the bond was trading around par. the investor may use the bond received from physically settling the CDS contract. an investor may consider selling protection and selling the cash bond. 7. When the bond was trading at about $80. As a Bond Moves Further Away from Par… Par CDS – Z-Spread. Negative-basis trades require attractive funding rates (to pay the CDS premium) and balance sheet availability (to buy the cash bond). to cover the short position in the bond. 2013 Figure 18. the more Z-spread and Par CDS equivalent spread will differ.855. 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. If CDS trades wider than cash (a “positive basis”). Z-spread and Par CDS equivalent spread were within 10 bps of each other. an investor might expect that the CDS spread for a Reference Entity should equal the spread to LIBOR on an identicalmaturity par bond. The further a bond moves away from par. Moreover. Provided that the basis tightens. If a Credit Event occurs. an investor may consider buying protection and buying the cash bond.
but 1000 bps in CDS.000 1. CDS versus Cash in a Volatile Market Recently. Cash spread reflects par CDS equivalent spread to LIBOR. …Particularly in Wide Spread Environments Cash Spread versus CDS-Cash Basis GM 7.000 800 600 400 200 0 y = 1. Figure 19 illustrates the historical relationship between CDS and cash for General Motors Corp. an investor could earn roughly 750 bps in cash. if the cash bond widens 10 bps.600 1. For details. the CDS—cash basis tended to widen with the level of credit spreads Figure 19. 2008 35 In reality. 27 Also. Most recently. as credit quality deteriorated. Source: Banc of America Securities LLC estimates. for credits where five-year CDS spread is tighter than the CDX IG index. at wide credit spreads. For example. Source: Banc of America Securities LLC estimates. assuming a 40% recovery rate. Credit Default Swap Primer Glen Taksler 646. CDS spreads have often traded with a higher beta than their cash bond equivalent. even after adjusting for maturity differences. and the basis tended to narrow or even become negative.1708 R2 = 0. bps) Cash spread reflects par CDS equivalent spread to LIBOR. as CDS spreads have tightened. We note that. This makes it more difficult to sell bonds and sell protection.200 1. CDS Is More Risky than Cash… Interpolated CDS versus Cash Spread GM 7.7559 31 . 13 bps (and the basis has increased 3 bps). As Figure 20 shows. demand for buying protection also rose. CDS spreads reached particularly wide levels versus cash.855. That is. When credit risk has risen. In wider spread credits (Figure 22).3128x + 1. the repo market often dries up.500 Cash (Par CDS Equivalent Spread.9607 Spread (bps) Oct-04 Oct-05 Oct-06 0 500 1. driving the average CDS – cash basis to roughly -80 bps (CDS 80 bps rich to cash bonds) Since summer 2007. with CDS tightening more than cash. most basis package volume has been in the ten-year sector. the opposite occurred. both CDS and cash have rallied. CDS has aggressively outperformed cash. and the basis became more positive. cash spreads actually moved wider. say.” Historically—but less since summer 2007—one of the most important factors determining the basis has been the level of credit risk (or spreads). CDS has 27 tended to widen. particularly in tighter spread credits. When credit risk has declined. In this sense. Notice that CDS almost always traded wider than cash during this approximately two-year period.400 1. For example. Figure 21 shows cash versus matched maturity CDS spreads in the fiveyear sector. making it difficult or expensive to find a bond to borrow.200 1. please see the Chapter Appendix on page 44.125% July 2013 1.Credit Strategy Research May 27. even for par bonds. in early 2008. we focus our graphs on the five-year sector due to better data availability. and vice-versa. the basis widened with the level of credit spreads.125% July 2013 Figure 20. Historically (less since summer 2007). This means that. assuming a 40% recovery rate.400 1. We define this difference (CDS – cash) as the “basis.000 800 600 400 200 0 Oct-03 Interpolated CDS (bps) Matched-Maturity CDS Spread to LIBOR 1. a number of factors cause differences in CDS and the cash spread to LIBOR. in mid-May 2005. however. CDS has outperformed cash.
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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.
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Credit Strategy Research May 27. 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.855. For the sample bond in Figure 29.3-year swap yield is 4.) As illustrated in Figure 30.3-year (August 2018) bond is 11. the yield to maturity of a 10.7559 35 . we interpolate the 10.38%.889%. This matches up with the 751-bp I-spread from Figure 29 (“ISPRD. (To calculate the 10. The corresponding 10.51%. 2008 35 Figure 29.and 15-year swap yields. YAS Screen on Bloomberg Source: Bloomberg. Credit Default Swap Primer Glen Taksler 646.” in white toward the bottom-left of the circled area). the corresponding I-spread is 7. I-spread simply compares the yield of a bond with a matched maturity swap yield.3-year swap yield.
investors usually prefer the lower dollar-priced bond (4. in exchange for selling the fixed cash flows of the bond 36 Credit Default Swap Primer Glen Taksler 646. the investor buys the fixed-rate corporate bond and swaps the fixed-rate payment into floating LIBOR-based payments. 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. a 4.7559 . Calculating I-Spread 11. I-spread only considers the yield of the bond.5% coupon bond has the same I-spread as a 6. For leveraged investors who fund the purchase of corporate bonds with a floating rate liability. to meet cash flow requirements on the funding side. not the timing of its cash flows.275 years) = 7.855. Banc of America Securities LLC estimates. because they will lose less of a premium following a Credit Event. whose cash flows are more front-loaded. a credit investor earns 751 bps more per annum on the corporate bond than on a matched-maturity swap.38% Swap Yield (at 10.5% coupon). That is. for the same yield and maturity. assuming no default. Asset Swap Spread Most investment grade corporate bonds are structured as fixed-rate bullets. 2008 35 Figure 30.51% I-Spread Sources: Bloomberg. Asset swap transactions are designed to solve this problem.5% coupon bond.889% Yield – 4. A par asset swap is based on Asset swap spread is the annual spread over floating-rate LIBOR that an investor earns. not the timing of its cash flows It is important to note that I-spread only considers the yield of the bond. That is. That is. In reality.Credit Strategy Research May 27. The reason for the 751 bps extra yield is the risk that the corporate bond issuer may fail to pay. with a flat coupon payment plus par at maturity. there is an interest-rate mismatch.
an asset swap continues. are discounted at LIBOR. the investor receives LIBOR + 579 bps quarterly (circled area in the third column). Figure 31. Credit Default Swap Primer Glen Taksler 646. but will only pay out fixed-rate cash flows 28 Intraday movement in the swap curve may cause slight differentials in spreads between screens.25% semiannually (second column.7559 37 .Credit Strategy Research May 27. In exchange. the par portion of the bond is discounted at the risky rate. Net cash flows. with any premium or discount settled up-front in cash when the investor enters into a transaction. Asset swaps have a quarterly day-count convention. calculated as a 6. The par portion of the bond is discounted at the risky rate (the bond coupon). to arrive at the present value in the far right column. 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. while the premium or discount portion is discounted at LIBOR. The net cash flows (floating minus fixed) are shown in the fourth column. In this case. which represent the premium or discount portion of the bond. Banc of America Securities LLC estimates. the investor is expected to receive a present value of $1 million in floatingrate LIBOR over the life of the asset swap. An asset swap is a separate agreement between two parties. Consider Figure 31. Calculating Asset Swap Spread F6.5% coupon divided by two).5 Discount (Plus Accrued Interest) Sources: Bloomberg. In ASW.5 2018 Corp ASW <GO> Discounted at LIBOR $31. In this case. so in practice. while the floating-rate cash flows (floating-rate LIBOR plus the asset swap spread) are exchanged quarterly.855. Notice that 579 bps roughly corresponds to the asset swap spread (“ASW. so if the underlying issuer defaults. the fixed-rate cash flows are exchanged semiannually.” in 28 red) from Figure 29. 2008 35 par.
the investor also pays 31. This fixed spread is called the Z-spread. 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. The par portion of the bond is discounted at 6.7559 . The bond yield is 11. While I-spread is the incremental yield over a matched maturity swap. I-spread. 2008 35 worth $68. Z-spread is the OAS to the LIBOR curve under an assumption of zero volatility. In exchange.5%. This fixed spread is called the Z-spread 38 Credit Default Swap Primer Glen Taksler 646. For bonds at par. when the investor finances his purchase with a series of zero-coupon bonds. CDS—cash investors do not usually institute asset swaps.5 bond price). Instead. Zspread. Z-spread may be interpreted as spread income on a corporate bond. and asset swap spread are relatively close to each other. they use asset swap spread as a relative value tool to estimate the appropriate spread to LIBOR against which to compare a CDS spread.5 points upfront ($100 par – $68. Z-spread is the incremental yield over the entire LIBOR spot curve (or zero curve). For readers familiar with option-adjusted spreads (OAS).5. The Z-spread is chosen to make the present discounted value of the cash flows equal to the price of the bond. asset swap spread incorporates the timing of coupon payments.855.889% and the coupon is 6.Credit Strategy Research May 27. while the discount portion of the bond is discounted at LIBOR. The origin of Z-spread is the mortgage market. With the exception of cross-currency trades. while I-spread ignores the timing of a bond’s cash flows. Each cash flow is discounted at the zero-coupon LIBOR rate plus a fixed spread on the cash flow payment dates. The most important point to remember is that. Z-Spread Another often-used but easily misunderstood spread terminology is the Z-spread. where an investor may actually want to swap US dollars for euros.5%.
29 roughly the same as that from Figure 29 (“ZSPR.5 2018 Corp OAS1 <GO> Zero Volatility Assumption (Valid for Bullet Bonds) USD Swap Curve (Semiannual. This gives a Z-spread of 763 bps. is the same under asset swap spread. recognizing the incremental default risk of a less creditworthy bond. the discount rate on the premium or discount portion of a AAA-rated bond. For our example bond. Figure 32 illustrates the calculation of Z-spread. So. So while both Zspread and asset swap spread take into account cash flows. This is because all the zero29 Intraday movement in the swap curve may cause slight differentials in spreads between screens. We also use the USD swap curve because Z-spread is a spread to LIBOR. Z-spread discounts the premium or discount portion of a BBB-rated bond at a higher (LIBOR + Z-spread) rate. We use a $68. 30/360) Sources: Bloomberg. The Z-spread (763 bps) is wider than the asset swap spread (579 bps) because of a difference in discounting methodology. using the OAS1 screen in Bloomberg.” in red). An asset swap assumes that the premium or discount portion of a bond bears very little risk. Calculating Z-Spread F6. which is valid for a bullet bond. Recall that I-spread ignores the timing of cash flows entirely. By contrast. Z-spread discounts the premium or discount portion at a more realistic rate.855.5 bond price and add in a zero (the “Z” in Zspread) volatility assumption. with a discount rate of LIBOR. Banc of America Securities LLC estimates. 2008 35 Figure 32. and a BBBrated bond.7559 39 . Credit Default Swap Primer Glen Taksler 646. If the LIBOR yield curve is flat. then Z-Spread is exactly the same as I-Spread.Credit Strategy Research May 27.
For example.7559 .Credit Strategy Research May 27. the Z-spread widens. However. A Note of Caution: Callable/Puttable Bonds The preceding analysis has looked solely at bullet bonds.. The opposite is true when the yield curve is downward sloping. when the LIBOR yield curve is upward sloping. the lower discount rate on the coupon due in six months would cause the present value of the cash flows to rise. Ordinarily.e. For bonds with options. an investor should relax Z-spread’s assumption of zero volatility and look at OAS to LIBOR. 40 Credit Default Swap Primer Glen Taksler 646. 2008 35 coupon LIBOR rates coincide with the LIBOR swap rates. Z-Spread tends to be higher than I-Spread Figure 33.125 Source: Bloomberg.25% plus the Z-spread. Figure 33 shows why it is important to relax the zero volatility assumption. To keep the present value equal to the bond price.855. This is because on balance. Z-spread may discount the coupon due in six months at 3. Comparing OAS to LIBOR with Z-Spread for a Callable Bond Bond is Callable November 1.10% plus the Zspread. i. and the coupon due in one year at 3. for a 2015-maturity bond that is callable in 2011: When the LIBOR yield curve is upward sloping. Z-Spread tends to be higher than I-Spread. zero rates are lower than the yield-to-maturity used in I-spread. Z-Spread adjusts upward to keep the present value of the cash flows equal to the price of the bond. 2011 at $105.
say $120. consider an underlying cash bond that trades at a premium. The Par CDS equivalent spread adjusts the Z-spread for a bond’s premium or discount. Details on Par CDS Equivalent Spreads In this section. 150 bps of Z-spread in the cash bond may provide just as much compensation for risk as. Should there be a Credit Event with a 40% recovery rate. 2008 35 The Z-spread is 495 bps. For example. Figure 34 illustrates the mechanics: Credit Default Swap Primer Glen Taksler 646. For relative value purposes. in a single-name credit default swap.6% gives an OAS to LIBOR of 557. the value of the call option is the 557.5 bps. Par CDS equivalent spread is higher than the Z-spread. For bonds with options. Namely.7559 41 . and therefore should be used only for bullet bonds. or 40%.2-bp Z-spread. Although Z-spread does adjust for the shape of the LIBOR curve. it ignores the value of the call option completely. Par CDS equivalent spread is the same as the Z-Spread. 143 bps of CDS spread. 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. because both cash and CDS are based on par. the bond was bid at $78. the investor will recover $40 on an initial $120 investment. for cash bonds trading at par. or 62 bps. 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. As another way to think of this. We look at the General Motors Corporation 7. Calculating OAS to LIBOR with a volatility of 22. To calculate the par CDS equivalent spread. Par CDS equivalent spread is the Z-spread minus a recovery adjustment. or 33%.7% 2016 as an example. adjusting for the difference in recovery rates between cash and CDS for the $120 bond. for cash bonds trading at discount (say an $80 price). So in reality. In April 2008. Consequently.Credit Strategy Research May 27.5-bp OAS to LIBOR minus the 495. for a spread of 874 bps over the 10 year Treasury and a Z-spread of 802 bps over Swaps. In this case. we show how to calculate par CDS equivalent spread to LIBOR.855. we look for the spread for which the present value of expected cash flows equals the bond price. By contrast. relax Z-spread’s assumption of zero volatility. Par CDS Equivalent Spread All of the measures illustrated above ignore the value of a bond’s premium or discount. Similarly. If the underlying cash bond is trading at par ($100 price). For example. ignoring day count and other operational conventions. 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. from the pricing of a cash bond. say. the difference in recovery rate becomes a non-issue. the investor is indifferent between the 150 bps of Z-spread for the cash bond and the 143 bps of CDS spread. For bonds trading at a premium. the investor will recover $40 on an initial par ($100) investment. the bond investor’s actual recovery rate will be lower. the 557-bp OAS to LIBOR should be compared with the CDS spread. A spread of 143 bps for the cash bond is therefore called the Par CDS equivalent spread.
85 $2.19 4. Assumes a 40% Recovery Rate. By market convention. see the section “Implied Probability of Default” on page 100 of the main text. the investor receives recovery plus half the coupon.49 $2.11% 98.94 $5.68 3.70 $23. This probability rises as par CDS equivalent spread widens.92% 32.61 $6.35% $3. Such that the Present Value of Expected Cash Flows Equals Bond Price ($78) GM 7.5 8.82% 7. approximately all of the coupon would be missed. Banc of America Securities LLC estimates. Add up the present value of expected cash flows across coupon periods.72% 6. see the section “Implied Probability of Default” on page 100.5 902 bps 902 bps 902 bps 92. First.04% 79.85 $103..80% $1.23% $3. so that half the coupon is accrued upon default.11 Sum of PV of Expected Cash Flows = Bond Price $78. How to Calculate Par CDS Equivalent Spread Solve for Par CDS Equivalent Spread.50% 96. Provided the issuer does not default. sometimes also called Survival Probability: exp( -[ Spread ] / [ 1 – Recovery ] * Years ). However.e.39% 30.85 $6.7559 . Probability of Not Defaulting. This is the par CDS equivalent spread. survives the prior period). Par CDS Probability Marginal Equivalent of Not Probability Years Spread Defaulting of Default exp( -[ Spread ] / [ 1 . Then solve for the spread for which the present value of expected cash flows equals the bond price. For details. divided by one minus the expected recovery rate.0 1.85 $3.88 $1.05% 2.855. we 31 assume that default occurs halfway through a coupon period. that is. For details.73% 2. we include accrued interest. Mathematically. Mathematically.85 $3.31 $32. The reason for including half the coupon is that.85 $3. look at the expected cash flow during a particular coupon period. the probability that an issuer defaults during a particular coupon period.59% 71.08% 4. For each coupon period.7% 2016.Credit Strategy Research May 27.13% 4. discount the cash flow by LIBOR.18% 75.39% 73. the investor receives the bond coupon. Since we are looking at the spread that makes a bond equivalent to a CDS contract. minus the probability that the issuer does not default in the current 30 coupon period.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 0.00 Settlement on April 22.53% 2. expected cash flow is ( Probability of Not Defaulting ) x Coupon + Marginal Probability of Default x ( Recovery + ½ x Coupon ). Second. we assume that default occurs halfway through a coupon period. because there is little incentive for to default well before a coupon payment or principal is due.76% 86. or at maturity.48% $6.0 902 bps 902 bps 902 bps 34. 31 More realistically. if the issuer defaults.13 $5.24% 6.96% 95. 2008.11% 3.04% 3. Third. In this case. look at the marginal probability of default. 42 Credit Default Swap Primer Glen Taksler 646. par plus the coupon.0 7.43 7.51 $5. 2008 35 Figure 34. by market convention. 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. calculate the present value of the expected cash flow as follows. the marginal probability of default is the probability that the issuer does not default in the prior coupon period (i. 30 The one-year probability of default is the spread. we would expect an issuer to default shortly before (or after) the end of a coupon period.5 1.
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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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resulting in tightening pressure on CDS spreads. it is important to understand their effect.855. protection Sellers (who are long credit risk) are increasingly attracted to the CDS market. please see Structured Credit Market Basics on page 179. all senior unsecured debt at the Reference Entity may go away. Similarly. and favorable regulatory capital treatment. or spun-off.. as happened with monoline insurers in February 2008.and ten-year maturities. Perceived advantages for the investor included higher risk-adjusted returns. Structured transactions embedding credit default swaps provided a vehicle for investors to sell protection (go long credit risk). please see Chapter VI – CDS Case Studies and Legal Issues on page 158.7559 . for historical perspective. However. particularly at popular seven. 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. Also see several case studies in the same appendix. Historically. Changes in the Cost of Funding Higher funding costs cause CDS to outperform As financial institutions’ funding costs rise. CDS has no such protection and often widens to reflect expectations of the new capital structure.e. 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). cash bonds—particularly in high yield—may have covenant protection that prevents bond spreads from widening significantly. Consider a case where one or more entities succeed to more than 25% of bonds or loans outstanding for a Reference Entity. Additionally. which does not require funding. Demand for Structured Portfolio Investments Synthetic transactions tended to compress the CDS—cash basis. 46 Credit Default Swap Primer Glen Taksler 646. Succession risk often causes CDS to widen relative to cash. Succession risk may cause CDS to tighten.Credit Strategy Research May 27. Although structured transaction volumes plummeted in 2007. CDS market participants have become more aware of issues surrounding Succession Events. in case volume eventually returns. demand for structured portfolio investments caused dealers to hedge by selling protection. less complexity relative to cash flow CDO waterfall rules. it could cause wider CDS spreads. entity. For details on structured credit. it is possible for an investor to end up with CDS protection that does not exactly replicate the LBO’d. the influx of protection Sellers tends to drive CDS spreads tighter. if a potential unwind of such structures were to occur. 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. Moreover. For details. making a 34 synthetic short position relatively cheaper to a cash short position. 34 This general observation may not apply to a specific user of CDS. For more details. there may become no Reference Obligation for the CDS contract. please see Chapter VI – CDS Case Studies and Legal Issues on page 132. A potential unwind should widen the basis. Under these rules. Then CDS language (2003 ISDA Credit Derivatives Definitions) allows a change in the Reference Entity of the CDS contract. i. for corporate finance activity accompanied by a tender offer. and in case existing structures ever unwind en masse. because it is uncertain what entity a CDS contract will eventually reference. In this case.
7559 47 .” July 2001. According to 35 a 2001 study conducted by Moody’s.” October 19. Modified Restructuring terminology has greatly limited. To account for the greater potential loss following a Credit Event.Credit Strategy Research May 27. convertible arbitrage traders needed to buy credit protection in the CDS market. 2008 35 Cheapest-to-Deliver Option Less relevant in today’s CDS market. “Impact of Convertible Bond Issuance on the Credit Default Swap Market.855. 35 For more details. the cheapest-to-deliver option may cause CDS to underperform Less relevant in today’s CDS market. protection Sellers demand a wider spread. Additionally. while cash settles without accrued interest. the rapidly expanding convertible market was driven primarily by issuers tapping an alternative source of low-cost financing (in a deteriorating equity market). In the US. In 2001. Convertible Bonds CDS spreads may widen after the announcement of a new convertible issue. there is a 7% price difference between straight and convertible bond issues. the cheapest-to-deliver option. while cash trades on a 30/360 convention. “Default and Recovery Rates of Convertible Bond Issuers: 1970—2000. after Credit Events. Technical Conditions CDS settles with accrued interest following a Credit Event. please see BAS research report. 2001 and Moody’s Investors Service. 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. There are two main reasons. This pushed CDS spreads wider. with the same seniority. Credit Default Swap Primer Glen Taksler 646. this may cause CDS spreads to widen relative to cash. In certain cases. CDS settles with accrued interest following a Credit Event (up to and including the Event Determination Date). To strip the perceived cheap equity option from convertible issues. the delivery option may impact the CDS—cash basis. and the demand created from convertible arbitrage funds’ purchase of cheap equity options. The second reason is a perception of lower recovery rates on convertibles. The protection Buyer in a CDS transaction has an option to deliver the cheapest deliverable instrument he can find in the cash market. although not completely eliminated. driving the CDS—cash basis wider. The first reason is temporary supply and demand imbalance.
XO) consists of CDS on 35 North American four.855.857%. The CDX indices are static portfolios of equally weighted credit default swaps. In the High Yield (HY) index. The North American Crossover index (CDX. it is possible to gain direct exposure to an index of liquid credits. at least 2 out of 3 ratings must be high yield. LCDX rolls on April 3rd and October 3rd. The indices roll every six months. at index inception. For the high yield index.0% (1 / 100 members). and XO roll on March 20th and September 20th. ratings must be either double-B by all three agencies.HY) consists of 100 North American high yield Reference Entities. Underlying CDS contracts based on “No Restructuring” Credit Event definitions. Key Features of CDX Indices CDX provides liquid exposure to the corporate CDS market. 37 For eligibility in the investment grade index. at index inception.NA) references CDS on 100 North American Reference Entities. The index represents a portfolio of individual CDS contracts purchased simultaneously at the same spread.IG index) consists of CDS on 125 North American Reference Entities.NA. XO volume has declined substantially since mid-2007.NA. at least 2 out of 3 ratings (Moody’s. 36 CDX IG. intended to reflect the 30 most volatile credits. Overseas versions also exist under the brand name “iTraxx. Only Bankruptcy and Failure to Pay trigger Credit Events. in March (to a June maturity) 36 and September (to a December maturity). designed to provide diversified North American credit exposure in the CDS market. CDX HY rolls on March 27th and September 27th. How the Indices Are Constructed Reference Entities in the CDS indices are selected by a consortium of market makers.0% (1 / 100 members). 2008 35 Chapter III – CDX and iTraxx Indices The CDX and iTraxx indices are portfolios of equally weighted credit default swaps.333% (1 / 30 members). Facilitates relative value trades.7559 . The North American Investment Grade index (CDX. HVOL is a subindex of IG.and five-B rated Reference Entities. at index inception.8% (1 / 125 members). The North American Leveraged Loan index (LCDX. each entity is weighted at 1. S&P. and Fitch) must be investment grade. 38 Reference Entities overlap between CDX HY and LCDX. In the Leveraged Loan (LCDX) index. 37 BB and B subindices also exist. or double-B by two agencies and triple-B by one agency—each entity is weighted at 2.NA.” These indices represent the evolution of the market toward a benchmark index recognized by the market. The weighting for each HVOL entity is 3. Currently. or triple-B by one agency and double-B by the other two agencies. Trades in an unfunded/CDS format. The North American High Yield index (CDX. Each of the Reference Entities is equally weighted: In the Investment Grade (IG) index. 48 Credit Default Swap Primer Glen Taksler 646. designed to provide diversified credit exposure In the CDS market. In the Crossover (XO) index—whose members are rated double-B by all three agencies.Credit Strategy Research May 27. each entity is weighted at 0. For the crossover index. at the secured (first-lien) loan level. each entity is weighted at 1. The indices roll every six months The Reference Entities included in the CDS indices are selected by a consortium of market makers. HVOL.
See the Chapter Appendix on page 60 for a full list of Reference Entities. 38 Eight Reference Entities trade at different parts of the organizational structure in LCDX vs. 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. one senior and one subordinated). Indices Trade Away from Par Unlike most single-name CDS. Charter Communications Holdings LLC is in CDX HY and Charter Communications Operating LLC is in LCDX. For example. Credit Default Swap Primer Glen Taksler 646.855. iTraxx XO (high yield. CDX HY Series 10 (current on-the-run index): Alltel Corp is in CDX HY and ALLTEL Communications Inc is in LCDX. The corresponding European indices are iTraxx Main (investment grade).Credit Strategy Research May 27. but the iTraxx version is far more liquid. Six Flags Inc is in CDX HY and SIX Flags Theme Parks is in LCDX. In single-name CDS. However. and there is no accrued interest at trade inception. Series 10). and LevX (leveraged loans). the Buyer of protection pays 102 bps running coupon. Sabre Holdings Corp is in CDX HY and Sabre Inc is in LCDX. consider a credit default swap at 102 bps. Intelsat Ltd is in CDX HY and Intelsat Corp is in LCDX.7559 49 . not to be confused with the North American definition of 39 XO). in the investment grade index (CDX IG. the credit default indices may trade away from par. RH Donnelley Corp is in CDX HY and RH Donnelley Inc is in LCDX. the coupon is fixed at 155 bps. 39 Technically. Owens-Illinois Inc is in CDX HY and Owens-Illinois Group Inc is in LCDX. iTraxx Financials (two indices. How Index Payments are Determined Unlike most single-name CDS. a North American IG Financials subindex exists. iTraxx HVOL (HVOL). the credit default indices may trade away from par Figure 37. 38 holding company). Please see the Chapter Appendix on page 57 for more detail on the construction of the indices and index rolls. 2008 35 plus 8 Reference Entities at different levels of the capital structure (operating vs.
Series 10) is estimated at Baa3. Citigroup. Since the notes incorporate an interest-rate swap. HVOL10 (high volatility index. Credit Suisse. Goldman Sachs. plus $13. The upfront payment equals $242. JP Morgan. to replicate the price movement of a fixed rate bond. the funded note settles through a three-part dealer auction. Note that.654 (“market value”) per $10 million notional. 40 Liquidity is significantly lower in funded indices versus their unfunded counterparts. because they require no ISDA contracts and operationally work in the same manner as trading in cash bonds. 2008 35 The index trades at 155 bps (right hand side of the screen). the CDX. Members of the CDX Consortium The consortium currently comprises ABN AMRO.778 accrued interest. Note that this is equivalent to a price of $102.NA. 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. Deutsche Bank. This leaves the investor exposed to basis risk between the funded and unfunded versions of the indices. This syncs the high yield indices with the traditional price. while the investment grade indices are quoted in spread (“102 bps”). By contrast. Morgan Stanley. they effectively add interest rate exposure (through the swap rate) to the CDS spread.Credit Strategy Research May 27. but the coupon is fixed at 102 bps running (“deal spread”).855. Ratings Although the indices are not rated. the high yield indices are quoted in dollar price (“$96.7559 . 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). Bear Stearns. In this case. Investors who would not otherwise invest in derivatives can gain exposure to the credit default swap market. Investors in the funded note receive a cash settlement price based on the auction results.432 (“total value”). 40 Although the definition of a Credit Event is the same for the CDX HY unfunded and funded products. UBS and Wachovia. for a total payment of $256.(not spread-) based high yield cash market. Series 10) at B2. XOVER10 (crossover index. using a Special Purpose Vehicle structure. Barclays Capital. although in practice most counterparties have agreed to cash settle. HSBC.50”). 50 Credit Default Swap Primer Glen Taksler 646. we estimate the credit quality of IG10 (investment grade index. These investment vehicles are a type of Credit Linked Note. Merrill Lynch. Bank of America. there is a difference in settlement mechanics. BNP Paribas.HY index is also available in funded form.43 (“price”). Lehman Brothers. HY10 (high yield index. Series 10) at B3 and LCDX10 (leveraged loan index. The unfunded index is technically physically settled. Series 10) at Ba2. Series 10) at Baa2.
2008 35 Figure 38. To view details regarding the funded CDX HY index on Bloomberg. For example. If the average spread of the 125 names.92 million until maturity.92 million. The notional amount on which premium is paid from that point forward is consequently reduced 0. Modified Restructuring is not a Credit Event.8% of the CDX.92 million.8% x $10 million notional). The market maker pays to the Counterparty $80.8% (that is. trades tighter than the index spread.NA. However. Standard confirms state that Credit Events in CDX. By convention. IG is a 125-name equally weighted index.NA.IG are physically settled. the Counterparty pays the fixed coupon of 155 bps on $9. Counterparties have had an option to cash settle the indices.2%. Trading the spread differential between the index and its underlying intrinsics is known as “index arbitrage. the index trades with a factor of 99.NA. Following the Credit Event. Credit Event Example: Counterparty Owns $10 Million CDX. 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.IG Protection Assume that a Credit Event occurs on one of the index’s Reference Entities.IG index). historically. Sources: Bloomberg.7559 51 .NA. type CDX10 CDS <Corp> <Go>. to $9.” 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. Credit Events in the CDX indices include Bankruptcy and Failure to Pay. the index is cheap to intrinsics. adjusted for convexity and Modified Restructuring. so that a notional quote of $10 million results in cash flows being exchanged on $9. CDX. then select the corresponding index.000 of Deliverable Obligations of the Reference Entity.000 (0.HY Series 10 Trades in Both Funded and Unfunded From Version Unfunded Funded Issuer CDX HY 10 T CUSIP 12514TAA8 Coupon (%) 5 8.Credit Strategy Research May 27. Please see the section “Credit Events” on page 17 for more details. Banc of America Securities LLC estimates. each entity makes up 0. The Reference Entity weighting is 0. type DJCDX <Corp> <GO>.855. 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.8%.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. then select the corresponding issuer.. and the Counterparty delivers to the market maker $80.
