Professional Documents
Culture Documents
Credit Strategy
21
18
$ Trillions 15
12
9
6
3
Additional Authors:
0
Jeffrey A. Rosenberg 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
646.855.7927
Sources: British Bankers Association; ISDA; Banc of America Securities LLC estimates.
jeffrey.rosenberg@bofasecurities.com
Ward Bortz X The credit crisis has changed the credit default swap (CDS) landscape.
646.855.8451
Riskier credits trade in points upfront, similar to a discount bond. Higher funding
ward.bortz@bofasecurities.com costs make it more expensive to take a leveraged position in cash bonds,
increasing the attractiveness of unfunded assets such as CDS.
X 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.
X 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.
X 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 35
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
Introduction
As this publication goes to press, credit derivatives have become a subject of
significant market and regulatory attention. The main theme is that rapid growth
involves risks, particularly in a volatile trading environment. Below, we comment on
some “hot topic” issues, along with the current state of the market. Throughout this
Credit Default Swap Primer, we address these topics in more detail.
The CDS market’s $62 Yet, headline market size estimates are drastically larger than the overall economic
trillion headline size is impact of the CDS market. There are two issues. First, CDS market surveys focus on
drastically larger than its gross, not net, credit exposure. Second, under many circumstances, the size of the CDS
overall economic impact market may grow without any change in overall risk.
Consider a trader at Bank A, who buys $10 million protection from Bank B. A week
later, spreads widen, and a different trader at Bank A sells $10 million protection to
Bank B. Both banks have zero net default exposure ($10 million – $10 million = zero).
But, because two different traders transacted, typically, the institution will record two
separate trades, with a total notional of $20 million, causing CDS market size to
increase. Through the ISDA trade association, the industry is developing netting
proposals to more accurately reflect net credit exposure.
Similarly, the CDS market is subject to double-counting of risk. For example, if an
investor buys protection in an index and sells protection in each of the underlying
constituents, reported CDS notional will grow, even though net credit exposure will be
unchanged.
As of December 2007, the Bank of International Settlements (BIS) estimates that the
gross market value of credit derivatives contracts was 3.5%. In cash market
terminology, if trades were implemented at $100, their market value as of December
2007 was $96.50.
Since that time, investment grade credit has lost about 1.2% in total return, and high
yield 1.5%. Roughly speaking, that suggests a current gross market value in credit
2
derivatives of $3 trillion. To be clear, this is a back-of-the-envelope estimate: If
spreads were to widen further, regardless of the reason, gross market value would
increase. Consequently, although the exact impact is unclear, the systemic risk of credit
derivatives is far less than the headline $62 trillion notional.
1
For more details, please see “The Credit Derivatives Market” on page 9.
2
For more details, please see “The $62 Trillion Question” on page 11.
Although credit However, ISDA also estimates that unsigned credit derivatives confirmations rose to
derivatives face 6.6x the daily volume of new trades in 2007, from 4.9x in 2006. The 2007 estimate
4
challenges, they fare compares with 9.9x for interest rate derivatives and 13.3x for equity derivatives. As
favorably to other such, while credit derivatives fare favorably to other product areas from an operations
5
derivatives produts from perspective, they still face challenges in a growing market.
an operations
perspective Counterparty Risk
As an unfunded market, CDS market participants promise to exchange cash flows
following a potential Credit Event. There are no hard assets set aside to guarantee
payment, creating an issue of Counterparty risk.
To manage Counterparty Recognizing this risk, the CDS market requires parties to post collateral (margin).
risk, the CDS market has Although no one knows exactly how much collateral is required to effectively manage
increased collateral Counterparty risk, as of year-end 2007, ISDA estimates that there was approximately
requirements and is $2.1 trillion in collateral in circulation, up from $1.3 trillion in each of 2006 and 2005.
6
working on a These numbers are across all derivatives transactions, not just credit derivatives.
clearinghouse to Recently, the CDS market began work on a clearinghouse to guarantee selected trades.
guarantee selected Rather than face banks or broker-dealers as Counterparties, investors would face the
trades clearinghouse. Effectively, if a clearinghouse member were to default, all remaining
members would be responsible for a proportionate share of trades. To reduce
outstanding notional, trades would be netted across parties. In its early stages, this
proposal may take effect for a small number of trades, among a small number of
7
parties, toward the end of 2008.
3
http://www.markit.com/information/products/metrics.html
4
Preliminary results of ISDA 2008 Operations Benchmarking Survey, and ISDA 2007 Operations Benchmarking Survey, available from
http://www.isda.org.
5
For more details, please see “Goals for CDS Operations Management” on page 67.
6
ISDA Margin Survey 2008, available from http://www.isda.org.
7
For more details, please see the section “Counterparty Risk and Leverage” on page 68.
individual trades. If a credit default swap were, say, to recover par, few investors would
be willing to buy protection in the future, causing potential market disintegration.
Risk of a Short Squeeze
Following a Bankruptcy, standard CDS contracts require the protection Buyer to
deliver a bond or loan to the protection Seller. If the protection Buyer cannot do so, he
may (eventually) forfeit the right to receive par from the protection Seller. As a result,
in 2005, bond prices started to short squeeze considerably following bankruptcies—the
price of Delphi bonds rose from $58 to $72 after the company declared bankruptcy.