Converting this back to spread gives an implied 41 spread for the portfolio (intrinsic spread) of just 651 bps.855. or 650 bps.149 3. the investor implicitly assumes the same DV01 for all of the underlying intrinsics.000 4. For five-year CDS.Credit Strategy Research May 27. the spread on Goodyear is 330 bps and the spread on Beazer Homes is 1075 bps. that the average present value is $2.7559 . Actual Present Value of Single-Name CDS Versus Estimated Present Value Ignoring Convexity Based on a notional of $10 million Present Value ($ Thousand) 5. note that Beazer Homes trades as 18 points upfront + 500 bps running. Also. take a DV01 weighted-average of the underlying spreads. Intrinsic Spread Determined by Average Present Value. Beazer Homes USA Inc and The Goodyear Tire & Rubber Co.000 1.169 1. the DV01-weighted average is ( 330 x 4169 + 1075 x 3149 ) / (4169 + 3149 ). We show the equivalent running spread of 1075 bps for illustrative purposes. which shows the actual present value of a single-name credit default swap. This produces an average spread of 703 bps.000 3.375.380.380. Banc of America Securities LLC estimates.000 2. Notice. Ignoring Convexity Actual Present Value ($ Thousand) 400 600 5y Spread (bps) 800 1000 Sources: Bloomberg.912 703 3.659 2. In this example. however. Instead of considering convexity. 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. Banc of America Securities LLC estimates. This line takes into account that a 1 bp move at 20 bps is more significant—hence. 52 Credit Default Swap Primer Glen Taksler 646.385.000 0 0 200 Estimated Present Value. 2008 35 Figure 39. which shows the present value of a single-name credit default swap.549. What the investor should be using is the red line. a higher DV01—than a 1 bp move at 300 bps.549 651 Sources: Bloomberg. Figure 40 shows an example for a portfolio composed of just two CDX HY (Series 10) credits.186 330 4. 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. Taking the average spread of underlying index components is analogous to looking at the gray line.: Figure 40.
the investor would buy intrinsic protection and sell index protection. in 2007.7559 53 . Including convexity reduces the actual intrinsic spread to 651 bps. Source: Banc of America Securities LLC estimates. If the intrinsic spread is tighter than the index spread. but also the shape of the distribution. some investors attempt to arbitrage the difference between the index and underlying intrinsic spread. As such. and vice-versa. Moreover. on any given day. investors should understand that P&L between two indices is unlikely to be fully hedged on any particular day. just because a particular hedge ratio was realized historically does not mean it will be realized in the future. an investor may hedge between indices by going long risk in one index and short risk in another. the greater the effect of convexity. However.Credit Strategy Research May 27. it is important to look not just at the average hedge ratio (or beta from a regression). When determining a hedge ratio. Figure 41 illustrates the realized hedge ratio between CDX IG (investment grade) and CDX HY (high yield). 2008 35 Figure 40. Credit Default Swap Primer Glen Taksler 646. look for P&L to average out over time. $47 million of investment grade protection was needed to offset $10 million of high yield index exposure. Amount of CDX IG Protection Needed to Offset $10 Million of CDX HY Exposure Weekly.855. Figure 41. Indeed. Appendix III – CDX and iTraxx Indices DV01 Neutral Index Arbitrage As discussed in the main text. Hedging Between Indices Like single-name pairs trades. The greater the dispersion of credit spreads within an index. On average. some investors were stop-lossed out of CDX IG—HVOL pair trades amid substantial mark-to-market 42 losses. 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. For example. the hedge ratio ranged from –$60 million to $180 million. Past performance is not indicative of future results. using weekly data between January 2006 and April 2008.
because the coupons of single-name CDS differ from the fixed coupon of the index. 43 Assuming a Bankruptcy or Failure to Pay. because it trades at a premium.180 per $10mm notional. 2008 35 A complicating factor in index vs. which trades at 16 points upfront + 500 bps running in single-name CDS.999 per $10mm notional.Credit Strategy Research May 27. please see “Restructuring Alternatives” on page 153. 44 For our analysis. index arbitrage investors have begun to adjust the notionals of single-name CDS. single-name CDS has a higher DV01. Modified-Modified Restructuring (“MMR”) is a Credit Event for both single-name CDS and the indices. because it trades at a higher dollar price than the same single name struck at the index coupon. Figure 42 shows the difference in DV01 of single-name CDS. Although the investor 43 would be hedged against Credit Events. In the event of a Modified Restructuring (“MR”). Consider an investor who bought protection on an index and sold protection on each underlying constituent in single-name CDS. the DV01 would fall to $2. For the CDX HVOL Series 10 index. so payments would cancel out. To adjust for this risk. intrinsics relative value is that single-name CDS and the indices have different durations. For iTraxx. relative to the DV01 of the single-name using the index coupon. Consider Radian. For tight-spread credits. notional-neutral. the single name struck at the index coupon has a higher DV01. The reason is that Modified Restructuring is a Credit Event in single-name CDS (for selected Reference Entities). But at the index strike of 350 bps (a deeper discount). 54 Credit Default Swap Primer Glen Taksler 646. similar to a Bankruptcy or Failure to Pay in CDX.855. In general. We assume that all other single names trade at par (all running spread). for wide-spread credits. and has a DV01 of $3. he would be exposed to some duration risk. we assume that all single names where 5y CDS trades wider than 700 bps trade in points upfront + 500 bps running. but not in the CDX indices. For more on Restructuring clauses. as 44 of April 2008. to keep them DV01neutral to the overall index. in 2008. the investor would lose money if he sold singlename CDS or make money if he bought single-name CDS.7559 .
only FON trades in running spread. Figure 43 shows the adjusted notional for single names.6 MBIA SFI Single Name Strikes Have Higher DV01s 5 Tightest Index Strike Has Higher DV01 DRI MDC RDN As of April 11.2 -0. Hedging the DV01 Mismatch In 2008. investors have been hedging DV01 mismatch between the index and underlying single names. For example. Less DV01 Using Index Strike Tight Spread Name Have Higher DV01s When Using Index Strike Wide Spread Names Have a Higher DV01 When Using the Single Name Strike 5 Widest DV01 Differential ($ Thousands per $10mm) 0. consider an investor who sells single-name protection and buys index protection. For Fortune Brands. 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.0 -0. and then Fortune Brands (FO) widens. RDN and MBIA have a lower differential than CIT because the former trade in points upfront + 500 bps running coupon.2 0. sending the overall index wider.Credit Strategy Research May 27. 2008 35 Figure 42. The DV01 differential from Figure 42 suggests that notional-neutral index arbitrage leaves an investor exposed to mark-to-market risk. As such. 2008.855. Among the five widest credits. Based on Figure 42. Credit Default Swap Primer Glen Taksler 646.6 0.4 0.4 -0. Source: Banc of America Securities LLC estimates. by adjusting the single-name notional. while CIT trades at 690 bps running.7559 FON CTL 55 WY CIT FO . the CDS at the index strike has a higher DV01 than at the single-name strike. 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.
Credit Strategy Research May 27. calculate the underlying intrinsics. 11.5 9. Notional for DV01 Neutral Index Arbitrage Notionals Vary Inversely With Spread For wide spread credits. reduce the single name CDS notional.0 5 Widest 5 Tightest MBIA KSS DRI MWV FON CTL SFI CIT As of April 11. For wide spread credits. 56 Credit Default Swap Primer Glen Taksler 646.7559 RDN FO .0 9.5 10. single name CDS has a higher DV01 than the single name struck at the index coupon. Since the whole point of index arbitrage is that the intrinsics differ from the index.0 10. to keep the overall DV01s the same between intrinsics and the index.5 8. 2008. if the intrinsics are 295 bps versus the index at 280 bps. 2008 35 Figure 43.0 8. single-name CDS has a higher DV01 than the single name struck at the index coupon. After applying the DV01 neutral notionals to each name. For example. Source: Banc of America Securities LLC estimates. To make the DV01s the same. the overall intrinsics (even after applying the DV01 neutral notionals) will have a different duration from the index. Figure 44 shows the difference in overall DV01s. To make the DV01s the same. Figure 45 scales the total notional of intrinsic protection (in the same proportions as Figure 43).5 Notional ($ Millions) 11. the investor sells protection on a lower single-name CDS notional.855. As such.
he will have net bought protection on the credit. the investor is left with potential risk following a Credit Event. consider the roll between IG9 and IG10 in March 2008. Figure 46 shows a more complete jump-to-default payoff profile: Figure 46. the indices roll to a new onthe-run version. 312 310 308 306 304 302 300 298 296 CDX HVOL Intrinsics Index Notional Total Intrinsics Notional As of April 11. Recall that. Notice that credits being added to the index traded at a tighter spread than credits being deleted. Index DV01 vs Intrinsics DV01 Different Notional for Each Underlying Intrinsic.7559 57 . 2008. As such. CDX Index Rolls Index Rolls Approximately every six months.Credit Strategy Research May 27. Source: Banc of America Securities LLC estimates. but the index trading with No Restructuring. if an investor sells protection on single-name CDS. This will leave him with positive P&L for a wide-spread credit post-Credit Event. in DV01 neutral index arbitrage. (2) an adjustment for intrinsics trading with Modified Restructuring. 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. an investor uses less notional on wide-spread single names. 2008. 2008 35 Figure 45. and buys protection on the index. This results in a “roll.” or difference in spread between the old and new on-the-run indices. We estimate the roll in three parts: (1) the change in credit quality. the indices roll to a new on-the-run version Approximately every six months (March and September). For example. 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. Source: Banc of America Securities LLC estimates. which should reduce the overall IG10 index spread: Credit Default Swap Primer Glen Taksler 646. and (3) a six-month maturity extension. 132 131 130 129 Jump-to-Default Risk After hedging out DV01 risk.855. Total Notional of Index vs Intrinsics Figure 44. Figure 47 shows the details. Eight credits dropped out of the on-the-run CDX IG index.
Estimate of IG Roll from Series 9 to Series 10 As of March 17.8 bps tighter than IG9. from Series 9 to Series 10 As of March 17. and buy protection on Series 10 indices (driving spreads wider). Figure 48. 58 Credit Default Swap Primer Glen Taksler 646. Changes to On-the-Run IG Index. maintain maximum liquidity. perhaps more importantly. these investors needed to sell protection on Series 9 indices (driving spreads tighter). as a way to both reduce carry and. Mid (bps) 198 187 -10. we used a 2% haircut. the maturity date of the five-year IG9 index. we assumed the same basis between intrinsics (underlying single-name CDS components) and the index. 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. singlename CDS trades with Modified Restructuring. IG9 intrinsics were 198 bps. Bloomberg. This would tend to reduce the roll versus the estimate in Figure 48. More realistically. 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.7559 . we expected that a portion of index shorts (with buy protection positions) would want to roll to the Series 10 (new) index.855. However.6 To December 20. 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. for IG9 and IG10. Banc of America Securities LLC estimates.8 -10. To execute the roll. while the CDX indices trade without Restructuring. To assess this factor.Credit Strategy Research May 27. That is. the IG10 index should trade 10.6 0 -10. compared to IG10 intrinsics at 187 bps. 2012. bringing the roll to –11 bps. 2008 35 Figure 47.
We also thought that a short base in IG9. to estimate the roll. For example. the spread differential will be 40 bps. Moody’s. our estimate was that Series 10 IG should trade 11 bps tighter than Series 9. each market maker submits to the Administrator a suggested fixed rate for Credit Default Swap Primer Glen Taksler 646. For the crossover index. and Fitch. Shortly before the roll date. also consider the coupon differential between the old and new indices Mechanics of CDX Index Rolls Approximately two weeks prior to the roll date. the roll should be $0. Modified Restructuring vs. the first criteria changes to entities that are no longer rated double-B by all three ratings agencies. No Restructuring. based solely on credit quality.855. we estimated a fair value roll of 40 bps ($2 5/16) from HY8 to HY9. Since investment grade credit curves were flat around the roll date. each market maker submits to the Administrator (currently Markit Group Ltd) a list of Reference Entities from the current index that. The Administrator will add to the new index those entities receiving the greatest number of votes. the Administrator releases the composition of the new index. and maturity extension components suggested that Series 10 IG should trade 11 bps tighter than Series 9. market makers submit a list of entities for inclusion in HVOL. as compared to IG. 2008 35 That is. there is a six-month maturity extension for rolling from December 2012 to June 2013. in its judgment. We think this difference is largely due to lower liquidity of HY underlyings. should no longer be included. HVOL is a subindex of IG. the effect of the maturity extension was negligible. Affiliates of entities that are guaranteed by entities already in the index are ineligible. the roll trades cheap to the methodology in Figure 48. reducing the roll. Special Issues for HY Index Rolls Since the high yield index trades in dollar price. There are no formal deletion/addition criteria. and (3) entities whose credit default swaps have become materially less liquid. versus an actual roll of 60 bps ($1 1/2). If the old index trades at par and the coupon on the new index is set 40 bps wider than the old index. would result in IG10 trading cheaper to intrinsics. or triple-B by one ratings agency and double-B by the other two ratings agencies. until the new index totals 125 entities (100 entities for the high yield index. in its judgment. This is because. an investor also must consider the coupon differential between the old and new indices. Then. Moody’s.7559 59 . and Fitch (2) entities for which a merger or other similar corporate action has occurred or has been announced. based on the following criteria: (1) entities downgraded below 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. the first criteria changes to entities upgraded to investment grade by at least two of S&P. The actual roll was IG10 trading 5 bps tighter than IG9. (This is for the investment grade index. Next. In high yield. with both indices trading at par. or 35 entities for the crossover index).Credit Strategy Research May 27. After the composition of IG is established. For example. Adding up the credit quality. should be added to the new index. For most HY rolls. any entity in the new series of IG is eligible for inclusion in HVOL.) Each market maker then submits to the Administrator a list of entities that. For the high yield index. rolling to IG10. Non-guaranteed affiliates are eligible for inclusion.
2. ISDA. HY 1.4.500% 75.4. HB 3-6 HY 1. 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.000% 19.5.4. 50% Alltel Corporation.5.6 New Reference Entities 50% Verizon Communications Inc. 50% Idearc Inc. Sources: Markit Group Ltd.5 HY 1. Inc. HV 1. Inc. XO 6-7 LCDX8 HY 1-6.5.3. Markit Group Ltd. LLC A Reference Entity may be removed from the LCDX index if it cancels its entire Syndicated Secured facility. Banc of America Securities LLC estimates.3. Indices HY 6-9. Succession Events in the CDX Indices Date 17 Nov 06 17 Jul 06 Original Reference Entity Indices Verizon Communications Inc.3.625% Collins & Aikman Products Co. HB4. Markit Group Ltd.3. not 100% Succession Events. 2008 35 the index coupons at various maturities. Advanced Micro Devices.4. BB 6-7. Banc of America Securities LLC estimates.2. Dana Corporation Calpine Corporation Delphi Corporation Delta Air Lines. Prepayment Events in the LCDX Indices Figure 51. Inc. HY4. B 8-9. BB4. ISDA.000% 43. By “removed. 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. XO 5 HY 1. B 1-3. 60 Credit Default Swap Primer Glen Taksler 646. including any revolver.2.3. HB 8-9. 50% Windstream Corporation Only shows 50% / 50% CDS splits.2 Trac-X Recovery 41. BB 1. Events and Reference Entities in the CDX Indices Credit Events in the CDX Indices Figure 18.104.22.16859 . Northwest Airlines.2. Alltel Corporation IG 1. without changing the weight on any other Reference Entity. Movie Gallery.3.000% 28.2.4.” we mean the weight of that entity is reduced to zero. HB 3.3.5 IG1.3. Banc of America Securities LLC estimates. The median of these spreads rounded up to the nearest 5 bps will be the fixed rate for the new index.855.7 IG 2. Succession Events in the CDX Indices Figure 50. and does not replace it within 30 Business Days.375% 18.125% 63. Prepayment Events in the LCDX Index Event Reference Entity WLT AMD Walter Industries Inc.500% 3. Inc.4 Trac-X is an index that traded before the inception of CDX.250% 91.2. Source: CreditEx.2. Dura Operating Corp.4.5..5. Source: CreditEx.Credit Strategy Research May 27.
855.Credit Strategy Research May 27.NA. 2008 35 Reference Entities in the CDX Indices Investment Grade: CDX. 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. Series 10 Figure 52. 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. Reference Entities in CDX.IG.NA.IG.7559 61 .
Series 10 Figure 53.NA. 2008 35 Crossover: CDX.855.7559 .NA.Credit Strategy Research May 27. Reference Entities in CDX. 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.XO.XO. 62 Credit Default Swap Primer Glen Taksler 646.
2008 35 High Yield: CDX.NA.HY. Series 10 Figure 54.NA. Reference Entities in CDX. 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.HY.855.7559 63 . 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.Credit Strategy Research May 27.
Series 10 Figure 55.Credit Strategy Research May 27. 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. -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 . 2008 35 Leveraged Loans: CDX.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.LCDX. INC.855. Reference Entities in CDX.NA.7559 . 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.LCDX.NA.
which may replace part of the language on the ISDA Master Agreement. margin requirements are due (initial margin. This document is optional. Credit exposure is granted in a risk equivalent. Its main purpose is to predetermine when. a $10 million credit line refers to the total allowable risk of a Counterparty. and a Bank of America. This agreement is negotiated between Bank of America. 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. N. and even regulators. (in this example) and a Counterparty to ensure enforcement of the CDS confirmation document. 3. and in what increments. For example. CDS Operations In general. The text is much more accountspecific than the ISDA Master Agreement and Schedule.Credit Strategy Research May 27. not a notional number. Main Documents The new credit derivatives investor should be familiar with five main documents: 1. 2003 ISDA Credit Derivatives Definitions. disclosure) Additional terms for foreign exchange 4. Confirmation (Master and Long formats). N. Language is relatively standard. 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. to trade in credit derivatives. Schedule. which refer to the Reference Obligation of the Reference Entity.A. The “Master” confirm is also called the “Short” form. 2008 35 Chapter IV – CDS Operations Management The rapid growth of the CDS market has brought operational issues to the attention of investors. Credit Support Annex. ISDA Master Agreement.A. banks and broker-dealers.7559 65 . It is negotiated only after Credit approves a Counterparty. Below.855. and threshold amounts). (for illustrative purposes only) credit officer must approve a credit line. which form the standard language for CDS transactions. Confirms may note a CUSIP. an investor must have an ISDA Master Agreement in place. 5. variation margin. 2. 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.
Of those eligible trades. which involves a Membership Package of legal documents. so the Counterparty need not purchase software. Partnership or LLC agreement. Alternatively.. 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. about 95% of credit default swaps are eligible for electronic settlement.markit. DTCC is web-based. BAS Portfolio Management may obtain information on publicly traded companies and regulated depository institutions.e. biographies.7559 . or other foundation documents Investment advisers: Form ADX Registered broker-dealer: Form BD Marketing materials. another nearly 95% (i. First.com/information/products/metrics. However. Counterparties may manually submit trades to DTCC and allow DTCC to match them with the relevant bank or broker-dealer. the Counterparty may allow the relevant bank or broker-dealer to submit trades DTCC and either accept (called “know”) or decline (called “DK. there is no charge to use the service itself. a bank or brokerdealer may facilitate the process. To confirm trades. Once the Counterparty submits the package and DTCC accepts it. the Counterparty receives a membership number and may begin using electronic settlement. While non-banks and broker-dealers must supply personnel to confirm trades. and other available information Electronic Settlement of Trades (DTCC) and CDS Operations Management About 95% of credit default swaps are eligible for electronic settlement. 90% of total trades) settle 45 electronically. 45 http://www. According to Markit Group Ltd. Counterparties use one of two methods.855.html 66 Credit Default Swap Primer Glen Taksler 646. through the Depository Trust & Clearing Corporation (DTCC).Credit Strategy Research May 27.” or “don’t know”) each trade. 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. For Counterparties not already established on DTCC. Currently. banks and broker-dealers absorb the costs of DTCC registration and settlement.
Credit Default Swap Primer Glen Taksler 646. After a client states that he would like to execute a trade. dealers noted the following goals for electronically eligible trades.pdf. 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. ISDA already estimates that 90% of electronic confirmations are normally sent by T+1. which comprises a list of standardized Reference Entities for CDS transactions. excluding novations. N.isda. and the Counterparty’s prime broker negotiate an agreement that allows a client to trade. on 100% of index trades and 90% of single name trades. faces the client’s prime broker as a Counterparty.org.A. The prime broker then faces the client in a separate trade.855. N.newyorkfed.3x for equity 47 derivatives. ISDA also estimates that unsigned credit derivatives confirmations rose to 6.Credit Strategy Research May 27.A. In a give-up. and ISDA 2007 Operations Benchmarking Survey. However.9x in 2006. RED subscribers are to accurately submit 9-digit RED codes. Exceptions to the above to be escalated internally and externally as 46 appropriate.” For year-end 2007. Bank of America. Bank of America. N. faces the client’s prime broker (not the client) as a Counterparty 46 http://www.6x the daily volume of new trades in 2007.A. N. By July 2008: “90% T+1 submission. N. Bank of America. matching without amendment. 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. 2008 35 Goals for CDS Operations Management Goals for CDS operations management In a March 2008 letter to the Federal Reserve. standard identifiers that greatly improve matching. available from http://www. Bank of America. If approved. 90% submitted accurately.A. The 2007 estimate compares with 9. Figure 56 and Figure 57 compare a normal trade with a give-up: In a give-up. 47 Preliminary results of ISDA 2008 Operations Benchmarking Survey. “RED” denotes Reference Entity Database.org/newsevents/news/markets/2008/an080327. from 4. sends a request to the client’s prime broker. 92% match by T+5. (for illustrative purposes only).9x for interest rate derivatives and 13.7559 67 .A.
CDS market participants promise to exchange cash flows following a potential Credit Event. 68 Credit Default Swap Primer Glen Taksler 646. 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. the protection Buyer simply becomes a general 48 creditor of the protection Seller. because of more favorable margin requirements at the prime broker. 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. credit default swaps may have a different seniority post-Bankruptcy. the client may be willing to pay a per-trade give-up fee to the prime broker. the client will owe Bank of America. Give-Up Figure 56. In Europe.7559 . the client may incur significant Counterparty risk. 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. 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. ISDA estimates that there was approximately $2. the risk of a Credit Event at the prime broker. i. In a typical give-up agreement. the client’s prime broker will specify a credit line for the client. rather than do new trades. If the prime broker declines the trade.1 trillion in 48 For the United States. The trade is automatically approved unless the prime broker declines the trade within a pre-specified period of time.. For example. Since all give-ups transact through the prime broker. for example. Should a client sell CDS protection and spreads tighten by the time a prime broker declines a trade.855. within two hours. money for unwinding the transaction.Credit Strategy Research May 27. Counterparties are required to post collateral (margin). As such. N. Counterparty Risk and Leverage As an unfunded market.e. As of year-end 2007. Client's Counterparty Source: Banc of America Securities LLC estimates. Initial Margin To reduce Counterparty risk. There are no hard assets set aside to guarantee payment. the client remains responsible for any associated unwind costs. the client will not receive the mark-to-market gain. should the protection Seller default on his obligation to pay the required cash flows post-Credit Event. 2008 35 Figure 57.A. So in return for lower margin. if a client sells CDS protection and spreads widen by the time a prime broker declines a trade.
initial and variation. 49 50 ISDA Margin Survey 2008. to reduce the risk that a hedge fund may not be able to meet variation margin requirements. Initial margin then would reflect the dealer’s expected loss over a two-week period. and only when they sell protection. Initial margin is then 6. this is in part because the Counterparty is usually satisfied that investors’ internal regulations require the holding of (internal) reserves. Separately. and effect an unwind. to reflect a lower likelihood of the Counterparty defaulting.2 points.isda. highrisk Counterparties will pay more margin than low-risk Counterparties. wider than 500 bps). These numbers 49 are across all derivatives transactions. obtain the necessary approvals. 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. suppose that a dealer believes it would take approximately two weeks to discover that a Counterparty were no longer creditworthy. available from http://www.6 points (8. with respect to that Counterparty’s portfolio. Regardless of spread. only 50 hedge funds are required to post initial margin.org. Although other investors may not be required to post initial margin. Initial margin is based on both risk of a particular trade and Counterparty creditworthiness.Credit Strategy Research May 27. Credit Default Swap Primer Glen Taksler 646. There are two types of margin. The example in Figure 58 assumes that a dealer believes spreads could double during the forced unwind period.3 trillion in each of 2006 and 2005. Generally. up from $1. hedge funds may be required to post initial margin when they buy protection on wide-spread or risky credits (for example.855.7559 69 . All Counterparties will pay higher margin to sell protection at 500 bps than 200 bps. decide to unwind that Counterparty. with a loss of 8. 2008 35 collateral in circulation. not just credit derivatives. The dealer scales that potential loss by 80%.2 points potential loss x 80% scaling factor). For instance.
Counterparties who share a greater portion of their portfolio with a particular dealer may face better margin requirements because of offsetting risk.Credit Strategy Research May 27. Banc of America Securities LLC estimates. Importantly.6 points Sources: Bloomberg. That hedge fund will face relatively high margin requirements on its sell-protection trades.2 points x Scaling Factor to Account for Likelihood of Counterparty Default.6% collected in Figure 58. Leverage Since initial margin is significantly less than 100%. at 80% scaling factor: Initial Margin = 8. In principle. protection Sellers are able to employ leverage. For example. initial margin requirements assume that a Counterparty will not default at the same time as a potential Credit Event. a protection Seller is able to leverage 70 Credit Default Swap Primer Glen Taksler 646. losses would be 60% of notional. because dealers will be aware that the hedge fund’s portfolio is more balanced. If a Counterparty and a Reference Entity were to file for bankruptcy at about the same time. at 10% margin. 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. far higher than the 6. a different hedge fund that has more balanced sell. losses would be significantly higher. because the relevant dealer will believe the hedge fund is exclusively long risk. 2008 35 Figure 58. By contrast. For example. For example.2 points x 80% = 6.and buy-protection trades through dealers may face better margin requirements.7559 .855. at 40% recovery. suppose that one hedge fund sells protection exclusively through one dealer but buys protection exclusively to another dealer.
for every $100. All types of Counterparties. Credit Default Swap Primer Glen Taksler 646. $100. For example. These payments may be reimbursed. CDS investors receive marks for outstanding trades.000). regardless of whether they buy or sell protection.Credit Strategy Research May 27. although this should not be construed as a recommendation. This means that.” discussed in the operational overview on page 65.000 / 98%).. daily).g. Many investors hold additional. Variation Margin The second type of margin is variation margin. 51 Generally. if the investor subsequently realizes mark-to-market gains.7559 71 . 51 Some investors also choose to purchase third-party data. the threshold may be zero for a higher-risk Counterparty and several million dollars for a lower-risk Counterparty. he is required to pay variation margin. Source: Banc of America Securities LLC estimates.041 face value of securities ($100. are subject to variation margin requirements. If an investor suffers mark-to-market losses beyond a pre-established threshold. Required Collateral Required collateral is billed in cash (for example. Marks As part of the margin process. 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. internal reserves. For example. Figure 59 illustrates sample leverage that CDS protection Sellers may use. marks are supplied via website at a pre-established frequency (e. Markit Group Ltd is one popular third-party data provider. so actual leverage is likely to be significantly lower. This type of collateral accounts for markto-market P&L and is set in the Credit Support Annex. or “CSA. See Figure 58 for an example of initial margin calculation.855. Figure 59. 2008 35 10x (1 / 10%).000 in required collateral. an investor may be allowed to post five-year maturity Fannie Mae or Freddie Mac securities at a ratio of 98%. but may be posted with securities at a certain ratio. Posted collateral earns interest at the Federal Funds rate. the investor must post $102.
a medium-sized hedge fund). including costs such as terminating hedges and funding. (ISDA). or if such information is not available. 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. For example. The close-out amount is based on an average of these quotes. such as coupons or margin An event beyond a party’s control. Termination Events If a Counterparty breaches any one of “termination event” criteria specified in the ISDA Master Agreement. payment may be due as soon as the same business day. 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). The 2002 ISDA Master Agreement specifies a combination of the two approaches from the 1992 ISDA Master Agreement. if a Counterparty defaults. or in the extreme. as published by the International Swaps and Derivatives Association. that member would be responsible for all losses attributed to 72 Credit Default Swap Primer Glen Taksler 646. The net close-out amount across all products is offset against any collateral (margin) held by the non-defaulting party. The close-out amount is calculated on the same day for all types of trades covered by the ISDA Master Agreement—for instance. 55 The allocation of losses applies only if a member of the clearinghouse were to fail.” Recall that. implementing this process may prove difficult and disruptive. 54 For the United States. 53 This is just one method for determining a close-out amount. By contrast. As such. The non-defaulting party must supply details of its calculations to its Counterparty. in the 1992 ISDA Master Agreement. The actual method used depends on the ISDA Master Agreement. which is a governing document usually signed 52 during the approval process for derivatives trading. credit default swaps may have a different seniority post-Bankruptcy. Among the criteria are: Bankruptcy of the Counterparty Failure to Pay required payments. (ii) may be chosen as the initial method. for example. In some cases. currently. equity derivatives.855. investors would face the clearinghouse. Inc.7559 . If a member (for example. become a general creditor in bankruptcy proceedings. 2008 35 ISDA Master Agreement Rules surrounding margin and collateral posting often are agreed in a Credit Support Annex to the ISDA Master Agreement. the CDS market is working on a clearinghouse to guarantee selected trades. the clearinghouse would reduce 52 ISDA Master Agreements often are based on standardized 1992 or 2002 forms. discussed below. a bank or broker-dealer) processes a trade for a non-member (for example. the other party may force an unwind of all existing trades. for replacement trades with identical terms to the trades being terminated. In Europe. The non-defaulting party may obtain marks from 53 third-party dealer quotes. if a member of the clearinghouse were to fail. to high yield or triple-B Following a forced unwind. and interest rate derivatives.Credit Strategy Research May 27. then the remaining party would follow the “Termination Events” 54 above. an internal model. then (ii) use internal models or third-party quotes. credit derivatives. As one might imagine. Counterparties are required to exchange the net P&L at current marks (a “close-out” amount). and is one reason why the CDS market is working on the development of a clearinghouse. If there is any collateral shortfall. or if no quotes are obtained. then losses would be allocated 55 among other clearinghouse members. known as “The Clearing Corporation. practically. The Clearing Corporation Currently. Rather than face banks or broker-dealers as Counterparties.
855. Exchange-Traded CDS Currently. the non-member. Credit Default Swap Primer Glen Taksler 646. Figure 60 summarizes the major features of exchange-traded CDS versus over-the-counter CDS.7559 73 . In the extreme case. but it is possible to trade credit default swaps on an exchange. this proposal may take effect for a small number of trades. For example. among a small number of counterparties. In its early stages. toward the end of 2008. exchange-traded CDS is a fixed recovery swap that trades in present-value terms. rather than paying 100 bps running for five years. Broadly speaking. if such losses were to cause the clearinghouse member to fail. Following a Credit Event. the protection Buyer receives a fixed recovery rate rather than the actual recovery rate of the cheapest-to-deliver Bond or Loan. the protection Buyer makes a single up-front payment for the present value of the swap. such losses could be allocated among remaning clearinghouse members. essentially all CDS trading volume is over-the-counter.Credit Strategy Research May 27. with the exchange as a Counterparty. 2008 35 Counterparty exposure.
Then see “CEBO” (Credit Event Binary Option) products. Chicago time Chicago time • Credit Support Annex with Bank • Minimum standard set by exchange. contracts of $100. discount + 500 bp running coupon. Failure to Pay. 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. 2008. initially proposed to be Mar. Jun. Baskets: • Fixed at contract inception by As specified by the exchange the exchange • Monday 8:30am .$10 MM • Contracts of $100. Jun. Sources: Bloomberg. • Sunday 5pm . 74 Credit Default Swap Primer Glen Taksler 646. and Dec Sep. Banc of America Securities LLC estimates.7559 ..g. as shown on Bloomberg. To access CME contracts on Bloomberg. Sep and Dec • Floating (Determined by Physical or Cash Settlement) • Over-the-counter Trading Day • Single-names: Zero.Friday 3pm. type CBOE <GO> 1 (CBOE Equity Index.000 or fixed DV01 of $500 • Bankruptcy. To access CBOE contracts on Bloomberg. CBOE. 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. of Default or Restructuring as same as for Over-the-Counter Modified Restructuring specified by the Exchange CDS.000 • Depending on the product. Volatility and Credit Option Products) <GO>. but may be increased by or Broker-Dealer broker • Typically the Bank or BrokerDealer. unless both parties are Banks or Broker-Dealers.855. and Dec the third Wednesday of the Contract Month. • $2 MM .Friday 4pm. CME. or Bankruptcy and Failure to Pay • N/A • Swap terminates early if no • N/A Relevant Obligation remains (e. Indices: Premium or discount + fixed running coupon. or for wider• Par minus present value of the contract spread credits. Jun. • 2nd Business Day preceding Sep. Then see contracts in the “CDS” category. following a full tender) • 20th Day each of Mar. • 3rd Friday each of Mar.Credit Strategy Research May 27. and • Failure to Pay or another Event • Depending on the product. type CEM <GO> 3 (CBT) <GO>. 2008 35 Figure 60. for selected Reference Entities.