While not guaranteed, To accommodate these issues, the vast majority of investors have voluntarily agreed to
there are plans to cash settle CDS contracts following recent bankruptcies, thus reducing short squeezes
eventually hard-wire the as protection Buyers no longer have to locate bonds. While not guaranteed, there are
8
ability to cash settle CDS plans to eventually hard-wire such provisions into CDS contracts.
contracts Monoline Insurers
Uncertainty around CDS For CDS referencing monoline insurers, standard CDS contracts allow the protection
contracts referencing Buyer to deliver (by extension, the market to potentially cash settle to) any debt
monoline insurers obligation directly wrapped by the monoline. However, 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. Similar uncertainty exists
surrounding the effect on CDS contracts from a potential split of monoline insurers into
separate municipal bond and structured finance businesses. There is some potential that
monoline CDS notional could be divided between the two businesses or move entirely
to the municipal bond business. Although the eventual outcome is unclear, an ISDA
9
working group has been formed to try to develop a solution.
Changes in Corporate Finance Structure
Corporate finance is The development of new, tax-efficient corporate finance structures sometimes has
becoming increasingly created uncertainty as to how CDS contracts should be treated following a spin-off,
important to CDS merger, or acquisition. For example, in 2006, Verizon spun off its directories business.
investors As part of the transaction, some existing Verizon bonds were exchanged for loans in
the new directories business (Idearc). A debate ensued as to whether this structure
would cause some existing Verizon CDS notional to succeed, or change Reference
Entity, to Idearc, with its wider high yield spreads. Currently, our best advice is for
10
investors to learn these sometimes overlooked clauses of CDS contract language.
8
For more details, please see “CDS Settlement Protocols” on page 143.
9
For more details, please see “Special Issues Pertaining to CDS on Monoline Insurers” on page 158.
10
For more details, please see “Succession—How Corporate Finance Affects Credit Derivatives” on page 132.
Physical Settlement
Obligation
Protection Buyer Protection
ProtectionSeller
Seller
Par
Flexibility to manage The financial innovation achieved by credit default swaps—and their primary
credit risk attraction—is flexibility to manage credit risk. Unlike other financial instruments,
credit default swaps allow users to take unfunded, customized credit risk positions.
Traditional cash instruments are inherently funding vehicles and, as such, represent
Limitations of cash inflexibly bundled market and credit risks. For example, investors in the cash markets
instruments for who are bullish on an issuer’s credit must fund the investment and express their view
expressing credit views among available loans and bonds in whichever maturities, seniority, etc. are available.
In addition, investment in bonds or term loans can subject investors to either undesired
interest rate risk or additional expense in hedging out this risk. These cash market
limitations are more accentuated when investors seek to express a bearish view. In this
instance, 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.
Application of credit By contrast, credit default swaps—as side agreements, so to speak, among two parties
default swaps for on a third entity—provide more flexibility for expressing investment views on credit
expressing credit views risk.
As unfunded products, credit default swaps allow investors to separate the credit
decision from the funding decision. As such, credit default swaps make the credit
markets more accessible to investors who have higher funding costs. The total cost of
funding, including initial and variation margin, reflects the credit rating of the
particular Counterparty. 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.
Credit derivatives are not The buyer of an insurance policy is required to own the underlying asset; for example,
insurance a house. Since credit derivatives have no such requirement, they are not considered
insurance. This distinction is intentional, because it allows the transfer of risk from a
single party—for example, a bank lending a large loan facility—to a wide group of
investors.
Credit default swaps also provide flexibility in expressing credit risk views on
maturities, seniority and Credit Events, without regard to the availability of a physical
market instrument. In this sense, a credit default swap allows protection Buyers to fix
protection costs for the life of the CDS, while rollover risk from an alternative cash-
based shorting strategy will either become very difficult or costly to execute precisely
when an issuer’s credit profile significantly deteriorates.
With few exceptions, the legal framework of CDS—that is, the documentation
evidencing the transaction—is based on definitions set forth by the International Swaps
and Derivatives Association, Inc. (ISDA), a trade association. In May 2003, the 2003
ISDA Credit Derivatives Definitions took effect, expanding and revising the 1999
Definitions and Supplements. The Definitions provide a basic framework for
documentation, but precise documentation remains the responsibility of the parties
involved, because credit default swaps are bilateral contracts. These Definitions build
on a substantial case history of the CDS market. For details, please see page 129.
$ Trillions
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.
Total CDS Notional-Estimates are for total notional of the global credit derivatives market, including synthetic CDOs and index products.
Cash Notional—Estimates are for the total notional of the global corporate bond market.
For further details, please see the Chapter Appendix on page 23.
Sources: Bank of International Settlements; British Bankers Association; ISDA; Federal Reserve; Banc of America Securities LLC estimates.
ISDA estimates that CDS The International Swaps and Derivatives Association, Inc.’s (ISDA) 2007 year-end
notional grew by 81% in market survey estimates that CDS notional grew 81% in 2007, to $62 trillion.
2007, to $62 trillion Moreover, despite recent market conditions, ISDA estimates that CDS notional grew
37% during the second half of 2007, compared with 32% during the second half of
11
2006.
Single-name CDS has the greatest market share by product, but non-traditional
products have grown rapidly:
11
$62.2 trillion in year-end 2007 vs. $45.5 trillion in mid-year 2007, for a 37% growth rate, and $34.4 trillion in year-end 2006 vs. $26.0 trillion
in mid-year 2006, for a 32% growth rate. Sources: ISDA; Banc of America Securities LLC estimates.