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. and similar features of CDS contracts.7559 75 . a standard confirmation references a Physical Settlement Matrix (“Matrix”). published by ISDA. A sample confirmation and excerpt of the Physical Settlement Matrix are shown below: Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. The Matrix clarifies Credit Events. Deliverable Obligations Characteristics.855.
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
240 to execute the trade: 56 The reason for a long first coupon dates to earlier years of CDS. the 56 protection Buyer will pay a coupon for four months (November—March). N. the first coupon will be on March 20. 2015 to (including) June 20. 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. must pay $531. N. At that time. Credit Default Swap Primer Glen Taksler 646. or the next Business Day).7559 79 . The market needed time to complete these tasks and therefore moved to a long first coupon one month before a roll. and runs from March 20. 2015. 2008 35 before the December 20 roll. Bank of America. (for example) at 680 bps.A. However. if a Credit Event occurs. Then coupon payments will stop and the Counterparties must settle the contract. the protection Buyer must pay accrued interest up to and including the Event Determination Date (usually the same day as the Credit Event. The last coupon period will include the Scheduled Termination Date (maturity). when Counterparties settled trades by facsimile and agreed upon quarterly coupon payments by spreadsheet. On $4 million notional.A.855.Credit Strategy Research May 27.
240 unwind fee. Banc of America Securities LLC estimates.7559 . Sample Trade Recap for an Unwind Sources: Bloomberg.Credit Strategy Research May 27.855. Attached to the trade recap are the calculations for the $531. 2008 35 Figure 62. shown in Figure 63: 80 Credit Default Swap Primer Glen Taksler 646.
Bank of America. 2008 35 Figure 63. On $8 million notional. but will only pay 20 bps running to the original (“Remaining”) Party. (for example) at 50 bps. Credit Default Swap Primer Glen Taksler 646.796.855. 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. 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. less accrued interest. buys protection at 50 bps. N.7559 81 . Banc of America Securities LLC estimates. the client will receive $109. N. This is because Bank of America.Credit Strategy Research May 27.796.A. N. 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.A. for a total of $109.A.
2008 35 Figure 64.Credit Strategy Research May 27. Attached to the trade recap are the calculations for the $109.855. shown in Figure 65: 82 Credit Default Swap Primer Glen Taksler 646. Sources: Bloomberg. Banc of America Securities LLC estimates.7559 . Sample Trade Recap for an Assignment For illustrative purposes only.796 assignment fee.
Technically.” who assigns (transfers) liability for the contract. which is then assigned to a different broker-dealer. the “Transferor.855. Assignment Spread Sample Request for an Assignment 2005 Novation Protocol An assignment involves three parties An assignment involves three parties: the “Remaining Party.. This often results in a decrease in Counterparty risk. Expecting that the original broker-dealer (the Remaining Party) will agree to the assignment.7559 83 . Banc of America Securities LLC estimates. the Remaining Party must agree to face the Transferee Credit Default Swap Primer Glen Taksler 646. Should a Credit Event Prior to assigning a trade.Credit Strategy Research May 27. the client (Transferor) and the new broker-dealer (Transferee) have simply assigned the trade. an assignment may not occur unless the Remaining Party agrees to face the Transferee. However. where Remaining Parties may not know which Counterparty they face for months at a time. because the new broker-dealer is viewed as more credit worthy than the client (e. historically. the Transferor must obtain permission from the Remaining Party. Calculations Attached to Sample Trade Recap for an Assignment Notional Dates Original Spread Paid by Buyer Sources: Bloomberg. a hedge fund). To remove the Transferor from the original CDS contract and replace it with the Transferee. 2008 35 Figure 65. Operationally. and later sought permission from the Remaining Party.” who remains on the CDS contract even after the assignment takes place.” to whom the contract is assigned (transferred). this resulted in a backlog of assignments. This is because the original CDS contract was a bilateral agreement between the Remaining Party and the Transferor. This is one of the concerns highlighted by market regulators. Consider an original trade between a broker-dealer and a client. and the “Transferee.g. assignments were executed without the permission of the Remaining Party.
Clients who do not participate in the Protocol must obtain permission from the Remaining Party before attempting to assign (also called “novate”) a trade. the Remaining Party may not know its exact credit exposure for some time.7559 . 84 Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. on the day an assignment is agreed to. 2004. Moreover. the trade would follow Figure 89.855. 2008 35 occur before the assignment backlog is completed. In a March 2008 letter to the Federal Reserve. in the location of the Transferee. instead of the mechanics of Figure 90. The 2005 Novation Protocol is interpreted as an amendment to the ISDA Master Agreement and is irrevocable. In September 2005.pdf. required to execute an assignment. the assignment will instead be booked as a new trade. beginning in late 2008. Otherwise. As part of the 2005 Novation Protocol. the 2005 Novation Protocol took effect for the CDS market. 57 http://www. On October 24. dealers stated plans to implement a way for novation requests to be submitted by electronic platform. rather 57 than e-mail. the assignment will be booked as a new trade The Transferee must receive consent from the Remaining Party by 6pm. should either the Transferor or Transferee file for Bankruptcy.org/newsevents/news/markets/2008/an080327. the Remaining Party may contact the wrong Counterparty for payment. This Protocol requires the following: The 2005 Novation Protocol requires that the Transferee receive consent by 6pm on the trade date.newyorkfed. the Federal Reserve and 14 dealers met to discuss risks to the credit derivatives market. below is a sample e-mail or Bloomberg message from the Transferor to the Remaining Counterparty. If the Transferee does not receive consent by 6pm. That is.
subject to your consent to such transfer.855. Credit Default Swap Primer Glen Taksler 646. 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. Source: ISDA. for illustrative purposes only. by replying to all addressees of this email and indicating your decision regarding consent.7559 85 . 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. Indicative sample.Credit Strategy Research May 27. 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”).
A brief explanation appears in Figure 67. (for example) faces a client’s prime broker as a Counterparty.855. Sample Credit Event Documentation To trigger settlement of a CDS contract. as opposed to with each bank and broker-dealer). Banc of America Securities LLC estimates. N. The prime broker then faces the client in a separate trade. 2008 35 Give-Up In a give-up.7559 . Bank of America. Give-ups may be done for margining purposes (the prime broker sees the client’s entire portfolio. Sample Trade Recap for a Give-Up For illustrative purposes only. resulting in potentially lower margin) or because a client only has one ISDA Master Agreement in place (with the prime broker. a series of notices must be served. followed by sample documentation below. Figure 66. 86 Credit Default Swap Primer Glen Taksler 646.A. Figure 66 shows a sample trade recap. Sources: Bloomberg. as discussed on page 67.Credit Strategy Research May 27.
Credit Default Swap Primer Glen Taksler 646. 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. Bankruptcy Court in the [applicable bankruptcy court] (the “Bankruptcy Filing”).S. 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. 2008 35 Figure 67.7559 87 . Sample Credit Event Notice and Notice of Publicly Available Information A Credit Event Notice states that a Credit Event has occurred. both the Buyer and Seller of protection are permitted to deliver a CEN at any time from the Credit Event date until trade maturity. Capitalized terms used and not otherwise defined in this letter shall have the meanings given them in the confirmation of the respective Transaction. when [Reference Entity] filed a petition for voluntary Chapter 11 protection in the U. 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].Credit Strategy Research May 27.855. A Notice of Publicly Available Information documents the Credit Event A Credit Event Notice (“CEN”) states that a Credit Event has occurred. 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. In a standard confirm.
For CDS (often called “cash”) settlement protocols that have taken place.7559 . Instead. we provide the Publicly Available Information attached hereto. both Counterparties sign an adherence letter to the relevant CDS settlement protocol. 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. Nothing in this letter shall be construed as a waiver of any rights we may have with respect to the Transaction(s). [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. a NOPS is not delivered. Accordingly. to physically settle the Credit Default Swap. Sincerely.855. 2008 35 This letter also comprises our Notice of Publicly Available Information with respect to this Credit Event.Credit Strategy Research May 27. 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.
We hereby confirm that we will settle each Transaction and require performance by you in accordance with the Physical Settlement Method. 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. This letter constitutes a Notice of Physical Settlement with respect to each of the Transaction(s). 2008 35 Reference is made to the Credit Derivative Transaction(s) described on Annex A hereto (the “Transaction(s)”) between us.Credit Strategy Research May 27. if no meaning is specified therein.7559 89 . Subject to the terms of each Transaction. Credit Default Swap Primer Glen Taksler 646. 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. in the 2003 ISDA Credit Derivatives Definitions. Any capitalized term not otherwise defined in this letter will have the meaning. This notice assumes all Deliverable Obligations will be denominated in USD. assigned to such term in the confirmations of the respective Transactions or. Reference is also made to the Credit Event Notice(s) previously delivered. we will deliver to you on or before the Physical Settlement Date the following Deliverable Obligation(s). if any.855.
For investment grade credits. 6/20/2013). Sample Trader Runs Single-Name CDS Figure 68 shows a sample single-name CDS trader run. Readers looking for a basic introduction to credit derivatives may wish to focus on sections toward the front of this more advanced chapter. Notice that the bid-offer spread is 20 bps for a standard five-year maturity (in this case. the bid-offer spread is typically 4 bps to 10 bps in five-year CDS. 90 Credit Default Swap Primer Glen Taksler 646.7559 . Keep in mind that this example is for a relatively widespread credit (475/495 bps in five-year CDS). 2008 35 Chapter V – CDS Trading Management This section discusses trading and risk analytics specific to the CDS market. usually the most liquid part of the CDS curve.855. In this case. the bid-offer spread widens to 30 bps for shorter-dated maturities (6/20/2010).Credit Strategy Research May 27.
50 bp in HVOL.NA. That is. Credit Default Swap Primer Glen Taksler 646. Bloomberg Screen of Sample Single-Name CDS Trader Run For illustrative purposes only. 2018 for 10Y).25 bp in IG. The rows denote the maturity (June 20. Prior to the credit crunch beginning summer 2007. Sources: Bloomberg. after selecting the relevant index. click the red “Members” icon.7559 91 .). 0. the pricing convention is reversed from the cash market for investment grade. select one of the indices (or sub-indices) and type CDSW <GO>. 2013 for 5Y and June 20. bid-offer spread was approx 0. and 3 bps in HY. the bid is lower than the offer. Figure 69 illustrates a sample trader CDX. CDX Indices The CDX indices are available on Bloomberg at CDSI <GO> or CDX10 CDS <Corp> <GO> (CDX9 for Series 9. 2008 35 Figure 68. CDX8 for Series 8. The bid-offer spread is 1 bp in 5Y IG and 2 bps in 10Y. etc.IG Series 10 run. Banc of America Securities LLC estimates. Alternatively. The Reference Entity composition of the selected index or sub-index may be viewed on Bloomberg by typing MEMB<GO>. on the CDSW (“Credit Default SWap”) screen. To use the customized CDSW screen.Credit Strategy Research May 27. when quoted in spread. Keep in mind that because the CDX indices are composed of credit default swaps.855.
the protection Seller pays $256. Sources: Bloomberg.e. at inception..Credit Strategy Research May 27. single-name CDS usually trades at par).855. Bloomberg Screen of Sample CDX. Banc of America Securities LLC estimates. 2008 35 Figure 69. Since the index trades with a fixed coupon of 155 bps.IG Trader Run For illustrative purposes only. Series 10) protection at 102 bps (dealer bids 102 bps). Figure 70 shows the relevant CDSW screen for an investor who sells IG10 (Investment Grade index.NA. where the fixed coupon usually equals the running spread (i. 92 Credit Default Swap Primer Glen Taksler 646.7559 . This is different from single-name CDS.560 upfront (based on a $10 million notional) and receives 155 bps running.
Since the indices trade in dollar price. an investor may buy the CDX HY Series 10 index at $96 7/8 in dollar price or 582 bps in spread. Banc of America Securities LLC estimates.IG.Credit Strategy Research May 27.7559 93 .855. the bid is higher than the offer in spread terms. Bloomberg CDSW Screen for CDX. Sell Protection At 102 bps For the high yield market. Figure 65 shows a sample run of the overall index (HY10 and HY9) and the leveraged loan CDS index (LCDX10 and LCDX9).NA. Credit Default Swap Primer Glen Taksler 646. and price and spread are inversely related.10 Notional Coupon Settle Paid by Seller Sources: Bloomberg. That is. 2008 35 Figure 70.
2008 35 Figure 71. which is just over five years. credit default swaps have standardized maturities.855. Banc of America Securities LLC estimates.NA. single-name CDS “rolls” to a new standard maturity date To help make execution straightforward. The CDX indices roll every six months: 94 Credit Default Swap Primer Glen Taksler 646. Bloomberg Screen of Sample CDX.Credit Strategy Research May 27.HY and LCDX. CDS Rolls Every three months.7559 . Sources: Bloomberg. Every three months. single-name CDS “rolls” to a new standard maturity date. For example. a “five-year” trade executed on April 1. 2013. 2008 matures on June 20.NA Trader Run For illustrative purposes only.
and XO roll on March 20th and September 20th.75-Year” CDS matures in 5 years. New Maturities for CDX Indices. But by CDS market convention.25 years. Don’t Be Confused by Market Convention March 20. For more on CDS rolls. Source: Banc of America Securities LLC estimates. this results in a potential mismatch between actual and quoted maturities. For more details.25 years to 5 years (center column of Figure 73). For single-name CDS. as detailed in Figure 73: Figure 73. Over the following three months. investors roll to maintain liquidity. the on-the-run five-year contract is usually the most liquid point on the credit default curve.25 years 5 years That is. 2008 Roll Date On the roll date. Market Convention "5 years" "4.75 year” point on the curve (far right column of Figure 73). that is.25 years.Credit Strategy Research May 27. Single-Name CDS June September December March Single-name CDS rolls on March June September and December CDX IG. CDX HY rolls on March 27th and September 27th. Actual Maturity Contract 20-Jun-2013 20-Mar-2013 Source: Banc of America Securities LLC estimates.855. “4. on the roll date. 20th. HVOL. Credit Default Swap Primer Glen Taksler 646.7559 95 . investors roll to maintain liquidity Typically. at which time they look to unwind contracts. Typically. Other investors sell 7-year credit default protection and let their contracts roll down to the 5-year point on the curve. versus Single-Name CDS Roll Occurs on the 20th Day of the Month New Maturity Month of Roll March June September December 20th. 20th. 2008 35 Figure 72.75 years" as of 20 Mar 08 5. “five-Year” CDS matures in 5. please see the Chapter Appendix on page 113. LCDX rolls on April 3rd and October 3rd. this is referred to as rolling down from the “5 year” point on the curve to the “4. please see Figure 74. “five-year” CDS actually matures in 5. CDX Indices June No Roll December No Roll 20th. single-name CDS rolls down from 5.
but was delayed because. Banc of America Securities LLC estimates. 2008 35 Figure 74. Source: Markit Group Ltd.855. but was delayed until May 22. under index rules. HVOL. 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. We show a six-month holding period. The investor buys $10 million notional of credit default protection at 80 bps. 96 Credit Default Swap Primer Glen Taksler 646. and subsequently unwinds the trade at 120 bps. The CMBX index was scheduled to roll to Series 5 on April 25.Credit Strategy Research May 27.7559 . 2008. 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. 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. 2008 to include more recent deals. only five deals qualified for inclusion. 2008. XO. with cases in which the investor rolls or does not roll.
but pays $20.2% 151 -40 111 2.25 N/A 4 80 124 120 120 Expiry (Month) June September Horizon (Years) 0. With All Spread Widening Occurring After the Roll In the first scenario.25 0.) 10.7559 97 .25 Roll Fees (bps) N/A 4 Spread (bps) 80 84 Buy Protection in March at 80 Bps and Unwind Six Months Later (in December) at 120 Bps Unwind Buy Protection (Sell Protection) Spread (bps) 80 120 Principal Carry P&L Net P&L Return ($ Thous.000 Total No Roll 10. not an amendment to the original confirm. with all spread widening occurring before the roll 10. the investor unwinds the original trade at 80 bps. Credit Default Swap Primer Glen Taksler 646. in this case September 20.000 in carry (84 bps x $10 million notional x 0. Accordingly.000 Total Roll. As such. The roll costs the investor 4 bps. 2008.855. the valuation date (toward the bottom-left) is the date on which the investor expects to unwind the trade.000 in principal. is issued. the investor earns zero principal over the first three months.Credit Strategy Research May 27. Lastly.4% Roll. 2008 and mature September 20. Sample P&L Calculation for a Buyer of Single-Name Protection Contract Size ($ Thous. and enters into a new trade at 84 bps. CDS stays constant at 80 bps over the first three months. the roll increases the cost of carry to 84 bps per annum.) (Annualized) 0 159 159 -20 -21 -41 -20 138 118 2. th Since the investor rolls on June 20 .25 years).) ($ Thous. A new confirm.000 June 0. To project forward P&L. The investor also pays $21.000 in carry (80 bps x $10 million notional x 0. Buyer of Protection Rolls.) ($ Thous. The investor would earn $159. Banc of America Securities LLC estimates. Mechanically.25 0.000 10.25 years). as shown in the “Principal” line of Figure 76 (toward the bottom-left). Figure 76 shows the CDSW screen that an investor would use to project profit on the new trade. the effective date is one calendar day (T+1) following the roll. 2013.2% Sources: Bloomberg. assuming that 5-year CDS will widen to 120 bps. with all spread widening occurring after the roll 176 -17 159 -20 -31 -51 156 -48 108 2.50 N/A 80 116 June September 0.000 10. 2008 35 Figure 75. the new trade would be effective on June 21.
It would be more accurate to use the 3-month forward curve (i. 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. where spreads widen after the roll. In the second scenario. but now all spread widening occurs before the roll. The total return is 2. carry is 80 bps ($20.855.e. where spreads widen before the roll. The main difference between the first two scenarios lies in the cost of carry.000) during the second three months. a 4-bp roll means that the investor enters into a new contract at 124 bps. resulting in a principal gain of $176.Credit Strategy Research May 27. Over the six-month life of the trade.50 years). CDS widens from 80 bps to 120 bps. resulting in a $17.7559 . the expected interest rate curve at trade unwind). the investor earns $118. September 20..000 carry in the second three months).000. Sources: Bloomberg. In this case. the investor still earns $159.000) during the first three months and 84 bps ($21.000 / $10 million notional / 0. With credit quality constant.000 principal loss. but this feature is currently not supported in Bloomberg. 2008 35 Figure 76. 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. but in two parts. We show the Bloomberg screen to follow market convention. this contract rolls down to 120 bps over the second three months. Over the first three months. Banc of America Securities LLC estimates. 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. carry is the same 80 bps ($20.000 principal – $20.000 principal. Then.000) 98 Credit Default Swap Primer Glen Taksler 646. In the first scenario.4% ($118.000 ($159.000 carry in the first three months – $21. Buyer of Protection Rolls.
In addition.319 duration). Rather than earning $158. there is a tradeoff between carry and duration. If an investor does not roll.7559 99 . respectively. from 84 bps after the roll to 120 bps. x 4.143 duration). Credit Default Swap Primer Glen Taksler 646. the investor risks reduced liquidity by not maintaining an on-the-run contract.000 in principal (roughly calculated as 36 bps spread widening. However.000 net P&L / $10 million notional / 0.000 (roughly calculated as 36 bps spread widening. 2008 35 during the first three months.000) during the second three months. Moreover. to $108.855.4% and 59 2.5 years).75-years. x 4.2% ($111. In this case. For protection Buyers. there is a tradeoff for P&L: The investor does not increase the cost of carry by the 4-bp roll. Overall Tradeoff for the Buyer of Protection Overall.000 principal – $40. he saves the roll fee. This results in a return of 2. the investor unwinds a 4.2%. 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. since CDS rolls down from 5to 4. This reduces P&L from spread widening. the investor earns $151. but increases to 124 bps ($31. from 80 bps to 116 bps.50 years (first scenario) or $108. and subsequently unwinds the trade at 40 bps: 59 The annualized return is calculated as $118.000 carry).75-year contract after three months.000 / $10 million / 0. since CDS has a three-month shorter maturity than the on-the-run contract. If an investor rolls. the duration shortens. Net P&L is therefore $111. but suffers from a progressively shortening duration. not 120 bps.Credit Strategy Research May 27.50 years (second scenario). Returns are 2.000 net P&L / $10 million notional / 0. spreads only widen to 116 bps.000 ($151. Buyer of Protection Does Not Roll The bottom section of Figure 75 shows the case in which the investor does not roll. Rather than keeping a five-year on-the-run contract.000 in the spreads-widen-after-the-roll scenario. he pays a higher cost of carry (the roll fee) but keeps a roughly constant duration.000 in the spreads-widen-before-the-roll case. which benefits P&L. Lower carry reduces net P&L from $118.
times the 61 probability of default.8% Roll. the expected gain is simply the spread.6% Sources: Bloomberg.855.6% In spread tightening scenarios.000 Total Expiry (Month) June September Horizon (Years) 0. Assuming that CDS is priced solely on default risk. the expected gain from selling protection must exactly offset the expected loss: Expected Gain = Expected Loss At a one-year horizon. it is possible to back out an implied probability of default It is possible to back out an implied probability of default. An inverted curve could result in the protection Seller paying a premium to roll.000 10. This is both because the investor receives a 60 premium for rolling (in this case. the protection Seller does at least as well by rolling to a new on-the-run contract. Sample P&L Calculation for a Seller of Single-Name Protection Sell Protection at 80 Bps and Unwind at 40 Bps Contract Size ($ Thous. Implied Probability of Default For investors who are willing to assume a recovery rate. the annualized ROE is 23% (4.25 0.) 10. for spread tightening scenarios.5% collateral for selling five-year protection at 80 bps ($350.000 Total No Roll 10. The logic is as follows. For spread widening scenarios.000 on $10 million notional) and keep an additional 16. for total collateral of 20%.25 Roll Fees (bps) N/A 4 Spread (bps) 80 84 Unwind Sell Protection (Buy Protection) Spread (bps) 80 40 Principal Carry P&L Net P&L Return ($ Thous.) (Annualized) 0 199 199 20 21 41 20 220 240 4.) ($ Thous. these two factors would counteract: If the investor did not roll.6% return / 20% collateral). he would lose money at the duration of the 4. protection Sellers do at least as well by rolling to a new on-therun contract Notice that. particularly hedge funds. That is: 60 We assume an upward-sloping curve. the expected loss is notional minus recovery. with all spread tightening occurring before the roll 10. If CDS is fairly priced.Credit Strategy Research May 27. 4 bps) and because duration extends.50 N/A 80 36 190 40 230 4.000 10.75-year CDS contract.7559 .25 0. If the annualized return is 4. Banc of America Securities LLC estimates. with all spread tightening occurring after the roll Roll. as in the no-roll scenario of Figure 77. For example.6%. based on the traded credit default spread and an assumed recovery rate. Also noteworthy is that investors. an investor may post 3. If the investor did roll. June September 0. 2008 35 Figure 77. often sell protection with margin. 100 Credit Default Swap Primer Glen Taksler 646. 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.5% of internal reserves.25 N/A 4 80 44 40 40 181 18 199 20 11 31 201 29 230 4.) ($ Thous.000 June 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. For example. such as liquidity and mark-to-market risks. Source: Banc of America Securities LLC estimates.855. investors should realize 61 If there is a default. 62 At longer horizons. the one-year probability of default is the spread. 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). divided by one minus the expected recovery rate Figure 78 compares the five-year implied probability of default with realized default rates. of Default Is 49% Implied Probability of Default by CDS Spread Figure 79. 1920-2007. 5y Realized Default Rate and 5y Long-Term Average Default Rate (1920-2007) obtained from Moody’s Investors Service.7559 101 . As Figure 78 suggests. the market prices factors other than default risk into pricing. Banc of America Securities LLC estimates. Implied Default Probability Generally Trades Wide to Realized Default Rate Baa-Rated Bonds (Not CDS) For example. “Corporate Default and Recovery Rats. the 5y Implied Prob. with a CDS spread of 800 bps and an expected recovery rate of 40%.08 / ( 1 – 0. 62 The one-year probability of default is the spread. Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. At 800 bps. 2008 35 Spread = [ Probability of Default ] x [ 1 – Recovery ] So that: [ Probability of Default ] = Spread / [ 1 – Recovery ] In other words. Implied default probabilities trade wide to historic default rates Naturally. For example.” February 2008. the five-year implied probability of default is 1 – exp( – 0. The implied probability of default extracted from CDS spreads includes these other factors. divided by one minus the expected recovery rate. Assumes flat credit curve and 40% recovery rate. the probability of default is 1 – exp( -[ Spread ] / [ 1 – Recovery ] x [ Horizon ] ). For example. Sources: Moody’s. the one-year probability of default is 7% (400 bps / [ 1 – 40% ] ). Figure 78. or 49%.4 ) x 5 ). for bonds (not CDS) rated Baa by Moody’s. This is because the protection Seller owes notional on the CDS contract but receives a bond from the protection Buyer. the Seller of protection loses notional minus recovery. The likelihood that this event will occur is simply the probability of default. at a credit default spread of 400 bps and a recovery rate of 40%. 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.
Unwind 800” discounted at L + 800 / ( 1 – 40% Recovery Rate).3 -16. Unwind 400 Net “Buy 400. Figure 80. say. The reason is that each trade will have a different probability of default and therefore a different discount rate.7559 . Sources: Bloomberg. “Buy 800. because of different discount rates 20 15 10 5 0 -5 -10 -15 -20 13. the implied probability of default becomes more meaningful because default risk starts to dwarf liquidity and mark-to-market risk factors.Credit Strategy Research May 27. 63 For near-distressed credits. Banc of America Securities LLC estimates. But Loses 400 Bps in Another Case Net. unless the two trades have the same unwind spread.2 Buy 400. 2008 35 that the actual probability of default is typically far lower than that implied by CDS 63 spreads. This reflects the market-implied risk that the Reference Entity may suffer a Credit Event during the life of the contract. CDS Duration and Curve Trades Similar to cash bonds.9 P&L (Points) -2. CDS P&L is Determined by the Discount Rate Investor Makes 400 Bps in One Case. investor loses money. 102 Credit Default Swap Primer Glen Taksler 646. Mind the Discount Factor CDS trades are discounted at LIBOR plus the implied probability of default. 400 bps on one trade and loses 400 bps on another trade will not be P&L neutral. many single-name CDS investors use the CDSW screen on Bloomberg to calculate these sensitivities.855. Unwind 800 Buy 800. CDS contracts have an associated duration and DV01. By market convention. Unwind 400” discounted at L + 400 / ( 1 – 40% Recovery Rate). Figure 80 illustrates that an investor who earns.
572 DV01 / $10 million notional x 10. Sources: Bloomberg. The multiplication by 10. Banc of America Securities LLC estimates.572 of P&L. In Figure 81. a 1 bp spread change will result in approximately $4.Credit Strategy Research May 27. 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. particularly in Europe. Intuitively. an investor executes a CDS trade at 100 bps.000 occurs because DV01 refers to the change in P&L per basis point. but the market is slowly moving toward using a full credit curve (different spread for different maturities). for a $10 million notional position. 64 The calculation is $4. the current (markto-market) spread is also 100 bps. 64 Cash bond investors frequently refer to this number as a duration of 4. 2008 35 Figure 81. we show a flat credit curve of 100 bps on the right side of Figure 81. 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>.”) Since we are analyzing the trade at inception.855. This is the “Deal Spread” section on the left-hand side of the screen. and a basis point is 1/10.000 of a dollar.000.572. (Sometimes. deal spread is referred to as “coupon” or “strike. Spread DV01 is shown in the “Sprd DV01” portion toward the bottom-center of the screen.000 bps. Also note. As illustrated in Figure 82.7559 103 . For example. as illustrated in the circled portion on the right-hand side of the screen. Credit Default Swap Primer Glen Taksler 646. duration varies inversely with spreads. at a 100-bp starting spread.
500 4.7. June. Often.25 4. 5y CDS A 1bp move at 10 bps is more significant than a 1 bp move at 1.75 3. When trading. Duration Varies Inversely with Spreads Duration and DV01 vs. an investor always should confirm the exact notionals before execution. and December.” because the investor profits when the 5s/10s curve steepens. the CDS market often looks at credit curves in percent. this trade is referred to as “buying 5s/10s. so th the investor receives $15. 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. durations are approximately 4. Notional-Neutral Curve Trades (Jump-to-Default Hedging) Particularly for near-distressed or volatile credits.0 – 6.5 and ten-year duration is 7.50 3.25 3.750 4. suppose an investor sells five-year protection at 100 bps and buys tenyear protection at 110 bps.750 3.000 per $17 million of five-year and $10 million of ten-year notional.250 4.5 for five-year CDS.7 x 100 bps – 1 x 110 bps.855.7 times as much five-year protection as he buys in ten-year protection (7. The investor should sell approximately 1. 5. Weights on DV01-Neutral Curve Trades 65 To calculate the weights on single-name curve trades. As a rule-of-thumb.000 on the 20 day each of March. Still. meaning $60.250 3. In this case.0 – 4.75 for ten-year CDS. For example.” with the notional referring to the longer-dated (ten-year) maturity. this example often would be referred to as “buying $10 million 5s/10s DV01-neutral.50 4.00 0 5. and 6. multiply the weight on each leg by its respective spread.500 3.00 3. 104 Credit Default Swap Primer Glen Taksler 646. 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). Then divide the duration of one leg by the other.000 3.000 100 200 300 400 500 600 700 800 900 1000 5y CDS Source: Banc of America Securities LLC estimates.7559 DV01 per $10mm Notional Duration .7 / 4.000 bps 5.75 4. A higher number means a flatter credit curve—for example.5). 2008 35 Figure 82. or 1. Five-year duration is about 4. To find carry. September.0 for seven-year CDS. calculate the duration for each leg of the trade. carry is 60 bps per annum. investors may instead use notionalneutral curve trades.00 4.Credit Strategy Research May 27.25 – 7. Payments are exchanged quarterly.
The investor will be long duration. By “breakeven. if the investor is wrong and the Reference Entity suffers a Credit Event (in the first year). Butterfly Trades With a curve trade. based on the current (spot) credit curve. However. For example. either small spread moves (DV01neutral) or jump-to-default moves (notional-neutral). Credit Default Swap Primer Glen Taksler 646. An investor who wants to be long five-year risk may consider two trades: Sell five-year protection today.and ten-year protection. or an outright Credit Event). For example. 66 Assuming a Bankruptcy or Failure to Pay Credit Event. The breakeven spread for two-year protection that begins in three years is called the implied forward spread.855. please see Chapter VI – CDS Case Studies and Legal Issues on page 152.” we mean the spread that makes the two trades equivalent. parallel curve move and outright default. an investor may sell five-year protection and buy both three. Implied Forward Spread The implied forward spread shows the market’s expectation of future spreads. an investor may hedge one risk. Both the 3s/5s and 5s/10s legs are DV01 neutral. an investor with a bullish view may sell $10 million of five-year protection and buy $10 million of one-year protection. Consider two trades. For details. The investor would still be exposed to moderate spread moves. sell two-year protection. especially the section “Practical Trading Considerations Following a Restructuring” on page 157.Credit Strategy Research May 27. This supports the investor’s bullish view. because he sells protection on the longer duration asset (five-year protection). the investor will be hedged. illustrated in Figure 83. The investor may not be fully hedged following a Modified Restructuring. which fall between the extremes of a small. or Sell three-year protection today and then in three years. because gains on the short-maturity leg will exactly offset losses on the long-maturity 66 leg.7559 105 . 2008 35 (small spread changes) and more worried about jump-to-default risk (large spread changes. “Butterfly trades” combine two curve trades to hedge both extremes.