Figure 4. CDS Product Usage, 2003 Figure 5. CDS Product Usage, Forecast 2008
Other
Basket Asset swaps Options Options
Basket 8%
Total return products 4% 3% Equity linked 3%
products
swaps 4% products Credit linked Single-name
1%
4% 1% notes CDS
3% 30%
Credit linked
notes Tranched
6% Index
Single-name
Tranched 10%
CDS
Index 51%
2%
Index (Excl. Synthetic
Tranches) CDOs
Synthetic Index (Excl.
9% 16%
CDOs Tranches)
16% 29%
Sources: British Bankers Association; Banc of America Securities LLC estimates. Other includes total return swaps, asset swaps, and equity linked products.
No survey was released in 2007, so this forecast is from before the onset of the credit
crunch. The next release is expected in 2008.
Sources: British Bankers Association; Banc of America Securities LLC estimates.
The single-name CDS Based on the overall CDS market size shown in Figure 3, the size of the single-name
market is estimated at CDS market is pegged at $20 trillion for 2007, compared to $2 trillion in 2003.
$20 trillion for 2007 Synthetic CDO market notional was an estimated $10 trillion in 2007, up from $570
12
billion in 2003. The index market expanded to an estimated $18 trillion in 2007, from
$319 billion in 2003. (The CDX credit derivatives indices began trading in October
2003.)
12
Synthetic CDOs are debt obligations representing a pool of credit default swaps. To estimate the size of the synthetic CDO market, we
multiply the 2008 forecast market share from Figure 5 by the 2007 total CDS notional from Figure 3. We emphasize that the 2008 forecast
market share was made in 2006, before the onset of the credit crunch. Synthetic CDO volume declined substantially in the second half of
2007, as discussed in “The Synthetic CDO Market” on page 166.
13
Total return estimates based on the CDX IG and CDX HY indices, which are discussed in “CDX and iTraxx Indices” on page 48. Using these
estimates, we assume a 70% investment-grade and 30% high-yield market share, following British Bankers Association estimates from 2006.
The total estimated CDS return is -1.3%, as of May 22, 2008 ( -1.2% investment grade return x 70% market share – 1.5% high yield return x
30% market share). Add the BIS estimate of -3.5% from December 2007, for a total CDS market value of -4.7%. Multiply the result by $62
trillion notional, for an estimate of $3 trillion gross market value.
14
We emphasize that this is a back-of-the-envelope estimate. A mass unwind of derivatives trades, should such a scenario ever occur, would
widen quotes—and therefore losses—drastically. Netting agreements between counterparties, which are excluded from our analysis, would
partially offset these losses. The CDS market is working to improve netting of trades, as discussed in the section “Counterparty Risk and
Leverage” on page 68.
15
The British Bankers Association releases surveys bi-annually, so estimates are not available for 2007. The next release is expected in 2008.
Insurers tend to be net Insurers tend to be net Sellers of protection. The need for yield has led to participation
Sellers of protection in the credit derivatives market through selling protection on single-name and, to a
lesser extent, tranched CDS.
Credit Derivative Product Credit Derivative Product Companies (CDPCs) are a relatively new class of protection
Companies (CDPCs) are Sellers. CDPCs are triple-A rated investment vehicles that sell protection, primarily on
a relatively new class of investment grade credits. Owing to their high rating, CDPCs are exempt from initial
protection Sellers margin requirements, and therefore in principle are able to use leverage to seek high
returns. Equity, in the form of common stock, provides a cushion for potential loss of
16
principal on the credit portfolio.
16
In recent months, some Counterparties have expressed concern about trading with CDPCs, because CDPCs do not post initial margin.
According to Moody’s Investors Service, “Credit Derivative Product Companies 2007 Sector Review and 2008 Outlook,” March 11, 2008,
“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.” However, Moody’s also
writes that, “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, the newly launched CDPCs hope to become broadly accepted as trading partners.”
Figure 8. High Grade Liquid CDS vs. High Grade Cash Issuers
Estimate as of April 2008
Count %
Sector Liquid CDS HG Issuers Issuer Market Value
Basic Materials 28 44 64% 70%
Capital Goods - Manufacturing 29 45 64% 76%
Consumer Cyclical 34 40 85% 95%
Consumer Non-Cyclical 37 43 86% 97%
Energy 42 64 66% 86%
Finance 52 121 43% 87%
Gaming, Lodging & Leisure 4 5 80% 96%
Health Care 25 33 76% 89%
Insurance 23 52 44% 71%
Media 16 19 84% 95%
Technology 11 18 61% 65%
Telecommunications 16 20 80% 97%
Transportation 10 13 77% 94%
Utilities 34 53 64% 88%
Total 361 570 63% 87%
Includes corporate issuers with investment grade ratings by at least two of Moody’s, S&P, and Fitch, with cash bonds outstanding of at least $250 million.
Finance includes Finance, Banks, Diversified Finance, and REITs.
Source: Banc of America Securities LLC Estimates.