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. Sell 2y CDS at the Implied Forward Spread Sell 5y CDS Sell 3y CDS. sell 2y CDS at implied forward 250 200 150 100 50 0 1 Assumes 40% recovery rate. Implied Forward Spread Two Equivalent Trades: Sell Five-Year CDS. or Sell Three-Year CDS. and Then in Three Years.855.7559 . Source: Banc of America Securities LLC estimates.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. and then in three years. To do this. the investor would sell longer-dated protection and buy shorterdated protection. 2008 35 Figure 83.
Sources: Bloomberg. After CDS curve steepening in the first half of 2007. coupled with dealers’ desire to reduce default risk. Calculating the Implied Forward Spread For a Two-Year CDS Contract Beginning March 20.Credit Strategy Research May 27. Credit Default Swap Primer Glen Taksler 646. In these trades. 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>. CDS Curve Flattening (And Inversion) Since Summer 2007 Though 1H07 saw CDS curves steepen on record LBO activity. the real story was unprecedented flattening (and inversion) in the second half of the year. giving them a hedge against outright defaults while remaining long duration.7559 107 . 2008 35 Figure 84. dealers buy more five-year protection (short risk) than they sell in ten-year protection (long risk). the CDS market has seen significant volatility in CDS curves. resulted in DV01-neutral 5s/10s flatteners.855. Figure 85 shows recent performance of 5s/10s CDS curves. on record LBO activity. the real story was unprecedented curve flattening (and inversion) during 2H07 Since summer 2007. Banc of America Securities LLC estimates. Front-end illiquidity.
7559 .” Mechanically.Credit Strategy Research May 27. Under a points upfront convention. The Transition from Spread to Points Upfront Once five-year CDS spreads approach the 700-bp range. Source: Banc of America Securities LLC estimates. the Seller of protection would keep the points upfront.855. without ever having received a coupon payment from the protection Buyer. quotes typically change to “16. 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.000 per $10 million notional quarterly (5% per annum). Moreover. 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. as shown in Figure 86: 108 Credit Default Swap Primer Glen Taksler 646.4 points upfront plus a 5% running coupon.000 (16. 2008 35 Figure 85. instead of a “1000-bp” five-year CDS spread. 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 quoting convention often changes from running spread to points upfront plus a 5% running coupon.4 points on $10 million notional) at inception.640. Under a spread convention. the Seller of protection loses notional minus recovery. the change means: Under a points upfront convention. For example. the Buyer of protection pays $125. beginning on the next quarterly coupon date. the Buyer of protection pays $1.
Points Upfront 10 . An Unwind is Straightforward Investor Unwinds Trade.4 = 6 Notional . Mechanics for a Credit Event Occurring on Effective Date of Single-Name CDS Trade $10 Million Notional.855.000 per annum on $10 million notional Figure 88. Source: Banc of America Securities LLC estimates. please see the Chapter Appendix on page 115. in which an investor buys protection at 500 bps running.7559 109 . In general. with Same Counterparty. Client's Counterparty Payments are made quarterly. Suppose that protection widens to 1000 bps.64 = 4. and the deal (also called original. unwinds are settled in present value (points upfront).36 Assumes a flat credit curve. Since summer 2007. and Jump Risk How does a CDS investor terminate an existing trade? Consider Figure 87. homebuilder.4 . 40% Recovery Rate. or running) spread is 500 bps. For more details. there are three ways to do this: Figure 87. Unwinds. Original Trade Investor Buys Protection at 500 bps 500 bps is $500.Recovery 10 .Credit Strategy Research May 27. In this case. Source: Banc of America Securities LLC estimates.4 points upfront Client's Counterparty Payments are made quarterly. Unwind CDS unwinds occur when an investor terminates a trade with the original Counterparty The investor may unwind his position with the original Counterparty. Assignments. at 1000 bps 1000 bps is equivalent to 16. points upfront have affected the automobile. and paper sectors.4 points upfront + 500 bps running Client Client 500 bps running Protection 16. the unwind spread is 1000 bps. Source: Banc of America Securities LLC estimates. monoline insurer. which shows a sample trade. Credit Default Swap Primer Glen Taksler 646. 2008 35 Figure 86. and 16. To terminate the trade.Recovery . 1000 bps is equivalent to 16.1. media. and the investor wishes to terminate the trade at a profit.4 Points Upfront + 5% Running Coupon Five-Year CDS Quoting Convention Spread Points Upfront Seller Loses (Buyer Profits) P&L Example Notional .4 points upfront plus 500 bps running. as illustrated in Figure 88.
realizing profit over the remaining life of the trade. and the counterparty would owe 22. 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. the appropriate conversion would be to 22. The client’s name is removed from the trade. less accrued interest. If the client instead wants to take profits through a new counterparty. New Trade To terminate a CDS trade with a different Counterparty. NA 16. Source: Banc of America Securities LLC estimates. the original trade is amended. BANA pays the original Counterparty 500 bps running.e. The client keeps the difference. The running coupons cancel out. First.4 points upfront plus 500 bps running. and the Counterparty owes 16. Bank of America. less accrued interest. Figure 90 shows the setup. BANA faces additional risk. NA Margin Client 500 bps running Client's Counterparty Payments are made quarterly. Assignment The client may avoid posting margin. the client receives 1000 bps running from the new Counterparty (BANA) and pays 500 bps running to the original counterparty. i. There are two main disadvantages that make new trades unpopular in the marketplace. the original Counterparty may not always have the most favorable market. Bank of America.4 67 points upfront.855. one way is to simply sell protection at 1000 bps. The running coupon would cancel out. because the client is selling protection to the new Counterparty. Now the client would owe 300 bps running.9 points upfront.9 points upfront + 300 bps running (assuming 40% recovery). by trading with a new counterparty on assignment The client may avoid posting margin.9 points upfront plus 300 bps running. on Assignment from 500 bps Client does not post margin. Source: Banc of America Securities LLC estimates. and terminate the original trade. so that going forward. This adds complexity from an operational and risk perspective. The new Counterparty pays the client 16. the client owes 500 bps. so that the client simply receives 16. a new trade often requires the investor to post margin Naturally. …An Assignment Adds Risk Investor Sells Protection at 1000 bps. and the unwind still at 1000 bps. The original trade is then terminated.4 points upfront Client 500 bps running 1000 bps running Protection Protection Protection Client's Original Counterparty Payments are made quarterly. by selling protection to the new Counterparty on assignment (sometimes called “novation”). now the client has two trades.7559 . Figure 89. from the client’s perspective. he will likely be required to post margin (collateral). the original trade is terminated. As Figure 89 shows. the original Counterparty faces the new Counterparty (BANA). Moreover..4 points upfront. while an unwind allows the client to terminate the original trade. Moreover. one with the original Counterparty and one with the new Counterparty. and terminate the original trade.Credit Strategy Research May 27. 2008 35 So. 67 If the original trade were at 300 bps. Going forward. so that the client would simply receive 22. 110 Credit Default Swap Primer Glen Taksler 646.
interest rates still affect the present value of trades. the present value of that loss will increase. and the new Counterparty was better off having traded the credit at 15. By contrast. the new Counterparty only pays 500 bps running for protection that is currently worth 1000 bps in the market. 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.. Market convention requires that an investor state that the trade is on assignment before executing the 69 trade. The present value of the difference between the market spread and the premium paid by the new Counterparty. and is calculated based on market expectations. the present value of that gain will increase. By contrast. For more details. to the 68 original counterparty (500 bps).7 + 25 = 40. Figure 91 shows that the impact of interest rates increases as CDS moves away from par. the new Counterparty may receive margin from the client. the new Counterparty would have paid (and would lose) 16. is the 16. he will have a mark-tomarket loss. and instead must pay the client cash flows upfront (e. 69 This risk exists in any CDS trading in points upfront.Credit Strategy Research May 27. while a steeper LIBOR curve led by the back end approximates an interest rate rise. consider a Credit Event on the Effective Date of the new CDS contract.7 points) than it would have been at 1000 bps running (10 x 5 years = 50 points). If interest rates decline. 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. This meeting resulted in the 2005 Novation Protocol.855. 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. 16. running spread. In September 2005. 68 This amount goes to the client in return for the right to pay only 500 bps running to the original Counterparty for protection. which requires an investor to obtain permission before assigning a trade. the new Counterparty receives no collateral. suppose a Credit Event never occurs. over the life of the trade.7 + 5 x 1 day’s accrued interest = 15. which is worth 1000 bps running in the current market.4 points).g. please see 2005 Novation Protocol on page 83. if the investor sells protection. and cash flows are paid quarterly.7 + 5 x 5 years = 15. quotes for an assignment may be less favorable than quotes for a new trade.4 points. The reason is that CDS contracts discount cash flows at LIBOR plus the implied probability of default (page 100). But in an assignment. “Jump to Default Risk” accounts for the difference in quoting CDS protection in points upfront vs. But if a Credit Event occurs immediately.71 points). In a new trade.7 points upfront. This is because an assignment or unwind adds additional risk. For more details. Then the market applied too high a discount rate in calculating the 15. Why? In an assignment.7 points upfront + 500 bps running (total payment: 15. Credit Default Swap Primer Glen Taksler 646.4 points for the same protection. To understand the risk. If interest rates decline. A steeper LIBOR curve led by the front-end approximates an interest rate decline. the market applied too low a discount rate in calculating the points upfront. The investor will have a mark-to-market gain. resulting in further gains. Consider an investor who sold protection and then spreads tighten. Interest Rate Sensitivity Although CDS is based on credit risk. resulting in further losses. In a new trade. The present value of the 500 bps running depends on the timing of default. but spreads widen. the Federal Reserve and 14 dealers met to discuss risks surrounding assignments.7 points upfront + 500 bps running (15.” we mean dates close to the maturity of the CDS contract. 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 just one day’s accrued interest for that protection (the running coupon / 360). By “back end. in an assignment. For example. please see the Chapter Appendix on page 123.7559 111 .
Compared to spread duration. this is because spreads affect both the discount rate and the amount of money being discounted (unwind spread minus coupon). 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 $10mm notional Spread DV01 Strike (Coupon) 600 800 1000 1200 1400 1600 1800 2000 5y CDS Sources: Bloomberg. Nonetheless. Banc of America Securities LLC estimates. as illustrated in Figure 92. given the magnitude of recent declines in interest rates.Credit Strategy Research May 27. while interest rates only affect the discount rate. 2008 35 Figure 91. Figure 93 shows how to calculate interest rate sensitivity in Bloomberg: 112 Credit Default Swap Primer Glen Taksler 646. Banc of America Securities LLC estimates. Sensitivity of CDS Contracts to Interest Rates “IR01” Means CDS P&L Due to 1 Bp Move in Interest Rates Assumes parallel shift in LIBOR curve Investor sold 5y CDS protection at 500 bps IR01 ($ 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. Intuitively. the effect of interest rates is relatively small. CDS investors should understand the implications.7559 .855.
As discussed in the main text (page 94). beginning summer 2007. Models of the CDS curve became less accurate.682.g. Below.49 per 1 bp Spread Tightening Sources: Bloomberg. every three months.Credit Strategy Research May 27.75 years (e. Protection Seller Loses $361. 2008 35 Figure 93. we look at the value of three months on the 4s/5s CDS credit curve. single-name CDS “rolls” to a new standard maturity date..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 2007.7559 113 . liquidity became strongly focused on the five-year maturity. comparing its performance in early 2007 with early 2008. But. we describe our general methodology for estimating the roll in single-name CDS. As a simple model for the single-name CDS roll in the five-year sector. 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 $2.855. CDS liquidity became strongly focused on the five-year (historic benchmark) maturity. making the roll harder to predict As discussed in the main text. the reason we look at the 4s/5s curve is that an investor who rolls is extending a contract’s quoted maturity from 4. December) to 5 Credit Default Swap Primer Glen Taksler 646. Calculating Interest Rate Sensitivity (IR01) in Bloomberg In Bloomberg. making the roll harder to predict. We take the 4s/5s CDS credit curve across a variety of single-name CDS contracts and divide by four. Banc of America Securities LLC estimates.
73Ln(x) . 2012 to March 20. Due to spread widening. assuming an upward-sloping curve.24 R2 = 0. estimated roll is 9. the estimated roll widens about 0.24). a number of Reference Entities started to see significantly inverted curves. we only look at Reference Entities with five-year CDS trading 350 bps or tighter. For example. Figure 95. Three-Month Roll (bps) 100 200 5y CDS (bps) 300 Est. estimated roll is 9. in part due to liquidity concerns 14 11 8 5 2 -1 -4 -7 -10 0 Est. not bps) change in spread. at 200 bps. Figure 94 shows the results for February 2007. “five-year CDS” extends maturity--for example. Source: Banc of America Securities LLC estimates.24). On a roll date. At 220 bps. Based on 312 Reference Entities with five-year CDS 350 bps or tighter.9 bps (3. a Reference Entity is said to “capture less than the roll. for Reference Entities with five-year spreads wider than 200 bps.24 bps For every 10% (percent. we look at the 3s/5s curve and divide by eight quarters.) If five-year CDS widens by less than the predicted roll. even if credit quality remains constant. we use a logarithmic regression. from December 20. Three-Month Roll (bps) y = 3. Based on 258 Reference Entities with five-year CDS 350 bps or tighter. to model the single-name CDS roll. four-year CDS may trade at just 75% of five-year CDS.9 bps. But for Reference Entities with five-year spreads tighter than 50 bps.37 bps per 10% widening in spread For example.g. 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.10.73 * ln(200) – 10.22 100 200 5y CDS (bps) 300 27 Feb 07..Credit Strategy Research May 27. Notice that the model worked significantly better in 2007. the estimated roll is 9. five-year CDS should widen. March). at 200 bps. Model Doesn’t Work in Feb 08 Weak explanatory power (low R2) Variation in roll estimates is extreme. the estimated roll is 9. 2006. we estimate the following equation: Estimated Three-Month Roll = 3.5 bps. (Beginning in summer 2007. not bps) change in spread.373 bps to be more exact).5 bps (3. At 220 bps. 27 Feb 08. 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. 2008 35 years (e. Source: Banc of America Securities LLC estimates.37 bps (0.74 R2 = 0. fewer Reference Entities are in Figure 95 than in Figure 94. 2013. Simple Model of the Single-Name CDS Roll: Feb 07 Estimated roll widens about 0.31Ln(x) . for every 10% (percent. Figure 94.82 14 11 8 5 2 -1 -4 -7 -10 0 y = 1. as compared with February 2008 in Figure 95. which is 10% wider than 200 bps.73 * ln(220) – 10. the estimated roll widens about 0.855. As such. In general. If the 4s/5s curve is not available.3 bps This equation means that.” For example. To account for the tendency of credit curves to flatten (in percentage terms) at wider spreads. five-year Citizens Communications CDS widened 6 bps versus a predicted widening (roll) of 8 bps.3. CDS 114 Credit Default Swap Primer Glen Taksler 646. For February 2007.7559 . on December 20.73 x ln(5-Year CDS Spread) – 10. In both cases.
For publicly traded companies. Type <TICKER> Corp CDSW <GO> In Five-Year CDS. a shortcut is to type <TICKER> Equity CDSW <GO>: Figure 96. 1000 Bps Is About the Same as 16. enter the credit curve. Set the deal spread equal to 500 bps to reflect the 5% running coupon. and select the reference obligation. but simply enter the actual maturity date of the credit default swap. Do not use the model for very unusual sectors.370 / $10mm Notional = 16. the model is not perfect and will work less well for Reference Entities with flatter credit curves or liquidity concerns.7559 115 . On the far-right portion of the screen. Not surprisingly. 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.855. Type <TICKER> Corp CDSW <GO>. 2008 35 traders may refer to this situation by saying that the market captured 75% of the roll (6 bps actual / 8 bps predicted). We have chosen to keep the Credit Default Swap Primer Glen Taksler 646.4 Points Upfront Plus 5% Running Coupon 5y CDS at 1000 bps (Better to use full credit curve) 5y CDS 500 bps Running $1.Credit Strategy Research May 27. we have chosen five-year CDS. Converting from Spread to Points Upfront + 500 Bps Running Coupon In Bloomberg. such as the autos and auto parts. Banc of America Securities LLC estimates.638. such as those seen since summer 2007. Result Depends Heavily on Recovery Rate The circled fields show major points of which to take note.4 Points Upfront + 5% Running Spread This is about equal to 1000 bps all running spread Source: Bloomberg. For the maturity date.
In other words.” Notice that the resulting value of the credit default swap is $1. this is equivalent to 16. Figure 98 shows how to convert from points upfront + 500 bps running. Enter the points upfront (“up-front fee”) and 500 bps running coupon (“deal spread”). to all running spread. This is because front-end cash flows will have a lower discount rate. 116 Credit Default Swap Primer Glen Taksler 646.855. a five-year CDS spread of 1000 bps is about equal to 16. Recovery Rate and Credit Curve Matter Raising the assumed recovery rate reduces points upfront. How to Convert from Points Upfront to Spread Similarly.Credit Strategy Research May 27. A steeper credit curve increases points upfront.7559 . we have chosen 40%. a protection Buyer will pay less for credit risk with a higher recovery rate.638. Then change the “Mode” on the blue “Calculator” bar to “2.4 points upfront.4 points upfront. following a Credit Event. Intuitively. In the bottom-right hand corner. an inverted credit curve decreases points upfront. in the field marked “Principal. This is because front-end cash flows will have a higher discount rate.370. plus a 5% running coupon. raising the present value. Now look near the bottom-left hand corner. although it would be more accurate to enter a full credit curve. Similarly. This is because the protection Buyer is entitled to par minus recovery. 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. Figure 97. enter the assumed recovery rate. lowering the present value. 2008 35 credit curve flat at 1000 bps (the five-year CDS spread).” This mode allows you to convert from points upfront to all running spread. On $10 million notional.
For example. just convert points upfront + 500 bps running to all running spread. 10 points upfront + 500 bps running is 781 bps to a five-year maturity. and then calculate the unwind as normal.Credit Strategy Research May 27. 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. consider an investor who bought protection at 600 bps and now wishes to unwind at 10 points upfront + 500 bps running.7559 117 .855. However. Credit Default Swap Primer Glen Taksler 646. The only difference is the timing of cash flows. Type <TICKER> Corp CDSW <GO> In Five-Year CDS. at T+3 calendar days). As shown in Figure 99. As such. assuming a 40% recovery rate. because all cash flows in an unwind are exchanged immediately (more accurately. 2008 35 Figure 98. Banc of America Securities LLC estimates.000 per $10 million notional) less accrued interest. Converting from Points Upfront + 500 Bps Running Coupon to All Running Spread In Bloomberg. 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. As shown in Figure 100. but unwound in points upfront. 70 The present value of trades in points upfront versus running spread is identical. the distinction between points upfront and running spread is not meaningful. simply 70 convert the unwind level into its equivalent running spread. if any. output spread) Sources: Bloomberg.45 points ($645.
output spread) Sources: Bloomberg. to Obtain Equivalent Running Spread Points Upfront Level is for a Trade Effective T+1 (4/11/08). Unwinding a Trade in Points Upfront.Credit Strategy Research May 27. Which Was Executed in Running Spread: Part I In Bloomberg. Banc of America Securities LLC estimates.855. at a Given Maturity 10 Points Upfront + 500 Bps Running Equivalent Running Spread Change Mode to calculate spread (input points upfront. 2008 35 Figure 99. Type <TICKER> Corp CDSW <GO> Enter Points Upfront + 500 Bps Running (Deal Spread).7559 . 40% Recovery Rate 118 Credit Default Swap Primer Glen Taksler 646.
See Figure 101. Following the unwind.12 less $33. Which Was Executed in Running Spread: Part II In Bloomberg.662. and Maturity Date Equivalent Running Spread on Unwind (From Part I) Original Spread Protection Buyer Receives $644. and that cash flow is done. consider an investor who bought protection at 15 points upfront + 500 bps running. Unwinding a Trade in Points Upfront. of 500 bps.7559 119 .” or deal spread.855.79 Sources: Bloomberg.33 accrued interest = $611. The investor paid 15 points upfront. Banc of America Securities LLC estimates. For example. 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. less coupon payments on the 500 bps running. 2008 35 Figure 100. Effective Date. he will receive 20 points. Change Mode to calculate price (input spread.Credit Strategy Research May 27. Credit Default Swap Primer Glen Taksler 646.328. Type <TICKER> Corp CDSW <GO> Enter Original (Deal) Spread and Equivalent Running Spread on Unwind Notional. simply use a “strike. with the coupons canceling out. and then is unwound in points upfront. net profit will be 5 points (20 points received upon unwind – 15 points paid at trade inception). If the investor now wishes to unwind at 20 points upfront + 500 bps running.333.
For example.777. Banc of America Securities LLC estimates.Credit Strategy Research May 27. Change Mode to calculate spread (input points upfront) Unwinding a Trade in Running Spread That Was Executed in Points Upfront Similarly. and Maturity Date Both Original Trade and Unwind Use 500 Bps Running 40% Recovery Rate Protection Buyer Receives $2. The investor received 10 points upfront. 71 To a one-year horizon.” or deal spread.855. plus coupon payments on the 500 bps running. 120 Credit Default Swap Primer Glen Taksler 646. and that cash flow is done. he will receive the present value of the difference in coupons (500 bps – 71 400 bps).000 less $27. 2008 35 Figure 101. use a “strike. the discount rate is L + 400 bps unwind spread / ( 1 – 40% assumed recovery rate ). consider an investor who sold protection at 10 points upfront + 500 bps running.22 Sources: Bloomberg.000. for a trade was executed in points upfront and then is unwound in running spread.7559 . discounted at LIBOR plus the unwind probability of default. of 500 bps. Effective Date.222. Which Was Executed in Points Upfront In Bloomberg.972. Upfront Fee is the Unwind Level Notional. For details. Net profit will be 10 points received at trade inception plus 4. If the investor now wishes to unwind at 400 bps running. please see the section “Implied Probability of Default” on page 100.78 accrued interest = $1.1 points profit on the unwind. Unwinding a Trade in Points Upfront. Type <TICKER> Corp CDSW <GO> Deal Spread is 500 Bps Running.
4 points (16.14 Sources: Bloomberg. Type <TICKER> Corp CDSW <GO> Enter Original Coupon (Deal Spread) of 500 Bps and Unwind Spread Notional.4 points upfront. In-between.36 plus $27. the protection Seller receives a higher premium for trading in points upfront plus a running coupon. Change Mode to calculate price (input spread. the points upfront investor receives 16. 2008 35 Figure 102.777. 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. Unwinding a Trade in Running Spread. there is a breakeven.Credit Strategy Research May 27. or 16. the points upfront investor will receive a lower total premium over the life of the trade: 41. and Maturity Date Points Upfront Were Exchanged at Inception. versus nothing for the running spread investor.7559 121 . Figure 103 illustrates the breakeven graphically. So Irrelevant Upon Unwind Original Trade Uses 500 Bps Running Coupon Unwind Spread Protection Seller Receives $411. In our example. output present value) 40% Recovery Rate At trade inception. if there is no Credit Event.855.4 points upfront plus a running coupon of 500 bps. At trade inception. between which an investor is indifferent between trading in running spread or points upfront plus a running coupon. if there is no Credit Event.760. Effective Date. the investor would have been better off selling protection in points upfront Credit Default Swap Primer Glen Taksler 646.4 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).538. If a Credit Event occurs prior to the breakeven. Take an investor who is considering two trades: a running spread of 1000 bps. Banc of America Securities LLC estimates. However.78 accrued interest = $439. Which Was Executed in Points Upfront In Bloomberg.
However. Should a Credit Event occur relatively late in the trade (or not at all). 1000 bps—is subject to duration risk on the whole trade. If the investor implements a new trade. 122 Credit Default Swap Primer Glen Taksler 646.855. they have no duration risk—i. The difference in cash flows is called “jump risk.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. the assignee (bank or broker-dealer to whom the trade is being assigned) pays the investor 16. That is. he sells protection at 1000 bps running spread.7559 .4 points upfront. The reason is that points upfront are certain.. The assignee then pays the original (“Remaining”) Party 500 bps running coupon. Figure 103. ex-post the investor learns that he should have applied a lower discount rate to the cash flows. the points upfront remain constant. 500 bps—has duration risk. Actual results will depend on interest rate curve at trade inception. If a Credit Event occurs after the breakeven.e. regardless of whether spreads widen or tighten. the investor would have been better off selling protection in running spread. Our setup is identical to an investor who originally bought protection at 500 bps. the investor should have received fewer points upfront for selling protection. If the investor trades on assignment. See Figure 104.” and is described more fully on page 123 in this Appendix. Only the running coupon—in our example. Source: Banc of America Securities LLC estimates.3 years 1 2 Year 3 4 5 Assumes flat credit curve. a trade entirely in running spread—in our example. Breakeven Between Running Spread and Points Upfront 1000 Bps Running vs. and now wants to unwind at 1000 bps.Credit Strategy Research May 27. 16. 2008 35 plus a running coupon. 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).
DV01 Points Upfront + 500 bps Running DV01 per $10mm Notional 5.000 4. in our sample unwind/assignment. and then in December 2007. and then hedge the transaction with a new trade at par (450 bps). with a profit of 14 points. The reason is “jump risk”: as investors look to bank and broker-dealers to pay out significant profits. 2007. consider the change in issuer exposure to the bank or broker-dealer from buying $10 million notional protection.000 2. the dealer would also pay $1.4 million (14 points) to the Credit Default Swap Primer Glen Taksler 646. Points upfront are certain. 2008 35 Figure 104. buyers of CDS protection take a haircut to unwind trades For credits that gap wider in spread. the bank or broker-dealer will lose 14 points: Bank or broker-dealer buys protection from investor. with expected recovery of 40%. More on Jump to Default Risk – Take CDS Profit in Small Chunks The Unwind Surprise As spreads gap wider. 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.000 1. CDS Profit Creates Jump Risk Consider an investor who bought MBIA AA protection at 85 bps (the “strike”) on September 21. for the bank or broker-dealer to hedge positions.000 0 0 250 500 750 1000 1250 5y CDS (bps) DV01 All Running 1500 1750 2000 Source: Banc of America Securities LLC estimates. and expensive.855. 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. In other words. Trades that are unwound often result in lower payout than the investor might expect. A bank or broker-dealer that accepts this trade must pay the investor 14 points. issuer exposure would decline $10 million x (1 – 40%).7559 123 . investors who bought protection may find their contracts relatively difficult to unwind. the price of the CDS contract has fallen from par to $86 ($100 – $14). However. This results in reduced ability to unwind trades with substantial profits.Credit Strategy Research May 27. 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.000 3. wants to unwind at 450 bps. it becomes progressively more difficult. Normally. or $6 million.
Assignment/Unwind from 85 bps 0 -1 -2 -3 -4 -5 -6 -7 $10mm x ( 1 .7559 . Change in Issuer Exposure from Buying Protection Five-Year CDS. buying protection on unwind/assignment becomes less valuable to the bank or broker-dealer. and for selected Reference Entities. Figure 106 illustrates jump risk across a range of five-year CDS spreads. issuer exposure would only decline the normal $6 million. In other words. $10mm Notional Change in Issuer Exposure from Buying Protection ($ MM) Buy $10mm Protection at 450 bps Buy $10mm Protection at 450 bps . Modified Restructuring.New Trade . 2008 35 investor.Credit Strategy Research May 27. See Figure 105. 124 Credit Default Swap Primer Glen Taksler 646.Recovery ) $10mm x ( 1 .4mm Payment Source: Banc of America Securities LLC estimates. Accordingly.Recovery ) minus Initial $1. Figure 105. 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.4 million payout to the investor. because it 72 serves as less of a hedge against fundamental default risk.” we mean the Credit Events specified in North American corporate CDS contracts: Bankruptcy. 72 By “default risk.855. for an investor who originally bought protection at 85 bps: Figure 106. less the $1. Failure to Pay.
9 points x $10 million notional).39 million.Credit Strategy Research May 27. The bank or broker-dealer buys $2. expected P&L post-potential Credit Event would be $2. or $1. jump risk is 14 points. which compares cash flows in a new trade (450 bps) with an older trade (85 bps coupon): At trade inception. versus an Unwind (or Assignment) New Trade at 450 bps vs. if a Credit Event were to occur. However. jump risk is $1. The reason for buying $2.577. the bank or broker-dealer loses reinvestment income on the initial 14 points paid out to the investor.39 million (13. Cash Flows on a New Trade. Figure 108 shows jump risk by year (the difference between the two lines in Figure 107). with a present value of $124. the bank or broker-dealer benefits from paying a lower coupon (85 bps) on the old trade. Consider Figure 107.25 calendar years. Then: At trade inception (year 0). Jump risk declines over the life of the trade. Source: Banc of America Securities LLC estimates. the same as initial jump risk.7559 125 .31 million x (1 – 40%).855. as time passes. Somewhat offsetting the lower coupon. the bank or broker- Credit Default Swap Primer Glen Taksler 646. The trades break even just before maturity. 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. the bank or broker-dealer may buy front-dated protection. meaning that the bank or broker-dealer would lose this amount. when the unwind breaks even with a new trade. To hedge jump risk. Assume $10 million of five-year CDS notional. which reduces jump to default risk. while Figure 109 shows the notional needed to hedge that jump risk. To hedge. with an expected recovery rate of 40%. but remains positive until year 4. based on the expected recovery rate. Figure 107. Unwind or Assignment Struck at 85 bps Jump risk is 14 points at trade inception. 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 5.31 million notional is that. Original trade (85 bps coupon) adjusted to reflect loss of reinvestment income on jump risk.31 million of one-year protection at 500 bps. assuming trade inception on a quarterly roll date.75. assuming reinvestment at 3-month LIBOR.
sell a small amount of three-month protection at the beginning of year 4. an unwind or assignment (strike 85 bps) would be quoted at 372 bps. the bank or broker-dealer buys $2. 5y: 450 bps. The reason is simple: as CDS tightens. $0.13 million of one year protection beginning in four years (present value $4.372). Actual quotes may vary substantially.590). Jump Risk to Hedge an Unwind/Assignment versus a New Trade New Trade at 450 bps vs.0 1. the cumulative payout on a new trade would exceed the cumulative payout on the unwind.79 million of one year protection beginning in one year (present value $73. Source: Banc of America Securities LLC estimates. as a hedge to jump-to-default risk.0 3. 2y: 490 bps.5 2.0 0 1 2 3 Beginning of Year 4 4. 1y: 500 bps.0 0.241.855. the market does not use this model. we caution that.0 3. Unwind or Assignment Struck at 85 bps Five-Year CDS 4. To compensate for the cost of buying protection.13 million.31 million of one year protection (present value $124.0 0. $1. To make the two trades equivalent. CDS Notional Needed to Hedge Jump Risk New Trade at 450 bps vs. This payout is equivalent to a CDS unwind at 372 bps. the dealer effectively has negative jump risk.577).492 from the $1. such short maturities do not trade. The total present value of all protection purchased is $255. the implied likelihood of a Credit Event decreases.5 1. Of course.75.0 1. in practice. and $0. By “the beginning of year one.0 2. in reality. After the breakeven in year 4. Although 372 bps is the fair value for an unwind in this model. while a new trade would be quoted at 450 bps.71 million of one year protection beginning in three years (present value $15. Figure 108.” we mean one year after trade inception. for a total payment of $1. 126 Credit Default Swap Primer Glen Taksler 646. 4y: 460 bps.26 million of one year protection beginning in two years (present value $37. the bank or broker-dealer would. is $255.5 0. $1. that is.092). jump risk is far more important for CDS widening than for CDS tightening.39 million that normally would be paid upon a CDS unwind (from 85 bps to 450 bps). Jump Risk is Far More Important for CDS Widening than for CDS Tightening Importantly.492. Consider the reverse of the previous trade.75. The present value of all 73 protection purchased. Unwind or Assignment Struck at 85 bps Five-Year CDS Figure 109. where an investor now sells protection at 450 bps and wishes to unwind at 85 bps.5 2. 73 Net. As such. 2008 35 dealer buys smaller amounts of one year protection at the beginning of years one– three. the bank or broker-dealer subtracts $255.5 3. 3y: 475 bps.5 1.5 0. in theory.0 40% Recovery 60% Recovery Jump Risk ($ 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.0 2.Credit Strategy Research May 27.5 3.7559 . Assumed credit curve: 6m: 500 bps.609).