High Yield
In high yield, we estimate that there is an active market for credit default swaps
About 16% of high-yield referencing approximately 16% of issuers. While not as large as in high grade, these
issuers trade actively in issuers represent approximately 44% of high yield market value. Figure 9 illustrates
the CDS market, this point.
accounting for 44% of
market debt
Figure 9. High Yield Liquid CDS vs. High Yield Cash Issuers
Estimate as of April 2008
Count %
Sector Liquid CDS HY Issuers Issuer Market Value
Basic Materials 19 109 17% 34%
Capital Goods - Manufacturing 12 92 13% 50%
Consumer Cyclical 24 127 19% 36%
Consumer Non-Cyclical 8 57 14% 57%
Energy 8 85 9% 32%
Finance 8 61 13% 19%
Gaming, Lodging & Leisure 4 57 7% 52%
Health Care 5 49 10% 50%
Insurance 2 7 29% 42%
Media 13 67 19% 48%
Technology 11 35 31% 46%
Telecommunications 8 32 25% 60%
Transportation 1 17 6% 3%
Utilities 11 20 55% 90%
Total 134 815 16% 44%
Note: Includes corporate issuers with high yield ratings by at least two of Moody’s, S&P, and Fitch, with cash bonds outstanding of at least $100 million.
Source: Banc of America Securities LLC estimates.
Credit Events
A Credit Event is the A Credit Event is the “default” in “credit default swap.” It is a circumstance that allows
“default” in “credit parties to trigger a CDS contract. There are three types of Credit Events: Bankruptcy,
default swap” Failure to Pay, and for some contracts, Modified Restructuring.
17
17
For Reference Entities located in Europe, the market uses a variant known as Modified-Modified Restructuring. For details, please see the
Chapter Appendix on page 17.
Figure 11. Finding the Reference Entity and Reference Obligation in Bloomberg
REDL <GO>
REDL is not always correct. Before entering into a trade, agree on a Reference Entity and Reference Obligation with your Counterparty.
Search field in
Bloomberg
Reference Entity Reference Obligation
(Specific legal (Establishes required
entity on which a seniority, not security,
CDS contract is of the Deliverable
written) Obligation)
Credit Events
Credit Events include Importantly, CDS contracts do not protect against all defaults. For example, if a
Bankruptcy, Failure to Reference Entity violates covenants, bonds may be in technical default, but protection
Pay, and for selected Buyers will be unable to trigger CDS contracts. Instead, CDS contracts protect against
credits, Modified specific Credit Events, the most common in North American corporates being
Restructuring Bankruptcy, Failure to Pay, and for selected credits, Modified Restructuring. The
Additional criteria that do not involve an actual bankruptcy filing may trigger a Bankruptcy Credit Event. These criteria are
discussed in Chapter VI – CDS Case Studies and Legal Issues on page 158, and have been of particular concern to
monoline insurers.
Failure to Pay A Reference Entity’s failure to make due payments. Usually applies to borrowed money, a broader category than simply
bonds and loans. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days
in the U.S.—and usually sets a minimum threshold of USD 1 million.
Restructuring A reduction of interest or principal, or maturity extension. Or, a change in the priority of payment of an obligation, which
causes the subordination of such obligation to any other obligation. Must result from a deterioration in the
creditworthiness or financial condition of the Reference Entity, 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.
Usually applies to borrowed money, a broader category than simply bonds and loans, and sets a minimum threshold of
USD 10 million. To prevent parties from profiting by triggering bilateral loans, the obligation triggering the Restructuring
must have at least 4 unaffiliated lenders, two-thirds of which consent to the Restructuring.
The US investment grade market generally uses Modified Restructuring. The US high yield market generally uses No
Restructuring (i.e., Restructuring does not constitute a Credit Event), but credits that were downgraded from investment
grade usually continue to use Modified Restructuring. The CDX indices use No Restructuring. Europe (investment grade
and high yield, single-name and iTraxx indices) uses Modified-Modified Restructuring.
Modified and Modified-Modified Restructuring generally limit the maturity of Deliverable Obligations to the front-end of the
curve. For details, please see Chapter VI – CDS Case Studies and Legal Issues on page 152.
Restructuring criteria may also be triggered if the date for payment or accrual of interest is extended, or currency is changed to a non-permitted currency (G7 plus OECD members with a triple-A local
currency long-term debt rating).
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. Obligation Acceleration is subject to a
minimum dollar threshold amount. No longer used in G7 corporate contracts.
Repudiation/Moratorium: A Reference Entity’s rejection or challenge of the validity of its obligations. No longer used in G7 corporate contracts.
Obligation Default: Although rarely used, obligations may become capable of being declared due earlier than normal as a result of default.
Source: 2003 ISDA Credit Derivatives Definitions.
If no pre-specified Credit Event occurs during the life of the transaction, the protection
Seller keeps the periodic payment (quarterly payments calculated by notional x coupon
x actual/360, plus an up-front payment, if applicable) in compensation for assuming
18
credit risk on the Reference Entity. Conversely, should a Credit Event occur during
the life of the transaction, the protection Buyer receives a compensating payment
depending on the settlement of the contract (discussed below). The protection Seller
receives only the accrued periodic payment up to and including the Event
Determination Date (effectively, the date a Credit Event occurs).
The market standard is for CDS protection to begin at T+1 days. So, if a Credit Event
occurs on the same day that a trade is executed, the investor does not have protection.
Cash flows are settled at T+3 days.
Sample Credit Event documentation appears on page 86.
18
Upfront payments typically apply only to indices and Reference Entities with five-year CDS wider than approximately 700 bps. For details,
please see “The Transition from Spread to Points Upfront” on page 108.
Credit Events must occur All Credit Events must occur by 11:59pm Greenwich Mean Time (GMT) on the
by 11:59pm Greenwich Scheduled Termination Date for the CDS Buyer to have protection.
Mean Time (GMT) on the For example, Calpine filed for Bankruptcy at 10:57pm New York time on December
maturity date 20, 2005, which was later than 11:59pm GMT. As such, for holders of CDS contract
with a December 20, 2005 maturity, there was no Credit Event.
19
There are additional restrictions surrounding Deliverable Obligations following a Restructuring. For details, please see Chapter VI – CDS
Case Studies and Legal Issues on page 152.
20
By “original seniority,” we mean the seniority as of the later of the CDS trade date and the Reference Obligation issue date.
Credit Event An event that triggers the contingent payment on a credit default swap. There are two Credit Events currently used across CDS
products (see Figure 12), Bankruptcy and Failure to Pay. Additionally, single-name CDS contracts on US investment grade and
fallen-angel Reference Entities typically include Modified Restructuring. Single-name and index CDS contracts on European
Reference Entities (investment grade and high yield) typically include Modified-Modified Restructuring.
Reference Obligation and Reference Obligation is cited in the CDS term sheet. 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, up to a 30-year maturity (typically shorter for a Modified-
or Modified-Modified Restructuring). If no Reference Obligation is chosen, defaults to senior unsecured.
The Reference Obligation determines only the required seniority, not the security, of the Deliverable Obligation. For example, if the
Reference Obligation is a senior secured bond, the protection Buyer may deliver a senior unsecured bond following a Credit
Event.
Special language must be included for investors who wish to restrict the security of the Deliverable Obligation. Please see the
section “Secured CDS” on page 169, for details.
Settlement Can be Physical or Cash Settlement. Standard CDS documentation specifies Physical Settlement. Protection Seller buys
Deliverable Obligation from protection Buyer at par upon occurrence of a Credit Event. In Cash Settlement, protection Seller pays
protection Buyer the difference between the par and market values of a Reference Obligation.
In practice, market expectations are in the process of moving from Physical Settlement to Cash Settlement. Parties retain the
option to physically settle, provided that another market participant is willing to take the opposite position. Please see Chapter VI
– CDS Case Studies and Legal Issues on page 143 for details.
Note: For senior unsecured CDS, Deliverable Obligations typically are Bonds and Loans that meet the following criteria: Not Subordinated, Specified Currency (typically, USD, GBP, EUR, CAD, CHF, or
JPY), Not Contingent, Assignable Loan (if applicable), Consent Required Loan (if applicable), Transferable, Maximum Maturity: 30 years, and Not Bearer.
Maturity limitation is typically more restrictive following a Modified- or Modified-Modified Restructuring. For details, please see Chapter VI – CDS Case Studies and Legal Issues on page 152.
ISDA Definitions technically provide for additional Credit Event triggers, described in Figure 12.
Sources: ISDA; Banc of America Securities LLC estimates.
Guarantees
Under certain Naturally, the financial and risk profiles of different entities that fall under the same
circumstances, debt from organizational umbrella are not always the same. Consequently, the recovery values on
a subsidiary may be instruments of those different entities potentially will be very different following a
deliverable into CDS on a Credit Event. However, parties to a credit default swap should recognize that, under
parent company certain circumstances, debt from a subsidiary may be deliverable into CDS on a parent
company.
For Reference Entities located in North America, if a holding company (parent)
guarantees an operating company (subsidiary), that operating company’s debt is
deliverable into CDS on the holding company. See Figure 14. The guarantee must be
unconditional and irrevocable, where the holding company owns a majority of the
operating company.
Upstream guarantees (from subsidiary to parent) are not taken into account for
Reference Entities located in North America. That is, for CDS on an operating
company, under no circumstance is holding company debt deliverable.
For Reference Entities located in Europe, a broader class of guarantees applies to CDS
contracts, as illustrated in Figure 14.
Orphaned CDS (Lack of Deliverable Obligations)
A CDS contract on a company that has no Deliverable Obligation is sometimes called
“orphaned CDS.” For example, 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. Unless the
operating company issues new debt, there will be no Deliverable Obligation into CDS
contracts, and CDS will become near-worthless.
Succession
Succession refers to What happens if a Reference Entity is merged, acquired, or some other change is made
changes in a CDS contract with respect to its corporate structure? This issue is one referred to as Succession in
after a Reference Entity is CDS terms, and may be summarized as follows:
merged, acquired, or
X If one entity succeeds to 75% or more of the Relevant Obligations (Bonds and
undergoes some other
Loans) of the Reference Entity, that entity will be the sole Successor. The original
change in its corporate
Reference Entity will be deleted from the contract, and replaced with the Successor
structure
Reference Entity.
X If one or more entities succeeds to more than 25% but less than 75% of the
Relevant Obligations, each such entity and the original Reference Entity will be a
Successor. The notional for each contract will be the original notional, divided
equally by the number of Successors. For example, an investor with a $10 million
CDS contract may now have a $5 million CDS contract in the original Reference
Entity, and a $5 million Reference Entity in the Successor Reference Entity.
X If no one entity succeeds to more than 25% of the Relevant Obligations, and the
Reference Entity continues to exist, there will be no Successor. The Reference
Entity will not change.
For more details on Succession, including case studies on issues that have created
recent market uncertainty, please see Chapter VI – CDS Case Studies and Legal Issues
on pages 129 and 132.
21
2003 ISDA Credit Derivatives Definitions, Section 9.1(b)(iv)–(v).
22
The other participant need not be the original Counterparty, just another participant in the settlement protocol.