74 at improved credit quality. Unwind from 450 bps Strike (bps) Adj. three-year CDS at 75 bps. Figure 110. 3y: 75 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. 1y: 65 bps.855. and then immediately re-implement the trade. 5y: 85 bps. 2y: 490 bps. Assumed credit curve: 6m: 65 bps. we assume that one-year CDS tightens to just 65 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. With each roll. For example. Unwind from 85 bps Strike (bps) 5y CDS (bps) 5y CDS Adj. For example. 4y: 80 bps. For credits with substantial spread changes intra-quarter. and December). consider unwinding after moderate profits (3–5 points). in our improving credit scenario. keeping CDS more liquid. while one-year CDS was 500 bps in our earlier example. four-year CDS at 80 bps. Although this results in some extra paying of bid-offer spread. …Than When Credit Improves 5y CDS. increasing jump risk and reducing liquidity. it costs the bank or broker-dealer substantially less to hedge jump risk. the “fair value” unwind haircut for CDS widening is 78 bps (CDS widens from 85 bps to 450 bps. two-year CDS at 70 bps. September. with MBIA AA. and resets them with new trades at par. But as shown in Figure 111. 4y: 460 bps. it significantly reduces jump risk. the unwind haircut for CDS tightening is just 3 bps (CDS tightens from 450 75 bps to 85 bps. Haircut is Greater When Credit Deteriorates… 5y CDS.Credit Strategy Research May 27. 5y: 450 bps. 3y: 475 bps. it is hard to see simply because it is so close to adjusted CDS (thick gray line). Source: Banc of America Securities LLC estimates. 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 . As illustrated in Figure 110. 2y: 70 bps. it is hard to see simply because it is so close to adjusted CDS (thick gray line). reducing jump risk and maintaining on-the-run liquidity. the bulk of investors unwinds existing trades. However. A lower cost to hedge jump risk means a lower adjustment to “fair value” on an unwind. a rapid widening in spreads intra-roll causes CDS to fall well below par. 1y: 500 bps. 2008 35 With improved credit quality. but unwind at 372 bps). roll each quarter. although we acknowledge that none is ideal: For credits with only moderate spread changes. but unwind at 88 bps). Credit Default Swap Primer Glen Taksler 646. several options are available to CDS investors. for Unwind from 85 bps 5y CDS (bps) 5y CDS Adj. 75 Note that the five-year CDS (red-dashed line) is in Figure 111. Adjusted for Unwind from 85 Bps Investor Bought Protection Figure 111. Note that the five-year CDS (red-dashed line) is in the figure. Currently. Source: Banc of America Securities LLC estimates. June. and five-year CDS at 85 bps. This generally keeps CDS liquid and avoids the jump risk issues outlined above.7559 Adj. an 74 We assume one-year CDS at 65 bps. Rolls cause CDS to reset to par.
Consider an offsetting new trade rather than an actual unwind. sell protection in a new trade at 450 bps.Credit Strategy Research May 27. but give the undesirable effect that payments are only accrued over time (450 bps per annum. rather than unwinding CDS at 450 bps (from an original strike of 85 bps). This will eliminate jump risk entirely. paying at each smaller jump should improve liquidity.855. However. 128 Credit Default Swap Primer Glen Taksler 646. 2008 35 investor who bought protection at 85 bps. but unwound and then immediately rebought CDS every 150 bps of widening.7559 . because more banks or broker-dealers should be willing to transact at smaller jumps. rather than leaving the entire bidoffer payment for jump risk until the final trade unwind. paid quarterly) rather than immediately (14 points). 76 The paying of bid-offer in this example may be thought of as paying for jump risk at each smaller jump. For example. would have paid extra bid-offer but 76 maintained substantially higher liquidity.
Tyco International Ltd CDS and Tyco International Group SA CDS each split into three entities. wide disparity in the price of potential Deliverable Obligations raises concern that typical CDS (so called-”cash”) settlement protocols may not work. Below. a tender offer is announced for existing EOP bonds. and then alphabetically. ISDA organizes a committee to address possible changes to CDS (“cash”) settlement protocols for monolines. Some protection holders do not tender. CDS contracts are not triggered. but notes are canceled before the indenture’s grace period expires. Tyco spins off into three separate divisions. with greater than 25% but less than 75% of original Tyco debt assumed by each division. CDS succeeds to Domtar Corp. In connection with an LBO by Blackstone Group LP. 158 Tembec (TMBCN) 17 2007 Domtar (DTC) Equity Office Properties (EOP) Tyco (TYC) Domtar Inc. 132 21 132 Credit Default Swap Primer Glen Taksler 646. Moreover. Despite a payoff for bondholders that resembles a default. resulting in a presumed recovery rate close to par. Events are sorted by year. The remainder of this Chapter focuses on many of the outcomes from these case studies. bondholders agree to exchange more than 75% of outstanding debt into new Domtar Corp.855. For more details. rules and procedures are clarified through individual cases. Tembec borrows a new four-year term loan. focusing on events since 2005. with 1/3 of the original notional per entity. primarily by protection holders. Even if protection Buyers were to find a way to trigger.Credit Strategy Research May 27. Domtar Inc. 2008 35 Chapter VI – CDS Case Studies and Legal Issues Case Studies The CDS market is an evolving one. we highlight some case studies. only the new term loan would be deliverable. Tembec bondholders agree to cancel their existing notes in exchange for equity.7559 129 . Tembec had missed a coupon payment. and to plan for physical settlement if necessary. notes. 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. please see the page number indicated in the far-right column. 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. to ensure a deliverable into CDS contracts. Small notional remains of EOP bonds. To avoid Bankruptcy.
Cendant Corp (later renamed Avis Budget Group. However. No Succession. Overall market later agrees that such exchanges do count.Credit Strategy Research May 27. but with the added twist that some existing Verizon Bonds are exchanged for Loans in the new directories business (Idearc). Bombardier announces that Bombardier Capital (OpCo) financials will be consolidated with Bombardier Inc (HoldCo). 2008 35 Significance Credit Description Result Page 2006 Alltel (AT) AT spins off wireline business. to ensure a Deliverable Obligation into CDS. RAI (HoldCo) exchanges existing RJR bonds for new RAI bonds. new OpCo debt is not deliverable into existing Cendant Corp CDS contracts. only assets.855. Specifically. To overcome restrictive covenants in RJR (OpCo). Although convertible bonds normally are deliverable into CDS trades (see Railtrack case study in 2000).) CDS. of all Calpine secured Parties adhering to the CDS (so-called “cash”) settlement protocol agree that only the convertible 19. move to Tim Hortons. 132 2005 Major Calpine (CPN) (Part I) Calpine files for Bankruptcy. due to lack of a Deliverable Obligation. 143 130 Credit Default Swap Primer Glen Taksler 646. 132 Wendy’s (WEN) No Succession. The transaction structure is similar to Alltel. RAI purposely structures transaction so that RJR CDS can Succeed to RAI. which generates more than half of Wendy’s EBITDA. Following a spin-off of four divisions. CDS becomes nearworthless. Wendy’s sells Tim Hortons. with no debt. in February 2007. WEN CDS widens to reflect increased leverage. 21 CarrAmerica (CRE) Blackstone acquires CRE.7559 . not debt. RAI acquires Conwood. Beginning February 2007. Investor debate ensues as to whether a Bondfor-Loan exchange counts in calculations for CDS Succession. CDS Succeeds to RJR. In 2006. 50% Windstream. Inc.) remains a HoldCo. making new OpCo debt deliverable. 21 Major Cendant (CD) 132 RJR 132 Major Verizon (VZ) VZ CDS splits 50% Verizon. Verizon spins off directories business. 132 Bombardier (BOMB) Bombardier Capital CDS expected to become nearworthless after last bond matures. LLC) . Some protection buyers buy CRE bonds and then refuse to accept a tender offer. RAI does not guarantee existing RJR debt. However. AT CDS splits 50% Alltel. Bombardier states that no new debt will be issued out of Bombardier Capital. in May 2009. a temporary spin-off company (SpinCo) exchanges more than 25% of Alltel debt for new notes. SpinCo then merges with Windstream. 50% Idearc. two Calpine convertibles are expressly subordinated to the prior payment. renamed Avis Budget Group. because Cendant Corp does not guarantee OpCo Cendant Car Rental Group (later renamed Avis Budget Car Rental. To keep spin-off tax-free. OpCo debt becomes deliverable into HoldCo (Cendant Corp. in full. a guarantee is added. Inc.
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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
Importantly. That is. Figure 112 shows an analysis of possible scenarios for Ford Motor Credit succeeding Hertz. All of the original Hertz CDS notional would have continued to reference Hertz debt. Relevant Obligations 78 included Hertz Bonds and Loans outstanding immediately prior to the exchange date. total debt may have still included the tendered notes. This means that. By contrast. Overall. if Ford Motor Credit were to succeed to 75% or more of Hertz debt. 134 Credit Default Swap Primer Glen Taksler 646.7559 . depending on the calculation method—and this is subject to interpretation—Ford would have been either slightly above or below the 25% threshold. making it harder for Ford Motor Credit to succeed Hertz. the 2003 ISDA Definitions suggest that total debt should be calculated as of the date immediately prior to the exchange. However. $10 million notional of original Hertz protection would become $10 million notional of Ford Motor Credit protection. Relevant Obligations excluded debt outstanding between Hertz and its Affiliates. if Ford Motor Credit succeeded to 25% or less of the Relevant Obligations of Hertz. which prompted Hertz spreads to widen following the exchange offer announcement. The denominator would be larger.Credit Strategy Research May 27. 78 The exchange date may be referred to as the Succession Event date. it looked likely that Ford Motor Credit would have succeeded to more than 25% of Hertz. 77 77 In the extreme case.855. As an important note. then CDS contracts would simply reference Ford Motor Credit. there would be no succession. 2008 35 protection and $5 million in Ford Motor Credit protection. should the tender and exchange have occurred simultaneously. as determined by the Calculation Agent.
as announced at the time. Hertz.078 2. and one which also subtracts foreign subsidiary debt.3% Yes Based on all Hertz debt outstanding. Excl. 1/2 FMCC ? Sources: Securities and Exchange Commission. Bloomberg. meaning that half of notional protection would have remained with Hertz and half would have become Ford Motor Credit protection.000 22.142 EXCLUDED EXCLUDED 1.7559 135 . 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. This left the question of what Hertz CDS would reference: 1.896.078 2.185. Ford Motor Credit only would have succeeded to 22. one which excludes a note between Ford 79 and Hertz. would have taken out all senior unsecured debt.Credit Strategy Research May 27. but we show both scenarios to emphasize that the results are subject to interpretation.760. This is the second column of Figure 112.198. But Borderline EXCLUDED 7. Credit Default Swap Primer Glen Taksler 646.400.000 25. 79 Our initial belief was that foreign subsidiary debt should be excluded. Would Ford Motor Credit Have Succeeded to More than 25% of Hertz? Based on 10-Q. the two right columns subtract Affiliate debt.575.340 2. Ford Note and Subsidiary Debt 2. However.855. 2008 35 Figure 112. Provided that Hertz issued new senior unsecured debt under the LBO’d entity. Banc of America Securities LLC estimates.3% of Hertz debt.480. Ford Motor Credit would have succeeded to more than 25% of Hertz debt. we note a caveat: the combination tender-exchange. for Hertz protection. We would expect Hertz spreads to trade wider to reflect higher leverage at the new company.000 31. 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.000 5. Ford Note Excl.198 1. Under both of these scenarios.3% No 9. 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.1% Yes. which is how the actual 25% threshold is determined. so we include two scenarios. meaning that all notional protection would stay with Hertz.400. the Reference Obligation would change to reflect the new issuance.678.400.738 10. ISDA Definitions are broad regarding the definition of Affiliate debt.
say with a recovery rate of 50%. the same amount of debt but fewer assets. there would be no Reference Obligation for the Hertz protection. Travel. But if there were no senior unsecured debt and the protection Buyer were forced to deliver a more senior obligation.7559 . But for illustrative purposes. suggesting that Cendant did not intend to disadvantage its existing bondholders. and Hospitality would all emerge with investment grade ratings. not equity. that is. in 2006. Management suggested that Real Estate. credit default spreads should have widened back out to reflect senior unsecured recovery rates. That obligation would be likely to have a higher recovery rate than senior unsecured debt. Existing debt would be apportioned between Real Estate and Travel. the Buyer of protection would be forced to deliver an obligation structurally senior to senior unsecured debt (e. As such. Hospitality.Credit Strategy Research May 27. In the less-likely scenario that Hertz did not issue senior unsecured debt under the new parent company. Spreads widened to reflect higher leverage.g. general market belief was that the Cendant name would disappear. and remain the surviving entity. These two entities accounted for close to 70% of EBITDA and pretax earnings. Wendy’s sold Tim Hortons. Initially. For example. Car Rental (Avis) would acquire the broader Cendant Corp. if senior unsecured debt had a recovery rate of 40%. If Hertz later had issued senior unsecured debt under the LBO’d entity. which would make credit default protection less valuable. However. and Car Rental. and tighter spreads from the Buyer of protection only being able to deliver debt structurally senior to senior unsecured. Car Rental would emerge with a high BB rating. which generated more than half of Wendy’s EBITDA. secured debt). 2008 35 2. 136 Credit Default Swap Primer Glen Taksler 646. Travel Distribution. Should a Credit Event have occurred. Less valuable protection would suggest potentially tighter Hertz spreads. the protection Buyer would profit only $2. The key issue for CDS is timing: 80 There are two counteracting factors: wider spreads from a new parent company with higher leverage. not equity Timeline Surrounding an Early Repayment or Tender Offer In October 2005.5 million post-Credit Event ($5 million notional – $2. we discuss the implications in the “Guarantees” section below..5 million recovery). Not Equity Notice that CDS Succession language is based on debt. For example. This led to a belief that Cendant would prepay its debt obligations shortly before the spin-offs. the protection Buyer would profit $3 million post-Credit Event ($5 million notional – $2 million recovery). we now analyze the implications of those initial market beliefs.855. 80 Succession language is based on debt. CDS Follows Debt. This assumption later proved incorrect. Management acknowledged that the newly spun off entities would likely need to tap the markets. Cendant Corp. Cendant could not sell or transfer a substantial portion of properties or assets. Tim Hortons did not assume any of Wendy’s existing debt. The timeline associated with an early repayment of debt matters According to bond indentures. all CDS notional remained with Wendy’s.. 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.
all CDS would have gone to that division. the only relevant entities for CDS would have been Real Estate and Travel. CDS should widen significantly because of an expected high-BB rating versus BBB+ for Cendant before the initial spin-off news. If either Real Estate or Travel assumed at least 75% of all debt. all notional CDS would remain as Cendant.. 5 years). multiplied by the expected spread at re-issuance. the market initially placed the greatest weight on Scenario 1.855. (This is the same as for the Hertz case study above. In turn. In turn. This caused CDS to widen approximately 20 bps in the immediate aftermath of the news (an effective downgrade from triple-B to double-B).) For example. If Car Rental were to issue debt shortly after the company split.Credit Strategy Research May 27. CDS notional would have split evenly between the two divisions. all notional CDS eventually would become Car Rental (Avis). What We Saw in the Market As shown in Figure 114. Otherwise. Scenario 2: Real Estate and Travel assume all existing Cendant debt before an early repayment In this case. protection would succeed to Car Rental (Avis). cash bonds tightened approximately 30 bps in anticipation of an early repayment of debt. assuming that Cendant would repay its debt before the company split. Source: Banc of America Securities LLC estimates. Should the Cendant name have disappeared and Car Rental (Avis) became the surviving entity. 81 On the opposite extreme. 2008 35 Scenario 1: Cendant repays its debt before the company splits In this case.7559 137 . Credit Default Swap Primer Glen Taksler 646. CDS would price roughly as the probability of Avis reissuing debt over the remaining life of the contract (e.g. 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. By contrast. This is not a particularly realistic scenario following an LBO. With Real Estate and Travel combined representing about 70% of EBITDA and an expected investment grade rating for both entities. 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. CDS should tighten to zero because protection references no debt. CDS should price at about the expected new issue 81 spread for the Car Rental division. This is because Cendant stated that all existing debt would be apportioned between these two divisions. if Car Rental never issued new debt. the CDS spread would not have widened significantly.
7559 . Cendant Corporation later changed its name to Avis Budget Group. Banc of America Securities LLC estimates. Cendant announced that Cendant Corp. Without a Downstream Guarantee. as illustrated in Figure 115. Sources: Cendant. as a holding company for Cendant Car Rental Group (Avis). 2008 35 Figure 114.25% 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.Credit Strategy Research May 27.855. Cendant Car Rental Group Debt Would Not Be Deliverable Into Cendant Corp CDS Reference Entity Remains Cendant Corp In February 2007. LLC. Guarantees and “Orphaned CDS” The effect of Guarantees As noted in the previous section. 138 Credit Default Swap Primer Glen Taksler 646. a Downstream Guarantee was added. Cendant Cash versus CDS. No Guarantee X Intermediate Holding Cos Sr Sec Sr Unsec New Debt Cendant Car Rental Group . the initial market belief that the Cendant name would disappear proved wrong. making Cendant Car Rental Group Deliverable into Cendant CDS Cendant CDS Cendant Corp Initially. In March 2006. Cendant Corp. 1 June 2005 – 1 December 2005 CD 6.. Moreover. Inc. Cendant Car Rental Group. LLC later changed its name to Avis Budget Car Rental. would continue to exist. Figure 115. would not guarantee Cendant Car Rental Group..
bonds become deliverable into Cendant Corp. (by then renamed Avis Budget Group. giving CDS fundamental value and causing spreads to widen.) guarantees the operating company’s debt. from parent to a majority-owned subsidiary. although not applicable to Cendant. This debt would be deliverable against holding company (Cendant Corp. in Cendant Corp. with no assets and no debt. With the downstream guarantee.’s case. CDS. operating company debt cannot be delivered against a CDS contract in the original (Cendant Corp.Credit Strategy Research May 27.) CDS only if the holding company (Cendant Corp. 2008 35 The significance of a downstream guarantee is as follows. If the holding company does not provide a guarantee. The guarantee must be unconditional and irrevocable. See Figure 116. Guarantees. in February 2007. 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. Credit Default Swap Primer Glen Taksler 646. More Generally For Reference Entities located in North America. initially. CDS later widened on LBO concerns at the new (post-spinoff) entity. CDS contracts written on the original 82 Cendant Corp. Cendant Corp. New debt (likely) would be issued only out of the Cendant Car Rental Group operating company. are valid For Reference Entities located in North America. In turn. As a further twist.855. as with Cendant Corp. only downstream guarantees (from parent to subsidiary) are valid in standard CDS confirms. a group of investors paid Cendant Corp. Moreover. basically became a shell corporation. For CDS on an operating company. holding) company. 82 We note that. company became near-worthless and spreads tightened.7559 139 .) $14 million to guarantee $1 billion in senior unsecured bonds at Cendant Car Rental Group (by then renamed Avis Budget Car Rental. under no circumstance is holding company debt deliverable. only downstream guarantees. Inc. LLC).
When ISDA Definitions were last written in 2003. the entity providing the guarantee must receive sufficient consideration. A CDS contract on an operating company that has no Deliverable Obligation is sometimes called “orphaned CDS. 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. Owing to this uncertainty.Credit Strategy Research May 27. Confirmations for Reference Entities located in Europe state: “All Guarantees: Applicable. Globally Based on Location of Reference Entity. upstream guarantees are not taken into account for CDS contracts on North American Reference Entities. a guarantee must be unconditional and irrevocable.” regardless of where the trade occurs. the general view of the CDS community was that guarantees were more likely to be upheld in European courts. The reason for the discrepancy is precedent for U. Regardless of Where Trade Is Executed Globally. Downstream guarantees are taken into account because anything benefiting a majorityowned subsidiary also benefits the parent company. 83 To implement these issues. In particular. after Bankruptcy proceedings begin. for Europe only. suppose that. the parent provides a downstream guarantee to the subsidiary. Also of note: If the parent (or subsidiary) guarantees a third-party. the upstream guarantee may be declared invalid post-Bankruptcy because the subsidiary received no clear benefit. if the parent has no assets. For example. 83 as illustrated in Figure 116. If the parent has significant assets that improve the overall credit profile of the subsidiary. Effect of Guarantees on CDS Contracts. for Europe only.S. third-party debt is deliverable into parent (or subsidiary) CDS.” For example. regardless of security. debt delivered must be pari passu or better than the Reference Obligation in seniority. rather than each distinct corporate entity. confirmations for Reference Entities located in North America state: “All Guarantees: Not Applicable. 2008 35 Figure 116. 140 Credit Default Swap Primer Glen Taksler 646. the view was that European courts would tend to look at benefits to the organization as a whole. in exchange for an upstream guarantee. to be taken into account for CDS contracts. parent (or subsidiary) debt is deliverable into third-party CDS.855. By contrast. the upstream guarantee should be valid because the subsidiary received a clear benefit. Sources: ISDA. As such.” Globally. 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. a broader class of guarantees applies to CDS contracts on Reference Entities located in Europe. courts to declare upstream (and sideways) guarantees invalid. For a guarantee to be valid. Banc of America Securities LLC estimates.7559 .
) Figure 117. on LBO news. buy bonds strategy profitable. up to a maximum of 200 bps. In turn. CDS does not benefit from bond indentures and was expected to succeed to the new.855. in December 2005. For example. Normally. as bonds would benefit from step-ups while CDS would not. By contrast. (In particular.7559 141 . Computer Sciences Corp Cash versus CDS. 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. Temple Inland added step-up provisions to new issue bonds. but CSC debt contained a negative pledge provision. there will be no Deliverable Obligation into CDS contracts and CDS will become near-worthless. bondholders receive a 25-bp step-up per one notch downgrade by either Moody’s or S&P. 2008 35 Unless the operating company issues new debt. post-LBO entity.Credit Strategy Research May 27. (Spreads on both bonds and protection later tightened as LBO concerns dissipated. making a buy protection. as illustrated in Figure 117. Such a downgrade would be likely to cause bonds to outperform CDS. Covenants and Indentures Covenants and indentures affect bonds only. CDS widened by far more than cash. CDS should widen to reflect the capital structure of the new LBO’d entity.) Accounting Considerations (Tax-Free Spinoffs) Accounting considerations may cause CDS contracts to split In 2006. Similarly. not protection CDS investors should understand that covenants and indentures affect bonds only. in October 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. not protection. If the company is downgraded to high yield. Consider Alltel. such LBO activity would send bond spreads wider. which Credit Default Swap Primer Glen Taksler 646. 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. the telecommunications sector saw multiple Succession Events driven by accounting considerations: trying to keep spin-offs tax free. effectively giving investors a cushion should the company later be LBO’d. This led to a belief that the company would either securitize existing bondholders or launch a tender offer.
will now have an effective weight of 50% x 0. Single-Name Trades A single-name trade in Alltel Corporation must have occurred on or prior to July 16. a Succession Event occurred on July 17. $10 million Alltel CDS notional split into $5 million Alltel and $5 million Windstream.5 billion was not taxable to Alltel. Although the Calculation Agent will update its internal systems to reflect the new position. of which Alltel Corporation was a member. An investor would now have two trades. regardless of the trade date. As such.2% of the Relevant Obligations of Alltel.8% = 0. The merged entity then was renamed Windstream.4 billion special dividend to Alltel. 84 The formal Index Name for five-year CDX IG6 is DOW JONES CDX. 2008 35 spun-off its $3. Alltel Corporation.855. Alltel created a temporary spinoff company (SpinCo). indices that were effective on or prior to the date of a Succession Event will split.5 billion exchange represented 26. each with a new trade number.9 billion in cash. As a debt-for-debt exchange. 2006 (effective July 17. index trades in CDX IG6 always split.Credit Strategy Research May 27. SpinCo then merged with Valor Communications Group. SpinCo exchanged approximately $1. just above the 25% threshold. the CDX IG6 was the on-the-run investment grade index. The new trades would reflect the new position in each of Alltel and Windstream.NA. regardless of the trade date.4%. CDX IG6—even though 84 the weightings in the index change. the trade typically must occur no later than one Business Day before the Effective Date. which caused trades to split 50% Alltel Corporation / 50% Windstream Corporation. The investor would reference the original trade with its original trade number. which represented Alltel’s tax basis. or assign—then at that time. and will not be rebooked by the Calculation Agent. which had an original weight of 0. SpinCo issued a roughly $2.9 billion wireline business to Windstream.5 billion in Alltel debt. Had Windstream simply paid Alltel $3. As such. 2006) to split. 142 Credit Default Swap Primer Glen Taksler 646. Should the investor later wish to modify the trade—for example. the trade will not immediately be rebooked in DTCC. 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. the Calculation Agent will terminate the original trade in DTCC and book two new trades. In addition. Index Trades However. As CDS trades normally are effective T+1. Index trades are effective as of the inception date of the index and settle with accrued interest. the $1. for half of the original notional.4%. both with the original fixed coupon.IG. At the time.7559 . The $1. partially or completely unwind. Example For example.6 06/11.8% (1 / 125 Reference Entities). The original trade will retain its original trade number. Windstream Corporation will effectively be added to the index. 2006 in Alltel Corporation. the transaction would have triggered a capital gain for Alltel. Instead. This is because the Index Name is unchanged—for example. also with a weight of 0.
Thirdparties. The cash settlement price is determined through an auction process. as discussed on page 160. which provide incentive for the submission of reasonable quotes. In addition. Dealers commit to providing a baseline level of liquidity in the auction.Credit Strategy Research May 27.855. the mechanics of which resemble a Treasury auction. Any market participant. the $10 million x $10 million market size may change. Basic CDS Settlement Auction Mechanics As a first step. with a maximum 2 point bidoffer spread As a first step. are publicly released on the website http://www. may opt to provide additional liquidity. This should result in dealers quoting the cheapest-to-deliver obligation. Credit Default Swap Primer Glen Taksler 646. and tranche credit derivatives trades. including dealers. However. prespecified list of Deliverable Obligations. dealers may deliver bonds from a publicly disclosed. Dealers may be required to trade bonds at their submitted levels. in recent protocols.com. because the indices started trading (were effective) after the Succession Event occurred. The names of participating dealers. administer the process. the protocol would need some changes. no one is required to accept the settlement protocol because standard documentation is currently written for physical settlement. To be clear. depending on the Reference Entity. The methodology should be similar for a Failure to Pay. should a Modified Restructuring occur. and their respective markets.” for details). approximately 15 dealers submit a market on $10 million bonds. This protocol is expected to be used to settle most single-name. The exact minimum depends on how widely traded the relevant Reference Entity is.g. there are special issues pertaining to potential CDS Settlement Protocols for monoline insurers. Moreover. 2008 35 The Alltel Corporation weight in CDX IG7 and later series will not split.7559 143 . Similarly. approximately 15 dealers submit a market on $10 million bonds. For any required trades. Such requests would be filled to the extent that another market participant was willing to take the opposite position. almost all counterparties have consented. index. The process requires that a minimum number of dealers (e. These markets represent a sample of the broader market for a particular Reference Entity. just like in CDS physical settlement. 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. Figure 118 shows the dealer markets submitted in the 2005 Delphi CDS settlement protocol: 85 Fifteen dealers is an expectation. For example. 8) submit markets. CDS Settlement Protocols The most recent version of the CDS Settlement protocol This section discusses the most recent version of the CDS Settlement protocol. All cash-settled trades receive the same recovery rate. However. investors would retain the ability to request physical settlement.creditfixings. with a 85 maximum 2 point bid-offer spread. Even though the standard would be to cash settle. as of January 2008. as discussed on page 158 in this Chapter. Markit and Creditex.. CDS Settlement protocols have been used only for Bankruptcy Credit Events.
CreditEx. or Sell $10mm Bonds at its Offer For example. There are three parts: 144 Credit Default Swap Primer Glen Taksler 646. Sources: ISDA. “Dealer 1” submitted a 67/69 market Offer (As Submitted by Dealer) 70 69 68 67 66 65 64 63 62 0 1 2 3 4 5 Bid (As Submitted By Dealer) Price ($) 6 7 8 9 10 11 12 13 14 15 Dealer Number For illustration. Figure 119 uses the dealer markets submitted to settle Delphi. 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. 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.7559 . 2008 35 Figure 118. to illustrate the calculation of the inside market midpoint. Banc of America Securities LLC estimates. This level is an indication from dealers regarding the fair value of the cheapest-to-deliver obligation for the relevant Reference Entity.Credit Strategy Research May 27.855.
The best 6 form the “best half. pay a penalty to ISDA. These markets are excluded from the calculation of the inside market midpoint and may be subject to a penalty. In Figure 119.” The remaining non-tradeable markets are divided into two halves. the auction settles here. Credit Default Swap Primer Glen Taksler 646. and offers $66. rounded up. CreditEx. $66. $67. Sources: ISDA.7559 145 .50. as described in the section “Incentive for Dealers to Accurately Portray Markets. Some dealers who submitted these markets If there is no demand to physically settle contracts. Average of bids and offers in the best half. the best half is the average.50. Price ($) Worst Half: Excluded from calculation of inside market midpoint. For illustration. 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. rounded to the nearest eighth. $65. The “best half” is the lowest half of sorted offers and the highest half of sorted bids. and $64. $67.Credit Strategy Research May 27.” and the worst 5 form the “worst half. In Figure 119. Banc of America Securities LLC estimates. but there is no penalty. The “worst half” of non-tradeable markets (the far right portion of Figure 119) is the set of highest offers and lowest bids submitted. These markets are excluded from the calculation of the inside market midpoint. $65.855. $67. A “tradeable market” is a market submitted by one dealer that is inconsistent with that submitted by another dealer.50. there are 11 non-tradeable markets. the inside market 87 midpoint is $66. The average of all these bids and offers forms the inside market midpoint. Specifically. 86 86 If there is an odd number of non-tradeable markets. Calculation of Inside Market Midpoint Inside Market Midpoint Serves as a Baseline for Determining the Final Cash Settlement Price Sorted Bids (Descending Order) Sorted Offers (Ascending Order) 70 69 68 67 66 65 64 63 62 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Size ($ MM) Best Half of Non-Tradeable Markets: Tradeable Markets: Excluded from calculation Inside Market Midpoint = $66 of inside market midpoint.50.50. this figure uses data from the 2005 Delphi CDS cash settlement protocol.” 87 $66 is the average of bids $65. $65. and $67. while the offerer may have been trying to drive the price below fair value. $65. No penalty. 2008 35 Figure 119.
The settlement process may be broken down into two portions. Similarly.Credit Strategy Research May 27. 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.7559 . The client wishes to receive bonds from the trade. which the dealer then needs to sell. and now wish to deliver those bonds to physically settle CDS. Figure 120 and Figure 121 illustrate how a protection Buyer physically settles a transaction under the protocol. Figure 121. cash and physical: Figure 120.855. which is simply recovery. These net cash flows are the same as those exchanged in physical settlement. the protection Seller pays the protection Buyer the notional of the trade. a dealer enters an order to sell bonds. Net Cash Flows are the Same as Physical Settlement Protection Buyer Delivers Bonds. Since the dealer entered an order to sell bonds. For example. that investor may request 146 Credit Default Swap Primer Glen Taksler 646. up to his net notional position in CDS. less recovery. the final cash settlement price will be adjusted to reflect the net demand of market participants to physically settle. Any investor may enter a request to physically settle. a traditional investor may have bought protection as a hedge against an existing bond position. In the physical portion. 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. 2008 35 If there is no demand from market participants to physically settle any CDS trades. $10mm Cash Investor Protection Seller $10mm Bonds $10mm Protection Protection Buyer In the cash portion. when a protection Seller wishes to physically settle a transaction.Recovery Rate ) Dealer Physically Settled Portion: $10mm Bonds $10mm x Recovery Rate Source: Banc of America Securities LLC estimates. If there is no demand from market participants to physically settle any CDS trades. and Receives $10mm Cash Protection Buyer’s Recovery Rate is the Price at Which He Bought Bonds Cash Settled Portion: $10mm x ( 1 . For example. The client will deliver bonds into the trade. Which are then Sold In the Auction. a dealer enters an order to buy bonds. In such cases. the protection Buyer delivers bonds. the investor also receives those proceeds. Net. which the dealer will need to buy. However. then the final cash settlement price is the inside market midpoint. How a Trade is Physically Settled Under the Protocol Protection Buyer Wishes to Physically Settle a $10mm Trade Protection Buyer Delivers Bonds. the protection Buyer delivers bonds and receives the notional of the trade. Source: Banc of America Securities LLC estimates. if an investor is long $20 million of a credit in single-name CDS.