23
Roughly speaking, cash settlement protocols have asked banks and broker-dealers to quote the cheapest-to-deliver bond on a defaulted credit.
After applying a filtering mechanism to eliminate off-market quotes, the protocol settles near an average of the dealer prices. Additionally,
although single-name CDS notional for Dura Operating Corp. was relatively low, the settlement protocol set a precedent for including single-
name CDS transactions.
X However, if the offset is with the original dealer but has a different maturity date
(for instance, an investor partially offsets an off-the-run CDS contract with an on-
the-run CDS contract, but keeps the tail risk between the maturity dates), the
reported size of the CDS market grows $20 million ($10 million in initial trade +
$10 million in offset). Even though the offset causes net credit risk to substantially
decline, reported CDS notional increases.
X If the offset is with another dealer, regardless of maturity date, reported size of the
CDS market grows $20 million ($10 million in initial trade + $10 million in
offset). Unlike an assignment, each dealer faces the client, rather than another
dealer. As such, there is no adjustment for the offsetting position.
Index vs. Intrinsics Arbitrage
An investor sells $125 million in index protection and buys $1 million single-name
protection on each of the 125 underlying constituents:
X Even though there is no net credit exposure, 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 single-
name protection.
X Even though there is no net credit exposure, the reported size of the CDS market
grows $10 million
Structured Credit (Correlation)
An investor sells $10 million of 20x leveraged equity tranche protection, unhedged:
X Reported size of the CDS market grows $10 million. However, 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).
An investor sells $10 million of 20x leveraged equity tranche protection, delta-hedged
with protection in the underlying constituents:
X Reported size of the CDS market grows $210 million ($10 million tranche notional
+ $200 million of protection for the hedge). The result is the same if the investor
hedges with single-name CDS or an index.
Though the form of CDS fixed payment quotations may be unfamiliar to some cash
market participants, CDS payments in most instances are tied to the underlying cash
instrument through no-arbitrage relationships. In this sense, a bond’s spread to LIBOR,
discussed below, often provides a good indication—but not an exact metric—of credit
default swap levels.
24
This gives an important lesson: Different counterparties should view the benchmark CDS spread differently. For example, a protection Buyer
who funds at LIBOR + 3/8 should view the same credit spread as LIBOR + 3/8 + 380 bps, not just LIBOR + 380 bps.
Par
L+380
Swap
Spread +
380
380 bps
Assumes semiannual coupon for both corporate bond and CDS. A quarterly CDS coupon (still with a semiannual corporate bond coupon) would widen the Z-spread by approximately 3 bps.
Sources: Bloomberg; Banc of America Securities LLC estimates.
For a five-year credit default swap trading at 380 bps, the relevant comparison is a
corporate bond trading at five-year LIBOR + 380 bps; in this case, a yield of 7.582%.
Since single-name CDS trades usually begin at par, 7.582% is also the comparable cash
25
bond coupon. The equivalent cash bond spread is 463.7 bps over the five-year
Treasury. The difference between the 463.7-bp spread to Treasury and the 380-bp CDS
spread is the five-year swap spread (83 bps). The “Z-spread,” one of the spread to
LIBOR measures we will discuss in this section, is 380 bps, the same as the credit
26
default swap spread.
In practice, investors do not often replicate cash bonds out of CDS contracts. This is
To reconstruct a cash because most corporate bond buyers hedge with Treasuries, leaving them exposed only
bond out of a Credit to the credit spread component of risk. However, investors who want to reconstruct a
Default Swap, buy a AAA- cash bond out of a credit default swap may in principle buy a triple-A rated bond that
rated bond that yields yields roughly LIBOR—such instruments do not generally exist as of May 2008—and
roughly LIBOR and sell
sell CDS protection. This yields the investor LIBOR (from buying the bond) plus the
CDS protection
CDS spread (from selling protection).
25
Since the credit default indices trade with a fixed coupon, these trades often begin away from par. In addition, single-name CDS trades often
begin away from par for wide-spread Reference Entities. See the section, “The Transition from Spread to Points Upfront” on page 108 for
details.
26
For simplicity, we assume a semiannual coupon and 30/360 day count for both the corporate bond and CDS. In reality, CDS trades with a
quarterly coupon and ACT/360 day count, while US corporate bonds pay a semiannual coupon and have a 30/360 day count. Relaxing the
coupon assumption would widen the Z-spread by approximately 3 bps, while relaxing the day count assumption would tighten the Z-spread
by approximately 3.5 bps.
200 110
150
150 100
Price ($) 100
100 90
50
50 80
0
0 70
-50
-50 60 65 75 85 95 105 115
Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Price ($)
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
The further a bond moves Notice that the error introduced by Z-spread is closely related to the dollar price of the
away from par, the more bond. When the bond was trading at about $80, Z-spread understated Par CDS
Z-spread and Par CDS equivalent spread by about 45 bps (Figure 18). By contrast, when the bond was trading
equivalent spread will around par, Z-spread and Par CDS equivalent spread were within 10 bps of each other.
differ Moreover, this relationship is nonlinear. The further the bond moves away from par,
the more Z-spread and Par CDS equivalent spread will differ.