A limit order is an order that will be filled only if needed to clear the net open interest. If the auction settles at $65.855. would be repeated one business day later. $63. and clients may enter limit orders through any dealer with whom they have a trading relationship. This is in contrast to recent Credit Events.Credit Strategy Research May 27. These requests are fulfilled.” 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. 89 All dealers’ $10mm x $10mm markets are used. Dealers may. provided the client states that the order reflects his net position across dealers. Similarly. 2008 35 physical settlement on $15 million or less. The entire auction process. if there is an extreme open interest. Dealers may enter limit orders directly. 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.7559 147 . 90 If the investor’s order is filled. but are not required. not just the “Best Half of Tradeable Markets” described in Figure 119. to the extent 88 that some other market participant is willing to take the opposite position. 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. Naturally. Additionally. on which he ultimately expects to earn at least 5 points profit (70% ultimate recovery minus maximum $65 90 purchase price). if the market has a net open interest to sell $100mm in bonds. As such. if an investor believes that ultimate cash bond recovery will be 70%. it is possible that cash bond prices will move after the net open interest has been released. 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 investor may be partially filled on his $2mm order. if more protection Sellers than protection Buyers want to physically settle. 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. Credit Default Swap Primer Glen Taksler 646. the investor will receive the $2mm in bonds. For example. To clear the market. Since the credit market (including dealers) does not know beforehand whether the net open interest will be to buy or sell bonds. 88 Dealers are required to accept a request for physical settlement that reflects the CDS position of a client with that dealer. the final price is the bid that clears $100mm in size. the investor would expect to earn 7 point profit (70% ultimate recovery minus $63 purchase price). he may enter a limit order to buy $2mm bonds at a price of $65. it is less likely that bond prices will move in advance. any market participant may enter a “limit order” to buy or sell bonds at a specified price. if the final cash settlement price is. including new $10mm x $10mm markets. the auction may be cancelled for that day. For example. the dealers’ $10mm x $10mm markets provide a base level of 89 liquidity. then he will pay the final cash settlement price. to accept a larger order. where the requirement to physically settle single-name CDS sent protection Buyers scrambling to buy bonds. For example. resulting in a short squeeze. 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. 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. 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.
$2mm of this final $5mm limit order is filled at the cash settlement price ($63. using data from the settlement of Delphi. this figure uses data from the 2005 Delphi CDS cash settlement protocol.. the participant who bid $65 only pays $63. 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 ($63.375). 148 Credit Default Swap Primer Glen Taksler 646. All orders that are filled are done so at the final price (i.855. The final cash settlement price is the bid that clears the $99mm in net open interest. Those protection Buyers deliver bonds. this figure omits that data for readability. For illustration.375). The next two orders filled come from limit orders. in which there was $99mm of net open interest to sell bonds. In this example. CreditEx. which then need to be sold in the auction: Figure 122. the first four orders filled come from dealers’ $10mm x $10mm markets. The participant who bid $63. more protection Buyers than Sellers wanted to physically settle. and so on.7559 . not just the “Best Half of Tradeable Markets” described in Figure 119. Sources: ISDA. In this case. the final price is $63. There were additional (lower) bids that could have been used to fill demand beyond $175 million in size (the maximum on the horizontal axis shown here). to the extent necessary to clear the net open interest.375 is partially filled. Bid ($) 25 50 75 100 125 Cash Settlement Price: Bid that clears the $99mm of bonds that CDS market participants wanted to sell as a result of the Credit Event. Banc of America Securities LLC estimates.375). 2008 35 Figure 122 illustrates the calculation of the final price.375.Credit Strategy Research May 27. Notice. 150 175 Size ($ MM) All dealers’ $10mm x $10mm markets are used.e. Unused Bids: These orders are not filled.
if there is a significant net open interest. will be filled. the final cash settlement price will be 100.855. in addition to the dealers’ $10mm x $10mm markets. the maximum final price is capped at the inside market midpoint plus 1% of par. Then. If there is a significant net open interest. Additionally.Credit Strategy Research May 27. with a relatively high bid. there is a general expectation that the final auction price will be below the inside market midpoint. it is possible that just one limit order. If there are not enough limit orders. if there is a net open interest to sell bonds. For example. That is. this is not a problem. 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. if there are not enough limit orders. 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. In this case. market participants should seriously consider placing limit orders to avoid a final zero or 100 settlement price. Similarly. To guard against this scenario. But now suppose there were a very small net open interest to sell just $5 million in bonds. Preventing Unexpected Results The auction also contains a provision to prevent extreme scenarios from a small net open interest. notice that an insufficient volume of limit orders means that participants who requested physical settlement will be unable to do so. the final cash settlement price will be zero.7559 149 . against dealer $10mm x $10mm and limit orders that were received. 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. This provides baseline liquidity of $150mm. market participants should seriously consider placing limit orders to avoid a final zero or 100 settlement price Accordingly. established in the dealers’ $10mm x $10mm markets. That limit bid would normally become the final price. as illustrated in the example above (Figure 122). However. Provided there are enough limit orders. as illustrated in Figure 123. not enough market participants were willing to take the opposite side of the Counterparty requesting physical settlement. A provision to help prevent extreme scenarios Credit Default Swap Primer Glen Taksler 646. Consider the case where 15 dealers submit $10mm x $10mm markets. if there is a net open interest to sell bonds. resulting in an unexpectedly high recovery rate. requests for physical settlement will be filled on a pro rata basis.
7559 . This is because market participants would bind themselves to the protocol at trade inception. market participants would bind themselves to the protocol through the ISDA Master Agreement. 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. a procedure for determining the Deliverable Obligations (and potential disputes) would need to be added to the protocol.” Technically. There is a general expectation that the 92 cheapest-to-deliver obligation would be exchanged. 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. if ever. or an amendment thereof. as with any CDS contract.855. …But.Credit Strategy Research May 27. Preventing Unexpected Results If There is a Net Open Interest to Sell Bonds. Similarly. Additionally. there is an expectation that the final auction price will exceed the inside market midpoint. pre-specified list of Deliverable Obligations. (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. and must deliver a Notice of Physical Settlement. the Final Price is Capped at Inside Market Midpoint + 1% If There is a Net Open Interest to Buy Bonds.) An inter-dealer committee is working on a solution to potential disputes surrounding Deliverable Obligations. Source: Banc of America Securities LLC estimates. 92 The Buyer of bonds (Participating Bidder) enters into a contract to sell credit default protection.. the recent (since 2005) process of arranging an ad hoc CDS settlement protocol. we note that loans are also deliverable into credit default protection. the Final Price is Floored at Inside Market Midpoint – 1% 70 68 Bid ($) 66 64 62 60 0 With a small open interest. before entering into the auction. This means that a loan is rarely. As such. the maximum final price will be floored at the inside market midpoint minus 1% of par. they are rarely delivered. auction capped at $67 (Inside Market Midpoint + 1%) 25 50 75 100 Size ($ MM) 125 150 175 Hypothetical data. 93 More accurately. Should there be a very small open interest that would otherwise result in a significant price decline. Longer term. even though the list of 93 Deliverable Obligations would not be determined until after a Credit Event. the cheapest-to-deliver obligation. Difference from Figure 122 is the level of limit bids and the size of the open interest. allows adherents to know which obligations will be deliverable. post-Credit Event. auction normally would settle at $70. 2008 35 Figure 123. But in practice. 150 Credit Default Swap Primer Glen Taksler 646. 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.
Credit Strategy Research May 27. Offering Dealer Would Pay the Penalty.25 67. If Net Open Interest Were to Buy Bonds. some dealers who submit markets that are inconsistent with the markets of other dealers are required to pay a penalty. The logic is that the offering dealer may have attempted to drive the Credit Default Swap Primer Glen Taksler 646. For example. Penalty is the Bid Minus the Inside Market Midpoint. and the inside market midpoint minus the offer were negative. Similarly.75 0 Bidding Dealer Pays 1 Point Penalty to ISDA. if there is a net open interest to sell bonds. and the bid minus the inside market midpoint were negative. the offering dealer pays the penalty to ISDA. Similarly. Determining the Dealer Penalty When Net Open Interest is to Sell Bonds. on $10mm ($100. on $10mm ($100.25 66. Banc of America Securities LLC estimates. The penalty is the difference between the relevant bid and the inside market midpoint. 2008 35 Incentive for Dealers to Accurately Portray Markets As mentioned earlier. For example. Figure 124.50 66. then the offering dealer would pay no penalty. The logic is that the bidding dealers may have attempted to raise the price above fair value. Sorted Bids (Descending Order) 67. 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. For illustration. Sources: ISDA. CreditEx. on $10mm ($50.000 Penalty) 4 5 No Penalty Because Bid is Equal to (or Less Than) the Inside Market Midpoint A penalty is only paid if it is positive. if there were a net open interest to buy bonds. if there were a net open interest to sell bonds.00 Price ($) 66.7559 151 . as illustrated in Figure 124. This figure shows the calculation of the penalty under the current protocol.000 Penalty) 1 Inside Market Midpoint 2 3 Markets Subject to a Penalty Bidding Dealer Pays 1/2 Point Penalty to ISDA. Penalty Would Be the Inside Market Midpoint Minus the Offer.855. Bidding Dealer Pays the Penalty.75 66. then the bidding dealer would pay no penalty. the dealers whose bids formed part of the tradeable markets are subject to a penalty. However.00 65.000 Penalty) Bidding Dealer Pays 1 Point Penalty to ISDA. the method for calculating a penalty has since changed. this figure uses data from the 2005 Delphi CDS cash settlement protocol. if there is a net open interest to buy bonds.
For both Modified and Modified-Modified Restructuring. particularly for Reference Entities that were downgraded from investment grade. For this reason. and in these cases. if the net open interest were to buy bonds. 94 Penalties are only due if they are positive. Similarly. similar to the terminology used in the 2003 ISDA Credit Derivatives Definitions. Once this happens. Europe (investment grade and high yield. 152 Credit Default Swap Primer Glen Taksler 646. Modified and Modified-Modified Restructuring differ. parties may begin the CDS settlement process. Restructuring Criteria Bankruptcy and Restructuring The table below summarizes the five Restructuring criteria. For example. single-name and iTraxx indices) uses Modified-Modified Restructuring. and the inside market midpoint minus the offer were negative.7559 . if the net open interest were to sell bonds. we will be more specific. primarily used by the North American investment grade market. the offering dealer would pay no penalty. the triggers for a Credit Event are the same. Details Around Modified Restructuring In this section. When discussing which obligations a protection buyer may deliver post-Credit Event. and the bid minus the inside market midpoint were negative. The penalty would be the difference between the inside market midpoint and the relevant offer. a singlename CDS Credit Event.Credit Strategy Research May 27. we simply write “Restructuring” below when describing triggers.855. Proceeds from the penalty are used to defray auction 94 costs. Any one of these criteria causes a Restructuring Credit Event to occur. The North American high yield market also sometimes uses Modified Restructuring. 2008 35 price below fair value. we present a detailed discussion of Modified Restructuring. the bidding dealer would pay no penalty.
the standard has become 97 Old Restructuring. Instead: For single-name CDS contracts on US investment grade and many fallen angel Reference Entities. Similarly. With the universe of Deliverable Obligations already limited. it seemed unnecessary to include the additional maturity limitation of Modified-Modified Restructuring. plain vanilla Restructuring—sometimes called “Old 95 Restructuring”—has been rarely used since the Conseco Restructuring in 2000. we mean a Reference Entity that was high yield when it originally started trading in CDS and subsequently was upgraded to investment grade. For CDS contracts on European Reference Entities. Restructuring. as 95 Please see the Case Histories section on page 129 for details. Restructuring Criteria 2003 ISDA Restructuring Definitions. single-name and index. some single-name rising-star CDS and the CDX indices. accounting. Recently. 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. In the US and Europe. 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. by rising-star CDS.Credit Strategy Research May 27. note that Old Restructuring continues to be used for Reference Entities in emerging markets. the market standard is Modified Restructuring. please see page 169. Modified Restructuring. we mean a Reference Entity that was investment grade when it originally started trading in CDS and subsequently was downgraded to high yield.855. 2008 35 Figure 125. investment grade and high yield. for European leveraged loan CDS contracts. The primary differences between Modified Restructuring and Modified-Modified Restructuring lie in the maturities and transferability of Deliverable Obligations. such as single-name high yield CDS. 96 By fallen angel CDS. the standard is Modified-Modified Restructuring. Credit Default Swap Primer Glen Taksler 646. and Modified-Modified Restructuring. Additionally.7559 153 . For other CDS contracts on US Reference Entities. 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. 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. For more details.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. the standard is No 96 Restructuring.
Modified and Modified-Modified Restructuring Guidelines. two-thirds of which consent to the Restructuring. Figure 126. the two-thirds consent is deemed automatically satisfied if the restructured obligation is a bond. For Modified-Modified Restructuring (Europe): The Deliverable Obligation must be transferable to any entity that regularly engages in loan and securities markets. the protection Buyer should have the option to deliver obligations across the credit curve.855. even if affiliated with another holder. What’s important here is that these are relatively short-term and thereby limit the cheapest-to-deliver option. 99 Source: 2003 ISDA Credit Derivatives Definitions. The logic is that. not to be unreasonably withheld. 98 based on whether the protection Buyer or Seller declares a Credit Event: If the protection Buyer declares a Restructuring. Multiple Holder Obligation Figure 127 and Figure 128 show two examples of which obligations may be delivered following a Restructuring. 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. it will not be deliverable. or the Scheduled Termination Date of the CDS contract. However. Notice that there is a difference in Deliverable Obligations. For Reference Entities based in North America. 2008 35 illustrated in Figure 126. this limits Deliverable Obligations to bonds (not loans). As such.7559 . 154 Credit Default Swap Primer Glen Taksler 646. whichever is later. The protection Buyer may deliver the same obligations as for a Bankruptcy or Failure to pay. or with consent of the Reference Entity. MHOs have at least 4 unaffiliated lenders. 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. This prevents parties from profiting by triggering bilateral loans. Essentially. and the shorter of (i) 30 months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan. the protection Seller is likely to prefer not to trigger a Restructuring Credit Event. each holder has one vote.Credit Strategy Research May 27. Modified Restructuring also essentially limits Deliverable Obligations to bonds only (not loans). assuming that the protection Buyer declares a Credit Event: 98 If multiple Credit Events are declared—for example. Fully Transferable Obligation (North America) or Conditionally Transferable Obligation (Europe) For Modified Restructuring (North America): Obligation must be fully transferable to an eligible assignee. either without consent. Restructuring Credit Events are triggered only by Multiple Holder Obligations (MHOs). If the Reference Obligation fails to meet these criteria. For the two-thirds consent. Modified Restructuring and Failure to Pay—the limitations of Modified Restructuring and Modified-Modified Restructuring do not apply. if the Protection Buyer Declares a Credit Event If the Protection Seller Declares a Credit Event. usually up to a maximum maturity of 30 years. if the protection Seller declares a Restructuring. because the protection Seller forces the Buyer to settle. then Modified and ModifiedModified Restructuring attempt to limit the cheapest-to-deliver obligation to the portion of the credit curve that was restructured. these limitations do not apply. 99 Per the May 2003 Supplement to the 2003 ISDA Credit Derivatives Definitions.
or $40 post-default. Maturity (Non-Restructured Deliverables) Max. Banc of America Securities LLC Estimates. Sources: ISDA. Maturity (Non-Restructured Deliverables) Max. If the protection Buyer declares a Restructuring. 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. Maturity (Restructured Deliverables) For North America. he stops paying the CDS premium and receives 30 points (100% par – 70% post-Restructuring price). (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. Maturity (All Deliverables) Max. Assume that a company’s bonds would trade at $70 post-Restructuring. For further details on maturity limitations and transferability. Figure 128.855. Sources: ISDA. 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.Credit Strategy Research May 27. Banc of America Securities LLC Estimates. 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. Second Example of Which Obligations May Be Delivered Following a Restructuring Remaining Maturity of CDS Contract is One Year Under MR. Maturity (All Deliverables) Max. please see Figure 126.7559 155 . 2008 35 Figure 127. Credit Default Swap Primer Glen Taksler 646. 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. (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. please see Figure 126. Maturity (Restructured Deliverables) For North America.
the more likely the protection Buyer is to trigger Modified Restructuring immediately.855. the timing option also exists following Bankruptcy and Failure to Pay Credit Events. Figure 129. or 40% post-Bankruptcy. 101 Naturally. presumably the protection Seller will not trigger a Modified Restructuring. To be clear. More recently. when to declare a Credit Event. he is likely to wait to trigger CDS. the closer a CDS contract is to maturity. the investor would expect to receive 60 points (100% par – 40% post-default price). 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. In this case. the protection Buyer has a choice on when to trigger CDS--that is. However. 2008 35 Alternatively. Exception: CDS—Cash Basis Packages One exception is CDS—cash basis packages.Credit Strategy Research May 27. it should be to one party’s advantage to immediately declare a Credit Event. one should generally expect the protection Buyer to trigger a Modified 100 Technically.7559 . its probability of default rises 101 significantly. Source: Banc of America Securities LLC Estimates. where the protection Buyer already owns a bond. because following a Modified Restructuring. At that time. 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. Restructuring as an American Option Sample Discounted P&L from Perspective of Protection Buyer. From about 2005 until summer 2007. However. As such. Provided that CDS matures later than the bond. These payoff scenarios are illustrated in Figure 129. because either the protection Buyer or Seller may trigger CDS and the Deliverable Obligations are the same regardless of who triggers. He may do so anytime from the date of the Modified 100 Restructuring up to and including 14 calendar days after CDS contract maturity. Discounted by LIBOR. once a company has restructured its debt. 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. and thereby has locked in a recovery rate. the timing option is essentially irrelevant following a Bankruptcy or Failure to Pay. If the protection Buyer believes that. This creates a meaningful timing option for the protection Buyer. the bond will be deliverable under Modified Restructuring criteria. the perceived value of Restructuring provisions has increased. 156 Credit Default Swap Primer Glen Taksler 646. in part because of deterioration in the overall macroeconomic environment. the protection Seller will lose the advantage of the maturity limitation if he triggers.
which could be triggered at any time until contract maturity. 2008 35 Restructuring immediately. The low dollar price of the cash bond would make a buy CDS—buy bond trade look attractive. The appropriate duration depends on the difference in expected recovery rates between a Bankruptcy or Failure to Pay. the investor is notional neutral. if a Modified Restructuring occurs: If the investor is triggered on back-end protection. In practice. 102 For example. because of the option to trigger the CDS contract at any time until maturity. 103 CDS contracts discount at LIBOR plus the implied probability of default. By contrast. resulting in no loss. Alternatively. Presumably. he will be naked long risk. suppose that a bond traded at $70. in which an investor sold back-end protection and hedged by buying front-end protection. versus a Modified Restructuring. if the investor is not triggered on back-end protection. resulting in no loss. 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. Assuming CDS matures later than the bond. By contrast. However. but CDS traded at par (all running spread. he will become concerned about the potential for a trigger. spreads widen and the investor would like to record mark-to-market gains of the spread change multiplied by the duration. if the investor is not triggered on back-end protection. or to buy front-end protection as a hedge. if a Modified Restructuring occurs. he in turn can trigger the frontend contract. resulting in 103 unclear mark-to-market profits and reduced liquidity. duration should shrink. Post-Credit Event. CDS contracts (including the CDSW screen on Bloomberg) typically derive the implied probability of default.Credit Strategy Research May 27. Practical Trading Considerations Following a Restructuring Example 1: Curve Trades Consider an investor who sold front-end protection and bought back-end protection. However. Example 3: Mark-to-Market Risk Suppose that an investor bought protection but does not want to trigger immediately post-Modified Restructuring. he in turn can trigger the backend contract. if the investor is not triggered on front-end protection. which changes post-Modified Restructuring. Different dealers may assign different recovery rates. Using the methodology in the “Implied Probability of Default” section on page 100. resulting in a 30 point profit. Such activity could invert the credit curve and decrease liquidity post-Restructuring. this could particularly result in triggers for 102 credits where bonds traded at a deep discount but CDS traded at par. to a one-year horizon. as opposed to points upfront). the investor could deliver the bond following a Modified Restructuring. Absent a Restructuring. Absent a Restructuring. the investor is notional neutral. Accordingly. which could occur at any time until contract maturity. the investor’s position becomes unclear: If the investor is triggered on front-end protection. he still can trigger the front-end contract. he will be forced to either hold on to the back-end position. Example 2: Hedging Risk Consider the reverse situation.855. the investor would receive par on CDS with a locked-in recovery rate of 70%.7559 157 . 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. then once the front-end contract matures.
we discussed the various criteria that may trigger CDS contracts. 2008 35 CDS Settlement Protocols Recent CDS (so-called “cash”) settlement protocols. a further discussion of Bankruptcy criteria is relevant. have been used only for Bankruptcy Credit Events. any one of which is sufficient to trigger a Credit Event. Defining a Monoline Credit Event CDS Bankruptcy criteria contain more triggers than an actual bankruptcy filing. 158 Credit Default Swap Primer Glen Taksler 646. we discuss special issues pertaining to CDS on monoline insurers. First. Currently.Credit Strategy Research May 27. and (2) the option to trigger immediately post-Modified Restructuring or at any time up to and including 14 calendar days after maturity. Finally. Should a Modified Restructuring occur in the future. Second. In this section. 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. Generally. we apply these criteria to hypothetical scenarios for monoline insurers. we discuss potential issues in settling monoline CDS contracts.” beginning on page 17. Next. we discuss how rarely used criteria in CDS Bankruptcy definitions could (or could not) result in a Credit Event for monolines. because it enters a gray area in CDS language. But post-Modified Restructuring. For monolines in particular. discussed in the section “CDS Settlement Protocols“ on page 143. ISDA is looking into Modified Restructuring cash settlement solutions through a working group.855. Accordingly. any one of which is sufficient to trigger a Credit Event. 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. we address the implications of a proposed “good bank” / “bad bank” split on monoline CDS contracts. CDS mark-to-market profits and trade unwinds should use LIBOR plus this new implied probability of default. In the section “Credit Events. But Figure 130 shows that several other criteria meet the definition of Bankruptcy in CDS contracts. We emphasize that our analysis is incomplete. Special Issues Pertaining to CDS on Monoline Insurers We discuss special issues pertaining to CDS on monoline insurers. particularly based on additional information available at the time of a potential event.7559 . investors think of Bankruptcy as an actual bankruptcy filing. the protection Seller’s minimum expected Loss rises from zero to [ 1 – Recovery post-Modified Restructuring ]. should a Credit Event be determined. It may be possible to obtain different—or even opposite—interpretations.
clause b). sequestration or other legal process levied. has an analogous effect to any of the events specified in clauses (a) to (g) (inclusive). 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. because the monoline has not become subject to the appointment of an administrator for all or substantially all its assets (Figure 130. or any such process is not dismissed. in each case within thirty calendar days thereafter causes or is subject to any event with respect to it which. trustee. enforced or sued on or against all or substantially all its assets and such secured party maintains possession. A state regulator seizes control of a monoline. under the applicable laws of any jurisdiction. 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.855. or a petition is presented for its winding-up or liquidation. Monoline obtains a judgment of insolvency or bankruptcy Bankruptcy Credit Event at the monoline (Figure 130. discharged. in the case of any such proceeding or petition instituted or presented against it. stayed or restrained. (e) (f) (g) or (h) Source: 2003 ISDA Credit Derivatives Definitions. official management or liquidation (other than pursuant to a consolidation. regulatory or administrative proceeding or filing its inability generally to pay its debt as they become due makes a general assignment. discharged. clause f). conservator. 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. 2008 35 Figure 130.Credit Strategy Research May 27. amalgamation. receiver. provisional liquidator. 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. clause d).7559 159 . execution. stayed or restrained in each case within thirty calendar days of the institution or presentation threreof has a resolution passed for its winding-up. for all or substantially all its assets Bankruptcy Credit Event at the monoline (Figure 130. amalgamation or merger) seeks or becomes subject to the appointment of an administrator. clause f). Credit Default Swap Primer Glen Taksler 646. or merger) becomes insolvent or is unable to pay its debts or fails or admits in writing in a judicial. attachment. 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. 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. and.
” Typically. such as a municipal bond or super senior CDO tranche.S. Typically. monolines issued a financial guarantee on CDS on CDO tranches. we discuss potential issues in settling monoline CDS contracts. Monoline CDS contracts are governed by the usual 2003 ISDA Credit Derivatives Definitions plus a 2005 Monoline Supplement.. Should an investor want to deliver a CDO tranche—for example. We then discuss recent steps taken by ISDA to potentially reach a solution. dealers were not in the business of marking and trading financial guarantees. so that the insured instrument (i. may prove problematic due to vast dispersion in the recovery rates of potential Deliverable Obligations. not the underlying super senior tranche.. bond or loan—that is deliverable under standard CDS contract language. Should an investor want to deliver a CDO tranche. in exchange for a financial guarantee on the CDS.Credit Strategy Research May 27. whereas they are accustomed to trading CDS. Ultimate contract payoffs depend crucially on the type of instrument delivered. a super senior—that tranche must be guaranteed directly by the monoline.7559 . CDS was more attractive than a direct financial guarantee. More importantly. a broader category than simply Bonds and Loans. the bank receives CDS protection from the SPV. First. 104 A Failure to Pay is a Reference Entity’s failure to make due payments. At the same time. CDS is typically marked-to-market daily. whereas our understanding is that financial guarantees need not be re-marked unless they become impaired—namely. wrapped (guaranteed) CDO super seniors typically are not eligible for delivery.855. The protection Buyer may deliver debt that is wrapped by the monoline. Usually applies to Borrowed Money. These Deliverable Obligations are in addition to the direct debt of a Reference Entity—i. The bank buys protection from a special purpose vehicle (SPV). it must be guaranteed directly by the monoline. monolines issued a financial guarantee (wrap) on CDS on super senior tranches. This supplement allows the protection Buyer to deliver debt that is wrapped by the monoline insurer. which prevents the holding company from making a coupon payment Not a Credit Event at the monoline. First. owing to their structural characteristics. the tranche) is Borrowed Money. In exchange. should a Credit Event occur. after the expiry of any grace period in the relevant holding company bond 104 indenture.. Since dealers owned the underlying CDO tranche and wanted to be able to offset potential (now actual) mark-to-market losses. Notably. a premium is paid to the monoline. 160 Credit Default Swap Primer Glen Taksler 646. unless the tranche suffers a loss of principal. not the underlying tranche. 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 was done for two main reasons. a bank owns a CDO tranche..—and usually sets a minimum threshold of USD 1 million. The bank is thus protected against lost of principal and interest payments.e. in addition to bonds and loans. Figure 131 shows a sample structure that would allow for effective insurance from a monoline but would not be deliverable into CDS contracts.e. Settling a Monoline Credit Event Settlement of monoline CDS contracts Settlement of monoline CDS contracts. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days in the U. Failure to Pay Credit Event at the holding company. 2008 35 A state regulator prohibits a monoline from dividending any payments up to its holding company. In this structure.
Figure 131. though not necessarily impossible. 2008 35 MBIA provides this description of the process: LaCrosse Financial Products. Frequently Asked Question “What is LaCrosse Financial Products?” in Category “Derivatives & Mark-to-Market. CDS settlement protocols (commonly called “cash settlement”) are actually an auction. primarily pooled credit default swaps. it is consolidated in the financial statements of the Company on the basis that substantially all risks and rewards are borne by MBIA. MBIA Insurance Corp.com/investor/investor_inquiries_faqs. $10 million bonds. with a 2 point bid-offer spread. through a financial guarantee policy.html. However. then 105 guarantees the obligations of LaCrosse under the credit default swap. 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. Challenges with Cash Settlement for Monolines We think it would be difficult. and incomplete. say. MBIA’s guarantees of synthetic CDOs are typically executed through LaCrosse. cash settlement is only an expectation. which enters into a credit default swap with the counterparty.7559 161 . not a requirement. Dealers may be required to trade bonds at their submitted levels. please see “CDS Settlement Protocols” on page 143. the mechanics of which resemble a Treasury auction. as we discussed on page 143 in this Chapter. Roughly speaking.Credit Strategy Research May 27. we think it would be very difficult to cash settle. While MBIA does not have a direct ownership interest in LaCrosse. description of CDS (so-called “cash”) settlement protocols. 105 http://www. The reason is that. For further details. because the wrap is not the CDO tranche itself. Not on the Tranche Itself Bank. which provides incentive for 106 the submission of reasonable quotes. Credit Default Swap Primer Glen Taksler 646.855. the CDO tranche would not be deliverable into CDS contracts referencing the monoline insurer.mbia. However. 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. approximately 15 dealers submit a market on. 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.. If a monoline were to suffer a Credit Event. to cash settle a monoline.” 106 This is only an approximate. currently.
107 For details. CDS Succession refers to the potential change of entity that a CDS contract references (for example. 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. 2008.55% June 2006. For example. suppose that the bulk of Deliverable Obligations have a price of $60 to $80. The dealer community would have to agree that the each proposed Deliverable Obligation is indeed deliverable into CDS contracts. or splitting 50% / 50% notional between the municipals and structured finance businesses. 2008 35 Before the beginning of the auction. if even a small portion of Deliverable Obligations have a very low recovery rate. 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. not a recovery value estimate. Potential Solutions To address these issues. This is possible but timeconsuming. in our view. 162 Credit Default Swap Primer Glen Taksler 646. the 6.Credit Strategy Research May 27. ISDA assembled a working group in February 2008. Similar to CDS. Should such a proposal be enacted. 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. As such. 6. the CDS settlement auction would be likely to result in a cash settlement price in the $10-$20 range. and 7. 6. not on assets.50% May 2009. we see the potential for CDS contracts to rally massively. 2. This would be a time-consuming and difficult process. should a Credit Event occur. one referencing municipal bonds and the other referencing structured finance On February 14.” and is not intended to be definitive. a CDS settlement protocol. a list of Deliverable Obligations is established. MBIA Insurance Corp). either entirely succeeding (changing Reference Entity) to the municipals division. To clarify. Then.50% August 2013. using the to-date methodology. and any of those obligations may be delivered/received if a dealer is required to trade. would have a substantial risk of realizing a very low recovery rate.isda. Succession is based solely on the transfer of debt.855. dealers participating in the auction quote markets assuming they will exchange the cheapest-todeliver. That is far more straightforward for non-monolines. but a few Deliverable Obligations have a price of $10-$20. Each dealer then would have to value each Deliverable Obligation to determine the cheapest-to-deliver obligation. where only bonds and loans are deliverable Moreover. please see http://www. Recovery Rate Risk Moreover. New York Insurance Department Superintendent Eric Dinallo suggested the potential for monoline insurers to be split into two divisions. in the Delphi auction. these figures are just an example. Deliverable Obligation Challenges To assemble a list of Deliverable Obligations for a monoline: 1. which could impede on the 30 calendar days within which parties normally settle credit default swaps. because each dealer would recognize that he may receive the lowest price Deliverable Obligation. a list of Deliverable Obligations is established. Before the beginning of the auction.125% May 2009 all were Deliverable Obligations. As discussed on page 132 in this Chapter. the auction could result in a very low cash settlement price To address these issues. ISDA subsequently published a list of obligations that dealers viewed as potentially likely to be delivered into monoline CDS contracts.org. one referencing municipal bonds and the other referencing structured finance.7559 .
a subordinated bond would not be deliverable into a senior unsecured CDS contract. These Succession rules include financial-guaranteed obligations. For a monoline.855. For example. Figure 132 shows pertinent statistics. 2008 35 For a monoline. as one might imagine. the 25% and 75% thresholds are not clear-cut for monolines. For these early estimates. if 75% or more of financial-guaranteed obligations are transferred to a new division. Similarly. For example. in our early view. because many of these products would neither be deliverable into CDS contracts nor counted for Succession 108 purposes. if between 25% and 75% of financial-guaranteed obligations are transferred to a new division. but would be considered for Succession purposes.. would split into two contracts of $5 million notional each. we exclude CDOs entirely. unlike Succession rules for non-monoline Reference Entities. but would be counted for Succession purposes. 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. the original monoline Reference Entity would be deleted entirely and replaced with the new division. although not applicable for monolines. existing CDS contracts would split 50% / 50% notional between the original and the new entity. prepared by our insurance analyst Michael Barry. which also would not be counted for Succession purposes. At the extreme.7559 163 . Credit Default Swap Primer Glen Taksler 646.Credit Strategy Research May 27. one referencing the municipals division and one referencing the structured finance division. In reality. However. a $10 million notional contract referencing MBIA Insurance Corp. but we do not yet have a sense of this proportion. some portion of CDOs should be included and some portion excluded. 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. We also exclude international financial guarantees because many of these products were written as reinsurance. CDOs with a direct financial guarantee but a maturity greater than 30 years would not be deliverable. if between 25% and 75% of financial-guaranteed obligations are transferred to a new division.