In reality, a number of factors cause differences in CDS and the cash spread to LIBOR,
Historically (less since even for par bonds. We define this difference (CDS – cash) as the “basis.”
summer 2007), the Historically—but less since summer 2007—one of the most important factors
CDS—cash basis tended determining the basis has been the level of credit risk (or spreads). When credit risk has
to widen with the level of risen, demand for buying protection also rose, and the basis became more positive.
credit spreads
When credit risk has declined, the opposite occurred, and the basis tended to narrow or
even become negative. In this sense, CDS spreads have often traded with a higher beta
than their cash bond equivalent. That is, if the cash bond widens 10 bps, CDS has
27
tended to widen, say, 13 bps (and the basis has increased 3 bps), and vice-versa.
For example, Figure 19 illustrates the historical relationship between CDS and cash for
General Motors Corp. Notice that CDS almost always traded wider than cash during
this approximately two-year period. As Figure 20 shows, the basis widened with the
level of credit spreads. This means that, even after adjusting for maturity differences,
CDS spreads reached particularly wide levels versus cash, as credit quality
deteriorated. For example, in mid-May 2005, an investor could earn roughly 750 bps in
cash, but 1000 bps in CDS.
Figure 19. CDS Is More Risky than Cash… Figure 20. …Particularly in Wide Spread Environments
Interpolated CDS versus Cash Spread Cash Spread versus CDS-Cash Basis
GM 7.125% July 2013 GM 7.125% July 2013
1,200 1,200
1,000 1,000
Spread (bps)
800 800
600 600
400
400
200
200 0
0 0 500 1,000 1,500
Oct-03 Oct-04 Oct-05 Oct-06 Cash (Par CDS Equivalent Spread, bps)
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
27
Also, at wide credit spreads, the repo market often dries up, making it difficult or expensive to find a bond to borrow. This makes it more
difficult to sell bonds and sell protection. For details, please see the Chapter Appendix on page 44.
Figure 21. Cash and Matched Maturity CDS Spread Figure 22. Cash and Matched Maturity CDS Spread
For Credits with Five-Year CDS < CDX IG Index For Credits with Five-Year CDS > CDX IG Index
January 2005 to April 2008 January 2005 to April 2008
160 600
Cash Cash
140
Matched Maturity CDS 500 Matched Maturity CDS
120
Spread (bps)
400
Spread (bps)
100
80 300
60 200
40
20 100
0 0
Jan-05 Jan-06 Jan-07 Jan-08 Jan-05 Jan-06 Jan-07 Jan-08
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. 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. The number of bonds analyzed each day depends on the availability of pricing data.
Currently, we look at a portfolio of 66 bonds. Currently, we look at a portfolio of 66 bonds.
Source: Banc of America Securities estimates. 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:
6
100 Wider Spread Credits
5
CDS - Cash Basis (bps)
50
6m Rolling Daily
4
0
3
-50 2
-100 1
-150 0
Jan-05 Sep-05 May-06 Jan-07 Sep-07 Apr-05 Feb-06 Dec-06 Oct-07
The number of bonds analyzed each day depends on the availability of pricing data. Currently,
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
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
42 tighter than the CDX IG index. tighter than the IG index.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
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 Figure 26. CDS- Cash Basis and the Effective Basis after
Together Adding Funding Cost
CDS – Cash Basis and AAA Credit Card Spreads Effective Basis = CDS – Cash Basis + Funding Cost
For credits with 5y CDS tighter than the CDX IG index spread For credits with 5y CDS tighter than the CDX IG index spread
0 60
-10 20
(Inverted) (bps)
40
-20 40 20
-30
60 0
-40
-50 -20
80
-60 -40
100 -60
-70
-80 120 -80
Jan-05 Jan-06 Jan-07 Jan-08 Jan-05 Jan-06 Jan-07 Jan-08
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
Figure 27. 2006: Cash Spread to Treasury Tightening, but Figure 28. 2006: CDS-Cash Basis On Top of Swap Spreads
Spread to LIBOR Widening Interpolated CDS—Cash Basis, versus Five-Year Swap Spread
Shown for BAS Broad Market Index of Investment Grade Cash Bonds 3 Jan 06—5 Jan 07
3 Jan 06—5 Jan 07
Based on approximately 145 investment grade and crossover credits. Based on approximately 145 investment grade and crossover credits.
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate.
Sources: Bloomberg; Banc of America Securities LLC estimates. Sources: Bloomberg; Banc of America Securities LLC estimates.
Source: Bloomberg.
I-Spread
I-spread is the simplest way to define and understand spread to LIBOR. I-spread simply
I-spread compares the compares the yield of a bond with a matched maturity swap yield. For the sample bond
yield of a bond with a in Figure 29, the yield to maturity of a 10.3-year (August 2018) bond is 11.889%. The
matched maturity swap corresponding 10.3-year swap yield is 4.38%. (To calculate the 10.3-year swap yield,
yield we interpolate the 10- and 15-year swap yields.) As illustrated in Figure 30, the
corresponding I-spread is 7.51%. This matches up with the 751-bp I-spread from
Figure 29 (“ISPRD,” in white toward the bottom-left of the circled area).
11.889% Yield –
4.38% Swap Yield
(at 10.275 years)
= 7.51% I-Spread
That is, assuming no default, a credit investor earns 751 bps more per annum on the
corporate bond than on a matched-maturity swap. The reason for the 751 bps extra
yield is the risk that the corporate bond issuer may fail to pay.
It is important to note that I-spread only considers the yield of the bond, not the timing
I-spread only considers of its cash flows. That is, for the same yield and maturity, a 4.5% coupon bond has the
the yield of the bond, not same I-spread as a 6.5% coupon bond, whose cash flows are more front-loaded. In
the timing of its cash reality, investors usually prefer the lower dollar-priced bond (4.5% coupon), because
flows they will lose less of a premium following a Credit Event.