7559 .Credit Strategy Research May 27.527 FGIC 314. CDOs with a direct financial guarantee but a maturity greater than 30 years would be considered for Succession purposes. we assume that all existing financial guarantees relevant to a particular division (municipals or structured finance) would be transferred.016 18. (*) For FGIC.934 395.518 71.956 425.027 176.298 130. we omit them entirely.855.628 79.725 23.569 70.973 20. but not deliverable into CDS contracts. It is entirely possible that the transaction would be constructed in a different way.870 44. 2008 35 Figure 132.100 28.331 72. We believe that results have not changed materially since then. for the time being.731 159. we assume it to be zero.549 SCA 154.344 3.% Would CDS Succeed to Municipals Division? Based on Preliminary Information and Data ABK 556. Banc of America Securities LLC estimates. Particularly for Ambac. A determination of the actual exposure may result in different implications for CDS.682 70% 30% 268. Sources: Company reports. Moreover. ex-CDOs . but because we do not know which CDOs have direct financial guarantees. For example. the international portion of CDOs is not available. “Est. 2007. but would not be deliverable following a potential Credit Event.164 59. 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.300 40. To be clear.173 300. $ Millions Total Net Par Outstanding Total Municipals Total Structured Credit Total International CDOs (US + International) US CDOs International CDOs Est.905 117. 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. likely one day prior to the Dinallo “good bank” / “bad bank” plan going through—so the final result may differ substantially.347 47. making our estimates invalid. these results are borderline—we estimate that 70% of obligations considered for CDS 164 Credit Default Swap Primer Glen Taksler 646. 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. Net Par of CDS Relevant Obligations for Succession (Total Net Par ex-CDOs and ex-Int'l) Total Municipals . This assumption is inaccurate.950 66% 34% 50% / 50% Split Full Succession Full Succession 50% / 50% Split But Borderline (*) Estimates as of September 30.467 28.% Total Structured Credit.100 (*) Not Available MBIA 672.500 50. Ambac and SCA Our preliminary estimates suggest that existing notional on CDS would split 50% / 50% between the municipals and structured finance divisions.247 84% 16% 472. these results are simply preliminary estimates based on financial guarantee disclosures by the monolines.289 84% 16% 89. 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.896 83. so for our preliminary purposes.814 224.
855.Credit Strategy Research May 27. CDS would succeed entirely to the municipals division. we have assumed that all CDOs are US exposure because of lack of information. Additionally. FGIC and MBIA Our preliminary estimates suggest that existing CDS notional would succeed entirely to the municipals division with corresponding spread tightening. for FGIC. Determination of the international portion of CDOs may change the denominator in the CDS Succession calculation. In reality. Credit Default Swap Primer Glen Taksler 646. 2008 35 Succession purposes would travel with the municipals. but if the actual number turned out to be at least 75%. we again caution that Figure 132 excludes CDOs entirely. However. some portion of CDOs is deliverable into monoline CDS and counted for Succession purposes. A determination of this number could result in a 50% / 50% split.7559 165 . rather than a full succession.
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. Such products include synthetic CDOs. an exhaustion point of at least 50%. correlation desks (groups responsible for managing structured credit risk and banks and broker-dealers) often use lists known as “Bid Wanted in Competition (BWIC). 109 To sell single-name protection on a large number of Reference Entities in different notionals. either the best bid wins a particular trade or the flow desk bidding the best overall wins the entire list. 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. By contrast. an OWIC is an Offer Wanted in Competition and signals the desire to buy single-name protection. shrinking the cushion that had prevented credit default swap spreads from moving wider. In the synthetic CDO market.7559 . Higher credit-risk tranches. had greater leverage. Identifiable super seniors defined as transactions with an attachment point higher than 20%. CDS on leveraged loans. and CDS on asset-backed securities.” Each recipient of the BWIC is responsible for entering a bid on trades in which it is interested. See Figure 133.855. Sources: CreditFlux. 166 Credit Default Swap Primer Glen Taksler 646. particularly at popular seven. However. Typically. should such structures ever unwind en masse.Credit Strategy Research May 27. Figure 133. For a further introduction to the structured credit market. Potentially. Banc of America Securities LLC estimates. or a super senior notation in Credit Flux data. resulting in 109 tighter CDS spreads. 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. Dealers hedged their short credit-risk exposure by selling protection in the single-name (secondary) CDS market. Correlation desks’ until-then persistent demand to sell protection dried up. please see the Chapter Appendix on page 179.and ten-year maturities. dealers typically sold credit risk to the end investor through one particular tranche. during 2007. losses in subprime mortgages and traditional cash CDOs caused synthetic CDO volumes to plummet. CDS spreads could move notably wider. such as equity and mezzanine structures. 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.
Banc of America Securities LLC. which includes Loans and Credit Default Swap Primer Glen Taksler 646. LCDS trades actively on 25 to 40 Reference Entities and is quoted for about 80 entities. Importantly.855. First Lien) Designated Priority is a trading (not a legal) standard. 2006. Sellers of protection include hedge funds. Leveraged investors may buy LCDS protection to short credit risk without the need for a repo market. Senior Unsecured CDS For North American Contracts. often with lower funding costs than a total-return swap on par loans. buying LCDS protection provides a more accurate hedge for loan portfolios than senior unsecured CDS.and single-B high yield universe.Credit Strategy Research May 27. 2008 35 Leveraged Loan CDS (“LCDS”) For more information on Leveraged Loan CDS. “North America” and “Europe” refer to the location of the Reference Entity. LSTA. Figure 134 compares key features of LCDS with senior unsecured CDS: Figure 134. Overview of Loan CDS vs.g. See Main Text for Major Differences in Europe.. Similarly. September 28. • Ability to physically settle.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). • Relevant Obligations are Syndicated Secured • Designated Priority (e. provided that another market participant is willing to take the opposite position. Focused on the double. please see our Guide to Leveraged Loan CDS. these Credit Events may occur anywhere within Borrowed Money. Bank loan portfolios may sell protection to add exposure to issuers with underutilized credit lines. there is a Credit Event in LCDS LCDS Credit Events are Bankruptcy and Failure to Pay.7559 167 . who seek quick access to leveraged loan exposure. • Relevant Obligations are Bonds and Loans - Sources: ISDA. Credit Events If an issuer defaults on just Bonds (not Loans).5 MM • Bankruptcy • Failure to Pay Senior Unsecured CDS • 2MM .10MM • Bankruptcy • Failure to Pay • Modified Restructuring (Selected Credits in SingleName CDS) • None • Bonds • Loans • 1 Year . regardless of where a trade Is executed Loan CDS Size Credit Events • 2 MM . Leveraged loan CDS (“LCDS”) allows investors to reference secured loans in standardized credit derivative contracts.
This is because the Counterparty may argue that. as the market tries to learn the fair value of early termination options. Succession criteria are Post-Credit Event. Accordingly. Succession language refers to potential changes in CDS contracts if the Reference Entity is merged. 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. in senior unsecured CDS. 85% versus a more commonly used 75%. the unwind payment 110 declines. Similarly. an LCDS contract may be terminated if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. 2008 35 Bonds. Investors who wish to physically settle may do so through the settlement process. Therefore. some protection Buyers find it difficult to unwind profitable trades. LCDS cash settles. For example. a haircut should be applied to the unwind payment. for a credit that has rallied. However. rip up) the trade. Investors need not agree on haircuts and recovery rates. That process is described in Chapter VI – CDS Case Studies and Legal Issues on page 143. reducing the protection Seller’s profit. When marking LCDS. higher recovery rates reduce expected profit. which facilitates consistent trading and liquidity. provided that 111 another market participant is willing to take the opposite position. reducing the protection Buyer’s profit. A Syndicated Secured List helps determine Deliverable Obligations into LCDS contracts. or undergoes some other change to its corporate structure. leveraged loan CDS cash settles using an auction process Unlike senior unsecured CDS trades. acquired. The protection Buyer is required to pay accrued interest up to and including the termination date. The list is based on dealer polls and is administered by Markit Group Ltd. parties should take these issues into account. Early Termination (Cancelability) LCDS may be terminated if a Syndicated Secured facility is canceled and not replaced For North American Reference Entities. Additionally. In other words. because a Counterparty may argue that the recovery rate may be relatively high—for example. Practical Issues in Trading LCDS As a young market. As long as investors can come to the same conclusion regarding cash flows (dollar price).7559 . it does not matter how they reach that conclusion. For LCDS in the interim.Credit Strategy Research May 27. if an issuer defaults on just its Bonds (not Loans). After that day. some protection Sellers find it difficult to unwind profitable single-name LCDS trades. First. the likelihood of prepaying a Syndicated Secured facility rises.855. the protection Buyer’s expected profit is par – recovery. Settlement Unlike senior unsecured CDS. LCDS is evolving toward standardized trading protocols. senior unsecured CDS uses a 40% recovery rate for almost all Reference Entities (autos and neardistressed credits are exceptions). 168 Credit Default Swap Primer Glen Taksler 646. much like senior unsecured CDS in the late 1990s and early 2000s. using an auction process that resembles recent protocols for senior unsecured CDS settlement. there still will be a Credit Event in LCDS. particularly for single names. Since a higher recovery rate would cause the protection Buyer to make less following a potential Credit Event. we point out some practical trading considerations. LCDS Succession language is based on Syndicated Secured Loans 110 111 Succession Language Like senior unsecured CDS. either party may deliver an Optional Early Termination Notice to terminate (effectively.
unsecured debt may be deliverable.. Only LCDS contracts will succeed. Early Termination depends specifically on the Reference Obligation and assets securing it. In North America. Early Termination depends on all Loans of the Designated Priority (e. in senior unsecured CDS. of the Deliverable Obligation. European LCDS (ELCDS) European LCDS uses different standards The above discussion focuses on Reference Entities based in North America. With the universe of Deliverable Obligations already limited. In Europe. suppose all Syndicated Secured Loans succeed to a new entity. it seemed unnecessary to include the additional maturity limitation of Modified-Modified Restructuring.Credit Strategy Research May 27. Successor provisions depend on the Reference Obligation and its corresponding credit agreement. we note some general differences for Reference Entities based in Europe: In Europe. with a settlement price determined through a market-wide auction. but this represents 25% or less of all Bonds and Loans outstanding at the Reference Entity. In Europe. if for some reason there is no LCDS (commonly called cash settlement) auction.g. In Europe. in 2006. cash settlement is possible under some circumstances but is based on an auction conducted by the Calculation Agent (in some cases. In Europe. Restructuring.855. In Europe. if the Reference Obligation is a senior secured bond. Under some circumstances. In North America. 2008 35 based on all Bonds and Loans outstanding. 112 113 The North American Deliverable Obligation still must be a loan of the Designated Priority (e. ELCDS Deliverable Obligations are limited to the Reference Obligation(s) or other senior loans with the same security and the same or equivalent guarantees. Successor provisions depend on all Loans of the Reference Entity. Senior unsecured CDS trades will remain with the original Reference Entity. In North America. first lien).g. or the auction fails to result in a final price. For example. with the intention that the only Deliverable Obligation would be second lien HCA bonds. the protection Buyer may deliver a senior unsecured bond. cash settlement is 113 the standard. physical settlement is the standard. In North America. 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. not the security.” or plain vanilla. the Reference Obligation determines only the seniority. please see Chapter VI – CDS Case Studies and Legal Issues on page 132. Below. the market introduced secured CDS contracts on HCA. For example. currently. A group is working on the development of ELCDS marketwide cash settlement mechanics. For example.7559 169 . Credit Default Swap Primer Glen Taksler 646. In North America. a Deliverable Obligation may have different 112 security. For more details on Succession language. The reason for secured CDS language is that.. first lien) based on a trading standard. rather than the Modified-Modified Restructuring (MMR) used for European senior unsecured CDS. ELCDS uses “old. trades may revert to physical settlement. following a Credit Event. LCDS Succession language is based solely on Syndicated Secured Loans outstanding. the protection Buyer) rather than a market-wide cash settlement price.
2008 35 Secured CDS therefore makes two changes from senior unsecured contracts. should there later be a Credit 115 Event. For example. the Deliverable Obligation Characteristic “Secured” would no longer apply. 116 Formally. Relevant CDS confirms specify. the Reference Obligation is changed to a secured bond from a senior unsecured bond. which essentially causes the trade to be ripped up.” ISDA. June 16. For example. suppose an investor buys a recovery lock at 50% and a Credit Event does not occur. if an investor buys a recovery lock at 50% and realized recovery is 60% post-Credit Event. through a tender offer--then secured CDS would become near-worthless. the investor profits 10 points. “Secured Deliverable Obligation Characteristic: Applicable. Figure 135 illustrates that the investor’s mark117 to-market profit is $440. 2006. “secured” is added to the list of Deliverable Obligation Characteristics.399 per $10 million notional. 114 “Additional Provisions for a Secured Deliverable Obligation Characteristic. a secured CDS trade would revert to senior unsecured CDS By contrast.7559 . Mark-to-market profits are based on the change in recovery rate relative to the implied probability of default. allow an investor to take a view on recovery rates rather than outright default risk. First. For example. 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. 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. If the security were to be released. But the market’s expectation for recovery increases to 60% and the spread remains constant. should such an obligation be issued before contract maturity. should there be a Credit Event. In this case. an opposite result occurs if the security goes away.855. that obligation would immediately become deliverable. suppose the secured Reference Obligation were to be refinanced and the collateral package simultaneously released. 170 Credit Default Swap Primer Glen Taksler 646. A regular senior unsecured CDS bond would become deliverable. Second. a clause “Substitute Failure Termination Date: Applicable” is inserted into a confirm. should there be no Deliverable Obligation. should all Deliverable Obligations cease to exist—for example. sometimes called recovery swaps.” 115 We say near-worthless because. the trade would revert to senior unsecured 116 CDS.Credit Strategy Research May 27. Similar to senior unsecured CDS. in some nonstandard CDS trades. Recovery Locks Recovery locks. 117 A wide bid-offer spread makes it difficult to realize mark-to-market gains on recovery swaps. We note that.
As the probability of default increases.Credit Strategy Research May 27. Notice that the mark-to-market is higher than in Figure 135. Current Spread Notional 5y CDS Original Recovery Rate and Current Spread (Better to use full credit curve) Recovery Swap Buyer Current Profit $440. Input current recovery rate in bottom-right corner. This is because a wider spread implies that a Credit Event is more likely. 2008 35 Figure 135. Both Deal Spread and Par CDS Spread equal the current market spread. 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.7559 171 . Input original (“strike”) recovery rate on left side. Banc of America Securities LLC estimates. the chance that the investor realizes the 10 point differential between the fixed recovery rate (50%) and the market recovery rate (60%) increases. Credit Default Swap Primer Glen Taksler 646.855. 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%.399 Sources: Bloomberg.
in the section. Banc of America Securities LLC estimates. “The Decline of ABX. if the CDS notional was $10 million Credit Default Swap Primer Glen Taksler 646. CDS on ABS is primarily designed for “soft” Credit Events. but on a reduced notional. The protection Buyer pays a premium with the same frequency as an underlying Reference Obligation (denoted by a specific CUSIP in the term sheet). the protection Buyer continues to pay the protection premium. recovery locks are far less liquid than single-name CDS. Input original (“strike”) recovery rate on left side. typically monthly.Credit Strategy Research May 27. such as write-downs and shortfalls The protection Seller must make the Buyer whole for any soft Credit Event Following a soft Credit Event. illustrated in Figure 137. the protection Buyer reimburses the Seller. 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. Below. Calculating Mark-to-Market on Recovery Locks with Widening CDS Spread Set Curve Recovery to False. Instead of focusing on outright default risk.855. For example. CDS on ABS CDS on ABS was decimated in price during 2007 CDS on ABS is primarily designed for “soft” Credit Events.” we will discuss 2007-early 2008 performance. The resulting structure. is called “Pay as You Go (PAUG)” CDS. Both Deal Spread and Par CDS Spread equal the current market spread.928 Sources: Bloomberg. including Credit Events and mechanics as compared with CDS on corporate Reference Entities. Current Spread Notional 5y CDS Original Recovery Rate and Current Spread (Better to use full credit curve) Recovery Swap Buyer Current Profit $576. In turn. such as write-downs and shortfalls. 2008 35 Figure 136. Input current recovery rate in bottom-right corner.7559 . with interest compounded at LIBOR. Following a soft Credit Event. But first we provide an overview of CDS on ABS more generally. Current Market Recovery Rate Generally. Should the underlying Reference Obligation later repay a shortfall. the protection Buyer continues to pay the protection premium. the protection Seller must make the Buyer whole for any write-downs or shortfalls.
The protection Buyer then would pay a coupon going forward on $9. Similar to CDS on corporate credit. the protection Buyer has the option to force Physical Settlement Alternatively. Source: Banc of America Securities LLC estimates.Credit Strategy Research May 27. 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. Payments are made with the same frequency as the underlying Reference Obligation. as the underlying Reference Obligation in ABS is often not sufficiently liquid in large quantity. 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. Optional Physical Settlement Difficult to Execute.000 ($10 million x 5%). 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.5 million notional ($10 million – $500. the protection Buyer has the option to force Physical Settlement.000). Source: Banc of America Securities LLC estimates.7559 173 . Alternatively. Figure 137. 2008 35 and an interest shortfall amounted to 5%. as illustrated in Figure 138.855. we note that it may be difficult to execute. Pay As You Go (PAUG) CDS Seller Provides Protection for “Soft” Credit Events Figure 138. Growth in the CDS on ABS market during 2006 brought the market to a more Pay As You Go-focused system. the protection Buyer would receive $500. Although the ability to physically settle technically exists. typically monthly. following any soft Credit Event.
Otherwise. This is because the Interest Shortfall is less than the annual protection premium. 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. should there be an Interest Shortfall of 200 bps. Pay as You Go CDS has a cap to limit the liability of the Seller of protection. Comparison of CDS on Corporate Credit. Currently. Comparison of Fixed and Variable Caps Based on a Premium of 150 Bps Per Annum In a Fixed Cap. There are two types of caps. the CDS Seller’s liability would be capped at LIBOR + 150 bps. Under a variable cap.7559 . Figure 140 compares the two caps: Figure 140. LIBOR is typically set at a one-month maturity. fixed and variable. A variable cap limits liability to LIBOR plus the annual protection premium. 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. (We assume that LIBOR is at least 0. the protection Buyer pays 150 bps and the Seller pays nothing. Following an Interest Shortfall of 100 bps. the protection Seller pays the Buyer only 150 bps. the protection Seller would pay the Buyer LIBOR + 150 bps.Credit Strategy Research May 27. because liability is capped at the annual premium. Variable Caps Pay As You Go CDS has a cap to limit the liability of the protection Seller Following a Soft Credit Event.855. Fixed vs. the protection Seller pays the Buyer the full 200 bps.50%. In the case of No Credit Event. A fixed cap limits liability to the annual protection premium.) 174 Credit Default Swap Primer Glen Taksler 646. Protection Seller’s Liability is Capped at the Premium In a Variable Cap. 2008 35 Figure 139. the Seller pays the Buyer 100 bps for both types of cap.50%. Otherwise. 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. the market appears to be evolving toward a fixed cap. While a fixed cap limits liability to the annual protection premium.
7559 175 . BBB. Principal Shortfall.Credit Strategy Research May 27. A. See Figure 141. 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. to single digits in some cases. The index is cash 118 settled. and BBB-. Like the CDX HY index. There are six indices. in 2006. The lesser of the two ratings applies.tranches dominated volume until late 2007. The ABX index uses a fixed cap equal to the coupon rate (recall Figure 140) and is intended to roll twice annually. ABX is quoted in dollar price. A. As such. the protection Buyer does not have the option to force physical settlement following a soft Credit Event. Credit Default Swap Primer Glen Taksler 646. there is no overlap between various series of the ABX index.indices with a weighted average life longer than 4 years. especially for participants in other markets who are less familiar with ABS and RMBS securities. called ABX. the “Buyer” of the index is like the protection Seller. and BBB. The “Seller” of the index is like the protection Buyer. The ABX indices also have served as a gauge for overall performance of securities backed by subprime mortgages. and a AAA index with an average life longer than 5 years Must be rated by Moody’s and S&P. Key Features of ABX Indices A dealer consortium selects 20 deals among the 25 largest issuers as ranked by subprime home equity issuance. 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 $500 million At least 90% of deal’s assets in first lien mortgages Weighted average FICO score of less than 660 Pays on the 25 of each month Pays interest at a floating rate benchmark of one-month LIBOR Has AA. around January 19 and July 19. with a fixed coupon. record weak performance in subprime mortgages has driven ABX prices down. AA. AAA (last AAA cash flow). and Writedown. the market introduced a series of indices on Home Equity Loans. The Decline of ABX th The ABX indices served as a gauge for performance of securities backed by subprime mortgages Since February 2007.855. Unlike the CDX and iTraxx indices. when severe expected losses pushed volume up the capital structure. 118 Unlike single-name CDS of ABS. Credit Events are soft and include Interest Shortfall. BBB. The BBB and BBB. based upon the rating of the Reference Obligations: Penultimate AAA (secondto-last AAA cash flow).
Key Features of CMBX Indices Similarly. Banc of America Securities LLC estimates. which roll approximately every April and October 25. the CMBX index references 25 commercial mortgage-backed securities. 176 Credit Default Swap Primer Glen Taksler 646. unlike ABX. and 119 BB. AA. Similar to ABX. Covering Deals Issued in the Second Half of 2006 120 100 Index Price ($) 80 60 40 20 0 Jan-07 Mar-07 May-07 Sources: Markit.7559 .0 119 The BB index began with the 06-2 series. BBB. AAA A BBB- Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 Owing to the collapse in subprime securities. the second CMBX series issued in 2006. 2008 35 Figure 141. However. 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. not price.855. CMBX is an index of commercial mortgage-backed securities Similarly. there are six separate indices by rating: AAA.Credit Strategy Research May 27. CMBX is quoted in spread. that is. 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. ABX 07-1 Price Performance “07-1” Means First ABX Series Issued in 2007. BBB-. 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.
risk exposure on CLOs was limited to long positions. multiplied by a factor of one). based on 0% constant prepayment yield at issuance and an initial issuance size of at least $100 million. 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.Credit Strategy Research May 27. AA.151 regular payment – $117. principal finance groups. the protection Buyer) normally would pay $2. Going forward. with interest compounded at LIBOR. the Seller of the index will pay just $2. S&P. multiplied by a factor of one. Soft Credit Event Example: Interest Shortfall Example of a soft Credit Event On November 27.150. Pay As You Go Credit Events. Must be rated by at least two of Moody’s. the protection Buyer will continue to pay a coupon of 267 bps per annum (paid monthly) on a notional of $1 million. CDS on CLOs allows an investor to take an unfunded long or short position and focuses on soft. CDS on CLOs largely focuses on recent vintage single-A to double-B tranches. and Fitch. with the longest average life. CDS on CLOs CDS on CLOs also focuses on soft Credit Events Traditionally.7559 177 . Preferred CDS (“PCDS”) Preferred CDS adds a Credit Event called “Deferral of Payment. In practice. Should the shortfall later be repaid. December 25. principal finance groups. times 29 actual / 360 total days in the coupon period. Credit Default Swap Primer Glen Taksler 646.86 interest shortfall. and Provide for deferral of interest or other scheduled payments on an optional or mandatory basis. traditional cash CLO buyers. 2006.” which affords protection against missed dividend payments 120 Preferred CDS references Preferred Securities. the AAA index must reference bonds with a weighted average life of 8-12 years.83 per $1 million of index notional. by either holding a cash position or using a total return swap.tranche of the ABX 06-1 Series had an Interest Shortfall of $117. and hedge funds. and trading desks.86 per $1 million of index notional.97 ($2. AAA index must reference publicly issued securities. BBB.855. Note that. and BBBindices may reference publicly or privately issued securities. 2006. On the next monthly coupon date. and In addition. the coupon date and the Interest Shortfall reimbursement are two separate cash flows. the Seller of the index (effectively. the protection Buyer must reimburse the Seller. to hedge new issue origination and pipeline risk. Protection Buyers include dealers.032. to hedge tranche-specific risk. The weakest of all ratings applies. A. The notional and factor are not affected by an Interest Shortfall. hedge funds. meaning obligations that: Are subordinated to other debt obligations. multiplied by a factor of one. and trading desks. 2008 35 AAA index references the bond from each deal that is composed of the most credit 120 enhanced tranche. To monetize the Interest Shortfall. Protection Sellers include CLO asset managers. technically. the BBB. they are netted in one payment. This comes from a coupon of 267 bps per annum. “06-1” means the first ABX series issued in 2006.
Bonds. The reason is that only the price of Preferred Securities (not senior unsecured bonds. The logic is that.7559 . The protection Buyer pays quarterly coupons in exchange for protection against hard Credit Events. PCDS Succession criteria are limited to Preferred Securities outstanding rather than the Bonds and Loans used in senior unsecured CDS. By contrast. Accounts Receivable CDS typically matures after three months – two years and may involve running coupons or a single up-front payment. who are more concerned about the recovery rate on Accounts Receivable. However. To this end. Failure to Pay. but instead pays the dividend in additional Preferred Securities. Bonds. 2008 35 Receive at least partial treatment as equity from at least one U. However. For a Deferral of Payment. The terms of these contracts are customized. or Fails to pay a dividend or other distribution in cash. if the indenture specifies a Grace Period. for example) should be affected by a Deferral of Payment. As such. versus Accounts Receivable. primarily to help suppliers to maintain shipments during periods of financial stress or alleviate concentration risk. As such. rather than deliver a Bond or Loan Standard CDS contracts require that the protection Buyer deliver a Bond or Loan. nationally recognized ratings agency. Preferred CDS triggers a Credit Event three Business Days after the first missed dividend payment. and Deferral of Payment. 121 Indentures for Preferred Securities typically do not specify a Grace Period for missed dividend payments. Preferred CDS triggers a Credit Event three Business Days after the first missed dividend payment. the Reference Entity or any Related Trust Preferred Issuer: Fails to pay a dividend or other distribution. because the issuer is allowed to miss them. or Otherwise defers a scheduled dividend or other distribution. In this case. or Modified Restructuring. only Preferred Securities are deliverable. Deliverable Obligations are Preferred Securities. 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.Credit Strategy Research May 27. the PCDS protection Buyer has a benefit not afforded by 121 the underlying security. and Loans. after any applicable Grace Period expires. Accounts Receivable CDS Accounts Receivable CDS allows the protection Buyer to assign Accounts Receivable. While extremely useful to the overall financial market. the protection Seller islikely to prefer not to trigger a Deferral of Payment Credit Event. at a predetermined price. because the protection Seller forces the Buyer to settle. “Deferral of Payment” means that. and Loans). This process effectively eliminates basis risk between the recovery rate on a Bond or Loan. that period must be breached before Preferred CDS triggers a Credit Event.S. Modified Restructuring (for selected Reference Entities). For example. Deferral of Payment applies only to Preferred Securities but occurs regardless of whether any terms of the securities permit them to transpire. in whole or in part. common stock. which include Bankruptcy. the protection Buyer should have the option to deliver obligations across the capital structure (Preferred Securities. these contracts may be less useful to suppliers of physical goods (inventory). in whole or in part. Failure to Pay. 178 Credit Default Swap Primer Glen Taksler 646. the suppler of inventory to a grocer may wish to protect against a potential Credit Event at that grocer. please see Chapter VI – CDS Case Studies and Legal Issues on page 132. Accounts Receivable CDS allows the protection Buyer to assign Accounts Receivable to the protection Seller. 122 Assuming the protection Buyer triggers the contract and the only Credit Event is a Deferral of Payment. Not surprisingly.855. if the protection Seller triggers the contract. this limitation does not apply. using the recovery rate on the inventory. or other equity interests. For more details on Succession language. For example. For a Bankruptcy. Deliverable 122 Obligations are Preferred Securities only.
in case the Counterparties are unable to locate a Bond or a Loan to deliver into 125 the trade. Appendix VII – Other Credit Derivatives Products Structured Credit Market Basics This section provides an overview of the structured credit market. Single-Tranche CDOs (STCDOs) Perhaps the most prominent product in structured credit is the single-tranche CDO. debt. debt Private Institutional CDS allows investors to obtain exposure to companies that issue 123 private placement. which states that transactions by an issuer that do not involve any public offering are exempt from SEC registration requirements. the protection Seller may be able to terminate a trade. This debt may be rated or unrated. Private Institutional CDS is typically callable. In a single-tranche CDO. The average of at least two quotes is used as a Cash Settlement price. a 60 Business Day flip-flop procedure begins. and may use Physical Settlement. Private Institutional CDS affords protection against debt that falls under section 4(2) of the Securities Act of 1933. with the exact details negotiated at the time of the trade. please see our Guide to Single-Tranche CDOs: Correlation Products in Plain English. Credit Events are Bankruptcy and Failure to Pay.7559 179 . 125 After delivery of a Notice of Physical Settlement. by the protection 124 Buyer. 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. 123 Specifically. If fewer than two quotes are obtained. then a poll is conducted across three secondary traders. in which the protection Seller and Buyer alternate every 10 Business Days as being the party responsible for locating a Bond or Loan. For a more detailed explanation of correlation products. rather than publicly traded. Credit Default Swap Primer Glen Taksler 646. with Cash Settlement as a backup. Unlike standard CDS. the protection Buyer has 30 Business Days to deliver a Bond or Loan. 2008 35 Private Institutional CDS Private Institutional CDS allows investors to obtain exposure to companies that issue private placement. The Settlement mechanism is chosen at trade inception. Private Institutional CDS typically matures in three to seven years. secured or unsecured. Modified Physical settlement refers to Physical Settlement. Figure 142 shows the liquid tranches of the CDX IG index.Credit Strategy Research May 27. such as a Succession Event. 124 Under specific circumstances. with a recovery rate pre-determined at trade inception. rather than publicly traded. or Modified Physical Settlement. investors buy or sell protection on a pool of credit default swaps instead of single names. December 21. If neither party has located a Bond or Loan by this time.855. Fixed Recovery settlement is similar to cash settlement. Fixed Recovery Settlement. then protection becomes worthless. If the Protection Buyer does not deliver a Bond or Loan. 2004.
100% (Senior) CDX IG Subordinated Tranches Source: Banc of America Securities LLC estimates. 180 Credit Default Swap Primer Glen Taksler 646.7% (Jr Mezzanine) 7% .10% (Mezzanine) 10% . If the CDX IG index loses 10% of principal. or More Generally.15% (Senior) 15% .66% of Reference Entities in the underlying portfolio would need to suffer a Credit Event before the 7%-10% tranche 126 investor lost principal. Assuming an equally-weighted portfolio and 40% recovery rate. An investor who sells protection on the 7%–10% CDX IG tranche has 7% subordination. 7% subordination implies that 11.Credit Strategy Research May 27. 7% is known as the “attachment” point and 10% is known as the “detachment” or “exhaustion” point. Tranches on CDX IG. STCDOs Senior Tranches Selected Tranche Standardized CDX IG Tranches 0% . 126 7% subordination / 60% loss rate per Credit Event.7559 . 2008 35 Figure 142. the 7%-10% CDX IG tranche will be wiped out.3% (First Loss) 3% . He suffers no loss of principal until 7% of the underlying CDX IG index is wiped out. In structured credit lingo. See Figure 143.30% (Senior) 30% . 60% loss rate is par – 40% recovery rate.855.
Investors with a high risk appetite and desire for yield may prefer tranches with little or no subordination. Market Participants At senior level attachment points. at the equity (first loss) level. 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. mezzanine-hedged equity strategies (long equity risk. while those with lower risk appetites may prefer higher levels of subordination. as idiosyncratic risk increased In May 2005. almost all this increase in idiosyncratic risk hit the equity tranche. or more senior tranches. A forced unwind followed. Dollar Losses on CDX IG Assumes Notional of $100 million CDX IG Index CDX IG 7% . the credit default indices. even as spreads in the underlying portfolio widened. hedge funds are large protection sellers.855. short mezzanine risk) backfired. as illustrated in Figure 144: Credit Default Swap Primer Glen Taksler 646. longer-term. The mismatch in the mezzanine-hedged equity strategy began with an increase in fundamental risk to the equity tranche. How CDX IG 7%–10% Tranche Principal Losses Compare with CDX IG Principal Losses Dollar Losses on 7% − 10% Tranche vs. Spreads on equity tranches widened greater than model estimates. 2008 35 Figure 143. As the first loss investor. while mezzanine tranche spreads actually tightened. Higher levels of subordination decrease the likelihood of principal loss. prompting a second leg lower. By contrast. as idiosyncratic risk—that is. Equity tranche investors may hedge risk by buying protection on single-name CDS.10% Tranche 100 Loss ($ 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. spread. and correspondingly.Credit Strategy Research May 27.7559 181 . significant individual issuer spread risk—increased. hold-to-maturity investors such as insurers are large protection sellers.
Hence. The total spread change across the tranches must add up back to the index level. from LBOs. To see this impact. 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. Spillover to the Broader Credit Market We also saw clear spillover to the credit index markets. 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. The amount of spread available to other tranches declined. 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 One way to think of spread movements across the tranches is as follows. the amount of spread available to other tranches declined. allowing mezzanine tranche spreads to actually tighten.7559 . consider the following chart: 182 Credit Default Swap Primer Glen Taksler 646. Mezzanine-Hedged vs. 2008 35 Figure 144. With the dramatic move lower in equity. In reality. 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. more and more of the overall index spread widening was allocated to the equity portion of the tranche structure.855.Credit Strategy Research May 27. autos.
855. creating negative leverage. long positions in higher-quality (senior) portions of the tranche market are held by longer-term. not only was the hedge ratio off (too high). and the broken line illustrates the underlying investment grade index spread. The thick gray line indicates the actual 7%–10% tranche spread. the 7%–10% tranche tightened as spreads widened. For simplicity. Source: Banc of America Securities LLC estimates. 127 In reality. dealers sold protection on about $22.25 times (54 bps divided by 24 bps). hold-to-maturity investors such as insurers. Based on model estimates. implying an expected leverage of about 2. this position was naturally attractive to the dealer and hedge fund community.7559 183 . Typically. it turned out that rather than being 2.25x. but it was the wrong sign However. The 7%–10% tranche tightened. senior tranches widened less than expected.25x the risk of the index. At the extreme. Now look at what actually occurred. a highly unexpected result. 2005 to May 10. To offset their risk. For example. from March 16. they also lost money on the hedge position. we focus on CDX index hedging. At the extreme. Hence. Series 4 beginning 21 Mar 05). not only did dealers and hedge funds lose money on the short position in the tranche. at an anticipated model leverage of 2. 2005 the expected spread widening in the 7%–10% tranche was 54 bps (from 55 bps to 109 bps). there is a mixture of index and single-name hedging. dealers 127 (or hedge funds) typically sell protection on the CDX index.Credit Strategy Research May 27. See Figure 146. During the same time period. 2008 35 Figure 145. causing hedge mismatches on correlation books. the underlying investment grade index widened 24 bps. The corresponding short position is typically held by dealers and hedge funds. it was the wrong sign.5 million of index protection for every $10 million in senior (7%–10%) tranche exposure. The thin red line indicates the model forecasted spread change for the 7%–10% (indicative AAA) tranche. not only was the hedge ratio off (too high). Credit Default Swap Primer Glen Taksler 646. 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. Model Error: Model Forecasted vs. As a source of positive carry. On days when the overall market moved wider.
Some dealers turned their attention to traditional.Sep. Dealers and hedge funds needed to reduce their long position in the index. the hedge ratio needed to be reduced. 184 Credit Default Swap Primer Glen Taksler 646. Leveraging Credit Following the May 2005 correlation crisis.Sep. 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% . dealers and hedge funds needed to reduce their long position in the index. …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 To adjust for the mishedge. dealers examined the strategies that led to losses. High Grade Corporates Offered Limited Spread… 10y Sector Figure 148. illustrated in Figure 147.15% 15% . Leverage (x) Figure 147. 2008 35 Figure 146. This is why we saw investment grade spreads move wider. The then-extremely tight credit spread environment. 2005. Figure 148 illustrates that structured credit appeared to offer that opportunity.7559 . Banc of America Securities High Grade Broad Market Index Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates. caused traditional investors to search for yield without hurting the ratings quality of their portfolio.30% Empirical Model-predicted leverage shown as of April 1.Mar.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. which led to significant buying of protection. hold-to-maturity investors and more conservative hedging strategies. That is.Mar.Credit Strategy Research May 27.855.7%) Senior (7% 10%) 10% .
the investor loses principal if the weightedaverage spread exceeds 250 bps. The triggers are set so that the overall mark-to-market loss on the portfolio is roughly constant throughout. the leveraged super senior has a mark-to-market trigger identified by the downward-sloping line. 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. In addition. Mark-to-market risk is based on the weighted averaged spread of the underlying portfolio. Two such important products are the leveraged super senior and Constant Proportion Debt Obligation (CPDO). Mark-to-market trigger shown at trade inception. If the underlying portfolio spread reaches a predetermined threshold.10% Already Lost All Notional. and leveraged super seniors.Credit Strategy Research May 27. Leveraged Super Senior A leveraged super senior breaks down risk into two components. cash CDOs. the investor loses principal.7559 185 . Figure 149 shows a sample structure: Figure 149. If in the first year there are no losses in the underlying portfolio and the weighted average spread exceeds 320 bps. Similarly. Canadian conduits issued commercial paper and used the proceeds to buy then-highly rated assets like triple-A CMBS. 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. 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.855. If spreads then tighten back through the mark-tomarket trigger. Source: Banc of America Securities LLC estimates. 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. default risk and markto-market risk. 7% . In the senior (7%–10%) tranche. the investor gets back the extra collateral. 2008 35 The search for yield while maintaining (then-) ratings led to the development of new products. Particularly between 2005 and early 2007. Default risk works the same as the typical tranche subordination structure—for example. These products tended to mitigate default risk and increase mark-to-market risk by adding leverage. losses begin at 7% of the underlying portfolio and all tranche notional is exhausted after losses in 10% of the underlying portfolio. either the trade is terminated at mark-to-market levels or the investor increases cash collateral. Similarly. The mark-to-market trigger is typically set so that the overall structure has a triple-A rating. if losses are 4% in the first year. The commercial paper’s interest cost was less than the Credit Default Swap Primer Glen Taksler 646. the tranche begins to lose principal after 15% of the underlying portfolio has suffered losses.
186 Credit Default Swap Primer Glen Taksler 646. Figure 150.100% 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. The CPDO investor always has the five-year on-the-run index even though the structure has a ten-year maturity date. in late 2006. CPDOs achieved their high credit rating through the expected accumulation of reserves (the excess of coupon income earned over coupons paid out). with the difference taken as a fee for the 128 conduit sponsor. the average spread for five-year IG and iTraxx was roughly 30 bps. Figure 150 illustrates the underperformance of the CDX IG super senior (30% -100%) tranche during the credit crunch. 2008 35 spread paid by the assets held in the conduit. For example. In the first round of issuance (2H06). 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). The underperformance of the senior portion of the tranche capital strucucture caused some leveraged super seniors to breach or renegotiate unwind triggers. Source: Banc of America Securities LLC estimates. 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.Credit Strategy Research May 27. 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. At 15 times leverage. 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.855. We estimate the tranche P&L by using the on-the-run 10y CDX IG index 30%-100% tranche spread. 50 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Example leveraged super senior product beginning March 22. CPDOs offered a triple-A rated spread of approximately Euribor+200 bps. Super Senior Spreads Widen Significantly… Figure 151. the investor may have to post more collateral 80 10y CDX IG 30%-100% Tranche 10y CDX IG 30% . 2007 with 10x leverage.7559 . … Causing Leveraged Super Seniors to Approach Market Value Triggers If the Leveraged Super Senior trips a market value trigger. In other words. the funded structure therefore earned three-month Euribor+450 bps. Source: Banc of America Securities LLC estimates. Additionally. Market value trigger is an example. This product often has 15 times initial leverage with a ten-year maturity. actual triggers vary by deal. every six months.
Figure 153 shows that the significant widening in IG and iTraxx caused CPDOs to approach and. but that during the wides in March of 2008. 2008 35 bps.855. 2008 Figure 153. in some cases even breach.Credit Strategy Research May 27. Credit Default Swap Primer Glen Taksler 646. 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. Historical 5y CDX IG. spreads were closer to 175 bps. Reserves were made available for potential losses from future defaults. the blended spread was around 30 bps. When CPDOs were initially issued. However. for net income (reserves) of approximately 230 bps. iTraxx and Blended CDX IG and iTraxx Spread CPDOs performance based on the blended spread of CDX IG and iTraxx From October 2. 2007 to April 15 . their forced unwind triggers. Figure 152. 5 year iTraxx and the blended spread between the two indices. which were set to an NAV of $10. 0 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Source: Banc of America Securities LLC estimates. Figure 152 shows the historical 5 year CDX IG.7559 Blended 5y Index Spread (bps) 187 5y CDX IG Blended Spread 5y iTraxx NAV Unwind Trigger Blended Spread .
For North America. Often used by correlation desks to sell protection. For Europe. but in practice.855. not required by standard CDS documentation. Same as novation. Bankruptcy (page 18) – Typically a Reference Entity’s insolvency or inability to pay its debts. the trade continues between the original Counterparty and the new party. Standard CDS documentation requires physical settlement. 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. Assignment (page 110) – A trade transferred by an investor to another party. the protection Seller pays the protection Buyer the difference between par and the market value of the cheapest-to-deliver obligation. From the investor’s perspective. the trade is terminated. Also see Prepayment Event. Asset Swap Spread (page 36) – Spread over LIBOR that an investor earns to swap a fixed-rate corporate bond to LIBORbased floating payments. To reduce risk. 2008 35 Chapter VIII – Glossary ABX (page 175) – Index of credit default swaps on asset backed securities. depends on the Reference Obligation and assets securing it. parties typically post variation margin and may be required to post initial margin. among a small number of counterparties. and I-Spread. Conditionally Transferable Obligation (page 154) – Only applies when the protection Buyer triggers a ModifiedModified Restructuring Credit Event (primarily for European-based Reference Entities). not to be unreasonably withheld. Cheapest-to-Deliver (page 47) – The lowest-price obligation that the protection Buyer may deliver following a Credit Event. see Fully Transferable Obligation. XO (35 crossover). the ability to terminate an LCDS contract early. and LCDX (100 leveraged loans). In reality. HVOL (30 high volatility investment grade). if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. Requires that the protection Buyer deliver an obligation that is transferable to any entity that regularly engages in loan and securities markets. Defines the level of subordination in a synthetic CDO. Z-Spread. either without consent or with consent of the Reference Entity. toward the end of 2008. Also see OWIC. Typically attached to trade recaps.Credit Strategy Research May 27. Counterparty Risk (page 68) – The risk that an investor’s counterparty may not pay cash flows when due. Signals tighter spreads. 188 Credit Default Swap Primer Glen Taksler 646.e. Also see Par CDS Equivalent Spread. Includes IG (125 investment grade). market expectations are in the process of moving to cash settlement. Adoption of a protocol is voluntary. HY (100 high yield). CMBX (page 175) – Index of credit default swaps on commercial mortgage-backed securities. which allows parties to trigger a Credit Event. Correlation desk (page 166) – The division of a bank or broker-dealer responsible for managing synthetic CDO risk. at which a tranche begins to suffer principal losses.. i. CDS Settlement Protocol (page 143) – Market procedure of allowing parties to cash settle a CDS contract approximately 30 calendar days following a Credit Event. CDSW (page 93) – Screen in Bloomberg to value a credit default swap. CDX (page 48) – Indices of credit default swaps referencing North American corporate issuers. Cash Settlement (page 8) – Approximately 30 calendar days following a Credit Event. May take effect for a small number of trades. Parties retain the option to physically settle.7559 . BWIC (page 166) – Bid wanted in competition. Discounts the premium or discount portion of cash flows at LIBOR flat. Also see CDS Settlement Protocol. Cancelability (Early Termination) (page 168) – For North American Reference Entities. provided that another market participant is willing to take the opposite position. Attachment Point (page 179) – The level of cumulative losses in an underlying portfolio.
2008 35 th Coupon Frequency (page 78) – Quarterly for corporate credit default swaps.g. Credit Event (page 17) – A pre-agreed circumstance that allows parties to settle a credit default swap. 2003 ISDA Credit Derivatives Definitions (page 9) – Standardized rules for CDS trades.Credit Strategy Research May 27. one month before a quarterly CDS roll. and December. usually includes Bankruptcy. that the protection Buyer may deliver (or cash settle to) following a Credit Event. if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. 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. Deal Spread (page 103) – Same as coupon and strike. approximately equal to LIBOR plus ( spread / [ 1 – assumed recovery rate ] ). 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. depends on the Reference Obligation and assets securing it. Depository Trust and Clearing Corp (DTCC) (page 66) – System used to electronically confirm credit derivatives trades. Early Termination (Cancelability) (page 168) – For North American Reference Entities. Same as exhaustion point. Usually. variation margin. June). 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 in what increments. September. Same as detachment point. Fixed Cap (page 174) – Limits the protection Seller’s liability in Pay As You Go CDS to the annual protection premium. Credit Support Annex (page 65) – An optional document that pre-determines when. and ModifiedModified Restructuring. On a th th coupon date. and threshold amounts). Failure to Pay. typically a bond or loan. the ability to terminate an LCDS contract early. For North American corporate Reference Entities.7559 189 .g. Failure to Pay. For European corporate Reference Entities. Typically allows parties to trigger a Credit Event. June 20 ). the final coupon payment includes the maturity date (e. on the 20 each of March.. DV01 (page 103) – Sensitivity of the present value of a credit default swap to a 1 bp change in spread. and for selected Reference Entities. Typically within two business days of a Credit Event.. Credit Default Swap Primer Glen Taksler 646. Delta (page 181) – The hedge ratio for a duration-neutral trade. Detachment Point (page 179) – Loss level in an underlying portfolio for which the remaining tranche principal is zero. ELCDS (page 169) – CDS on European leveraged loans.g. Credit Default Swap (page 8) – Bilateral contracts used to transfer credit risk among market participants. Credit Event Notice (page 86) – Notice served to argue that a Credit Event has occurred. For Europe. However. By market convention. Also see Prepayment Event. Failure to Pay (page 18) – A Reference Entity’s failure to pay interest or principal beyond any grace period specified in the relevant indenture. For example.855. Usually delivered at the same time as a Notice of Publicly Available Information. March) through the 19 th of the current roll month (e. margin requirements are due (initial margin. the protection Buyer must pay the premium from the 20 of the last roll month (e. Deliverable Obligation (page 19) – Obligation. Discount Factor (page 102) – LIBOR plus the implied probability of default. At a one-year horizon. usually includes Bankruptcy. Modified Restructuring. single-name trades switch to a long coupon (first coupon due in four months. Exhaustion Point (page 179) – Loss level in an underlying portfolio for which the remaining tranche principal is zero. 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. Day Count (page 93) – ACT/360 for standard credit default swaps. rather than one coupon due in one month and a second coupon due in three months). June.
an investor who funds at LIBOR+50 bps should compare CDS to the cash bond spread to LIBOR+50 bps. A bank or broker-dealer faces the Counterparty’s prime broker. The guarantee must be unconditional and irrevocable. For Europe. Usually applies to hedge funds that sell protection (at any spread) or buy protection at wide spreads. broker-dealers. Requires that the protection Buyer deliver an obligation that is fully transferable to an eligible assignee. Often results in a haircut for protection Buyers who want to unwind or assign trades with significant profits. Implied Forward Spread (page 105) – The market’s expectation of future spreads. and therefore usually overstates Credit Event risk. see Conditionally Transferable Obligation. For investors with a mark-to-market gain. For investors with a mark-to-market loss. Typically 30 years for a Bankruptcy or Failure to Pay. iTraxx (page 48) – Indices of credit default swaps referencing European corporate issuers. based on CDS and an assumed recovery rate. Often agreed in a Credit Support Annex. Give Up (page 67) – Allows a Counterparty to trade CDS without an ISDA Master Agreement. Members include banks. HVOL (30 high volatility investment grade). limits Deliverable Obligation to bonds (not loans). Includes iTraxx Main (125 investment grade). Essentially. lower interest rates increase the present value of the loss.855. Used to form a baseline for the final price in a CDS Settlement Protocol. A trade association that represents participants in the derivatives industry. a broader class of guarantees applies.Credit Strategy Research May 27. where the holding company owns a majority of the operating company. Additional series exist for Asia. Guarantees (page 138) – For Reference Entities located in North America. rather than LIBOR flat. Used to clear net open interest in CDS Settlement Protocols. ISDA (page 9) – International Swaps and Derivatives Association. XO (50 high yield). not cash flows. Jump to Default Risk (page 123) – Profit or loss resulting from a wide spread move or a Credit Event. Smaller impact that spread duration (DV01). lower interest rates increase the present value of the gain. Implied Probability of Default (page 100) – The implied probability that a Reference Entity suffers a Credit Event. based on the current (spot) credit curve. Z-Spread. but may be shorter for a Modified or Modified-Modified Restructuring. 2008 35 Fully Transferable Obligation (page 154) – Only applies when the protection Buyer triggers a Modified Restructuring Credit Event. Maturity Limitation Date (pages 77 and 154) – The maximum maturity of the obligation that a protection Buyer may deliver following a Credit Event. Implicitly incorporates liquidity and mark-to-market risk. For example. Initial Margin (page 68) – Requirement that a Counterparty post collateral at trade inception. Based solely on the yield and maturity of a bond. ISDA Master Agreement (page 65) – A governing document usually signed during the approval process for derivatives trading. and investors. Requires prime brokerage service. and LevX (75 senior or 45 subordinated leveraged loan). LCDS (page 167) – CDS on leveraged loans. IR01 (page 111) – The impact of interest rates on the present value of CDS. that operating company’s debt is deliverable into CDS on the holding company. I-Spread (page 35) – Yield difference between a cash corporate bond and a matched-maturity swap yield. and Asset Swap Spread. Also see Par CDS Equivalent Spread.7559 . who then faces the Counterparty in a separate CDS trade. Index Abitrage (page 51) – Strategy to trade the difference between an index and its underlying intrinsics. Inc. For Reference Entities located in Europe. 190 Credit Default Swap Primer Glen Taksler 646. 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. if a holding company (parent) guarantees an operating company (subsidiary). financials (25 senior or 25 subordinated). Funding Cost (page 33) – The price an investor pays to borrow capital and the appropriate metric for CDS—cash relative value. Limit Order (page 147) – An order to buy or sell bonds at a specified price.
Modified-Modified Restructuring (page 152) – Primarily used for European corporate Reference Entities. Novation (page 110) – A trade transferred by an investor to another party. Also see BWIC. PCDS (page 177) – CDS on preferred securities. writedown. 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. In reality. Deliverable Obligation Characteristics. Credit Default Swap Primer Glen Taksler 646. without an assumption of zero volatility. Physical Settlement Matrix (page 77) – Document to clarify Credit Events. If the investor does not receive consent by 6pm. published or electronically displayed news sources. in addition to the direct debt of a Reference Entity— i. Also see Multiple Holder Obligation. Also see Z-Spread. Used in CDS Settlement Protocols. and I-Spread. the trade continues between the original Counterparty and the new party. market expectations are in the process of moving to cash settlement. Also see CDS Settlement Protocol. Signals wider spreads. Not suitable for callable or putable bonds. Multiple Holder Obligation (page 154) – Requirement to trigger a Modified or Modified-Modified Restructuring Credit Event. two-thirds of which consent to the Restructuring. Restructured obligation must have at least 4 unaffiliated lenders.7559 191 . Limits the maturity and transferability of obligations that a protection Buyer may deliver following a Restructuring Credit Event. which were rated investment grade when they began trading in the CDS market. but in practice. typically from two internationally recognized. Usually delivered at the same time as a Credit Event Notice. Must be delivered within 30 calendar days of the Event Determination Date. Used in CDS on ABS. in the location of the investor. Negative Basis Trade (page 30) – Trade in which an investor buys protection and buys a cash bond of the underlying Reference Entity. with a spread pickup. Physical Settlement (page 8) – Approximately 30 calendar days following a Credit Event. Net Open Interest (page 147) – The net desire of the CDS market to buy or sell bonds. Asset Swap Spread. and receives par. For bullet bonds. OWIC (page 166) – Offer wanted in competition. Notice of Publicly Available Information (page 86) – Contains proof of a Credit Event. the assignment will instead be booked as a new trade. Same as assignment. on the day an assignment is agreed to. Also see Multiple Holder Obligation. Notice of Physical Settlement (page 86) – Details of the Deliverable Obligations that the protection Buyer will deliver to the protection Seller for physical settlement. as a result of a Credit Event. 2005 Monoline Supplement (page 160) – Standardized rules for CDS on monoline insurers. the trade is terminated. the protection Buyer delivers a bond or loan to the protection Seller. and maturity extension. the investor must receive consent from the original Counterparty by 6pm. Orhpaned CDS (page 138) – A CDS contract on a Reference Entity that has no Deliverable Obligation. Limits the maturity and transferability of obligations that a protection Buyer may deliver following a Restructuring Credit Event. From the investor’s perspective. 2005 Novation Protocol (page 83) – Market procedure to reduce risk surrounding assignments.e. Allows the protection Buyer to deliver debt that is wrapped (guaranteed) by the monoline insurer. distressed ratings downgrade. Pay as You Go (PAUG) (page 172) – CDS contracts focusing on Soft Credit Events such as failure to pay principal. and similar features of CDS contracts. 2008 35 Modified Restructuring (page 152) – Primarily used in single-name CDS for North American corporate Reference Entities. Referenced in standard CDS confirmations. Assumes a recovery rate to keep total credit risk equal between the cash and CDS markets.Credit Strategy Research May 27. bond or loan—that is deliverable under standard CDS contract language. To execute an assignment.. OAS to LIBOR (page 40) – Option-adjusted spread to LIBOR.855. Standard CDS documentation requires physical settlement. OAS to LIBOR is the same as Z-spread.
For North American Reference Entities. particularly the protection Buyer. not the security. Often the same as Deliverable Obligations but without a maturity limitation. to trigger a Credit Event. maturity extension. For Europe. 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. Protection Seller (page 8) – The party that receives periodic fixed payments in exchange for being required to make a payment. times the trade notional. 192 Credit Default Swap Primer Glen Taksler 646. In plain-vanilla corporate CDS.7559 . establishes only the seniority. Cash Settlement. CDX and iTraxx indices use points upfront with different coupons. Usually involves subordination (attachment point) and a detachment point. September. Reference Obligation (page 19) – An obligation that establishes the seniority of CDS within the capital structure. 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. Restructuring (page 152) – Usually refers to a reduction of interest or principal. Usually takes effect once five-year CDS approaches the 700bp range. Prepayment Event (page 168) – In LCDS. Also see Succession. Roll (page 94) – The process of changing the on-the-run maturity date for CDS contracts. the party that originally faced the Transferor but now faces the Transferee as Counterparty. Relevant Obligation (page 132) – Obligations considered for CDS Succession purposes. found on the REDL screen in Bloomberg. and December) and semiannual for indices. Protection Buyer profits (protection Seller loses) 100% minus the recovery rate.Credit Strategy Research May 27. Used in CDS Settlement Protocols. Note: REDL is not always correct. Before entering into a trade. 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. of the trade. 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. Also see Protection Seller. Recovery Lock (page 170) – CDS contracts that allow an investor to take a view on recovery rates rather than outright Credit Event risk. Recovery Rate (page 45) – Roughly speaking. See Physical Settlement. and CDS Settlement Protocol. Quarterly for corporate singleth name (the 20 each of March. Also see Protection Seller. Remaining Party (page 83) – In an assignment.855. Other criteria also exist. 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. may occur if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. REDL (page 17) – Screen in Bloomberg that often shows the market standard for Reference Entities and Reference Obligations. or change in the priority of payment of an obligation that causes the subordination of such obligation to any other obligation. Settlement (page 8) – The process of exchanging cash flows after a Credit Event. Reference Entity (page 19) – The legal entity on which a CDS contract is written. the mark-to-market on the cheapest-to-deliver obligation approximately 30 calendar days following a Credit Event. agree on a Reference Entity and Reference Obligation with your Counterparty. June. Typically a large and liquid bond issue. 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). the event that causes Early Termination to occur. Also see Early Termination (Cancelability). depends on the Reference Obligation and assets securing it. Single-Tranche CDO (page 179) – A slice of risk on a pool of securities. May allow parties.
Also see SingleTranche CDO. Used in both synthetic CDOs and cash structured products. Also see Relevant Obligations. distressed ratings downgrade. Credit Default Swap Primer Glen Taksler 646. Transferee (page 83) – In an assignment. Usually involves subordination (attachment point) and a detachment point.7559 193 . Settled in present value terms. Underlying Portfolio (page 179) – The pool of credit default swaps referenced in a synthetic CDO. 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 Transferee and Remaining Party. Strike (page 103) – Same as coupon and deal spread. Subordination (page 179) – The percent of a CDO capital structure that must be wiped out before a tranche begins to suffer principal losses. and I-Spread. Incorporates the shape of the yield curve and the timing of cash flows. and maturity extension. the party that transfers a trade. 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. Tranche (page 179) – A slice of risk on a pool of securities. or undergoes some other change to its corporate structure. Also see Transferor and Remaining Party. Often exchanged daily and agreed in a Credit Support Annex. Not suitable for callable or putable bonds. and premium bonds.Credit Strategy Research May 27. Transferor (page 83) – In an assignment. Often agreed in a Credit Support Annex. 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. Also see Synthetic CDO. discount. Z-Spread (page 38) – Option-adjusted spread to LIBOR under an assumption of zero volatility. Used in CDS of ABS. Soft Credit Events include failure to pay principal. Also see Par CDS Equivalent Spread. Succession (page 132) – Changes to a CDS contract that may occur when a Reference Entity is merged. Synthetic CDO (page 179) – A collateralized debt obligation referencing a pool of credit default swaps. Asset Swap Spread. writedown.855. but ignores the different recovery rates of par. Unwind (page 109) – The termination of an existing trade with the original Counterparty. Threshold Amount (page 71) – The level of mark-to-market profits beyond which Counterparties are required to exchange variation margin. acquired. the party to whom a trade is transferred.
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. As of 05/01/2008. is. Neutral: We are neutral on CDS and expect performance in line with sector performance. recommendation or investment thesis for review by an issuer prior to the publication of a research report containing such rating. Buy: Spreads and / or total returns are likely to outperform sector averages over the next six months.” “Sell. BANC OF AMERICA SECURITIES RATINGS DISCLOSURES BAS High Grade and High Yield Research employ a Buy/Neutral/Sell rating system. over the next six months. and (2) no part of the research analyst’s compensation was. namely the BAS BMI. 194 Credit Default Swap Primer Glen Taksler 646. using Overweight/Market Weight/Underweight. is or will be.7559 . 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. the company generally has solid credit fundamentals and/or it is trading in line relative to bonds of comparable risk within the sector. Sell: Spreads and / or total returns are likely to underperform sector averages over the next six months. but sector recommendation changes may occur at any time based upon sector analysis and relative value. 2006. Underweight: The sector is expected to underperform excess spread returns of High Grade corporate indices. Buy: We recommend that investors buy protection in CDS. 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. Neutral: Spreads and / or total returns are likely to perform equal to or near sector averages over the next six months. Materials prepared by BAS and affiliate research personnel are based on public information. directly or indirectly. but does not have any impact on the analyst’s “Buy. BAS and affiliate policy prohibits research personnel from disclosing a rating.Credit Strategy Research May 27.** 39 43 47 * For the purposes of this Rating Distribution. and these recommendations carry a time horizon of six months. This report may contain a trading call which highlights a specific identified near-term catalyst or event impacting a security. Such persons may own diversified mutual funds. therefore going long credit risk. High Grade and High Yield Research use the following rating system with respect to Credit Default Swaps (CDS). Market Weight: The sector is expected to perform in line with excess spread returns of High Grade corporate indices. IMPORTANT CONFLICT OF INTEREST DISCLOSURES The analyst and associates responsible for preparing this research report receive compensation that is based upon various factors. namely the BAS Broad Market Index (BAS BMI). over the next six months. (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. company. therefore going short credit risk. dated November 24. over the next six months. Portfolio Analytics and Data Analysis. 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. recommendation or investment thesis. or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research report. including the data input into the model. 37 46 17 Investment Banking Clients Buy Hold Sell Recommendations 101 139 54 Pct. please see Introduction to Lighthouse: Credit Option Adjusted Spread. 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. Research analysts and associates do not receive compensation based upon revenues generated from any specific investment banking transaction. BAS and its affiliates prohibit analysts. Any such direct securities ownership by the analyst(s) preparing this report is disclosed above. For a description of the Credit OAS proprietary credit evaluation model. High Grade Research also employs a formal structure to define sector performance. 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.855. Sell: We recommend that investors sell protection in CDS. A portion of the profitability of BAS and its affiliates. These include (i) the overall profitability of BAS and its affiliates. their fixed income department and each security asset class is generated by investment banking business. The sector recommendation time horizon is determined by the expected performance over the next six months. 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. Overweight: The sector is expected to outperform excess spread returns of High Grade corporate indices. Further information on any security or financial instrument mentioned herein is available upon request. Rating Distribution* Coverage Universe Buy Hold Sell Recommendations 262 321 116 Pct. 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. BAS and its affiliates are regular issuers of traded financial instruments linked to securities that are mentioned in this report. “Hold” is equivalent to our “Neutral” rating. namely the BAS BMI. industry sector or the market generally that presents a transaction opportunity. ** Percentage of recommendations in each rating group that are investment banking clients.” or “Neutral” rating (which is based on a 6month investment horizon).
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