Asset Swap Spread
Most investment grade corporate bonds are structured as fixed-rate bullets, with a flat
coupon payment plus par at maturity. For leveraged investors who fund the purchase of
corporate bonds with a floating rate liability, there is an interest-rate mismatch. Asset
Asset swap spread is the swap transactions are designed to solve this problem. That is, the investor buys the
annual spread over fixed-rate corporate bond and swaps the fixed-rate payment into floating LIBOR-based
floating-rate LIBOR that payments, to meet cash flow requirements on the funding side.
an investor earns, in
Asset swap spread is the annual spread over floating-rate LIBOR that an investor earns
exchange for selling the
in exchange for selling the fixed cash flows of the bond. A par asset swap is based on
fixed cash flows of the
bond
par, 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, so in practice, the
fixed-rate cash flows are exchanged semiannually, while the floating-rate cash flows
(floating-rate LIBOR plus the asset swap spread) are exchanged quarterly. An asset
swap is a separate agreement between two parties, so if the underlying issuer defaults,
an asset swap continues.
Figure 31. Calculating Asset Swap Spread
F6.5 2018 Corp ASW <GO>
Discounted
at LIBOR
$31.5
Discount
(Plus
Accrued
Interest)
Consider Figure 31. In this case, the investor pays out fixed cash flows of 3.25%
semiannually (second column, calculated as a 6.5% coupon divided by two). In
exchange, the investor receives LIBOR + 579 bps quarterly (circled area in the third
column). Notice that 579 bps roughly corresponds to the asset swap spread (“ASW,” in
28
red) from Figure 29. The net cash flows (floating minus fixed) are shown in the fourth
column. Net cash flows, which represent the premium or discount portion of the bond,
are discounted at LIBOR, to arrive at the present value in the far right column.
The key difference between asset swap spread and other spread measures is the way
In ASW, the par portion of that asset swap spread breaks up the cash flows. The par portion of the bond is
the bond is discounted at the discounted at the risky rate (the bond coupon), while the premium or discount portion
risky rate, while the premium is discounted at LIBOR.
or discount portion is
discounted at LIBOR In this case, the investor is expected to receive a present value of $1 million in floating-
rate LIBOR over the life of the asset swap, but will only pay out fixed-rate cash flows
28
Intraday movement in the swap curve may cause slight differentials in spreads between screens.
worth $68.5. In exchange, the investor also pays 31.5 points upfront ($100 par – $68.5
bond price).
The bond yield is 11.889% and the coupon is 6.5%. The par portion of the bond is
discounted at 6.5%, while the discount portion of the bond is discounted at LIBOR.
With the exception of cross-currency trades, where an investor may actually want to
swap US dollars for euros, CDS—cash investors do not usually institute asset swaps.
Instead, they use asset swap spread as a relative value tool to estimate the appropriate
spread to LIBOR against which to compare a CDS spread. The most important point to
remember is that, while I-spread ignores the timing of a bond’s cash flows, asset swap
spread incorporates the timing of coupon payments.
Z-Spread
Another often-used but easily misunderstood spread terminology is the Z-spread. While
Z-spread is the OAS to I-spread is the incremental yield over a matched maturity swap, Z-spread is the
LIBOR under an incremental yield over the entire LIBOR spot curve (or zero curve). For readers
assumption of zero familiar with option-adjusted spreads (OAS), Z-spread is the OAS to the LIBOR curve
volatility under an assumption of zero volatility. The origin of Z-spread is the mortgage market.
Z-spread may be interpreted as spread income on a corporate bond, when the investor
Each cash flow is finances his purchase with a series of zero-coupon bonds. Each cash flow is discounted
discounted at the zero- at the zero-coupon LIBOR rate plus a fixed spread on the cash flow payment dates.
coupon LIBOR rate plus a This fixed spread is called the Z-spread. The Z-spread is chosen to make the present
fixed spread on the cash discounted value of the cash flows equal to the price of the bond. For bonds at par, Z-
flow payment dates. This
spread, I-spread, and asset swap spread are relatively close to each other.
fixed spread is called the
Z-spread
Zero Volatility
Assumption
(Valid for USD Swap Curve
Bullet Bonds) (Semiannual, 30/360)
For our example bond, Figure 32 illustrates the calculation of Z-spread, using the
OAS1 screen in Bloomberg. We use a $68.5 bond price and add in a zero (the “Z” in Z-
spread) volatility assumption, which is valid for a bullet bond. We also use the USD
swap curve because Z-spread is a spread to LIBOR. This gives a Z-spread of 763 bps,
29
roughly the same as that from Figure 29 (“ZSPR,” in red).
The Z-spread (763 bps) is wider than the asset swap spread (579 bps) because of a
difference in discounting methodology. An asset swap assumes that the premium or
discount portion of a bond bears very little risk, with a discount rate of LIBOR. So, the
discount rate on the premium or discount portion of a AAA-rated bond, and a BBB-
rated bond, is the same under asset swap spread. By contrast, Z-spread discounts the
premium or discount portion of a BBB-rated bond at a higher (LIBOR + Z-spread) rate,
recognizing the incremental default risk of a less creditworthy bond. So while both Z-
spread and asset swap spread take into account cash flows, Z-spread discounts the
premium or discount portion at a more realistic rate.
Recall that I-spread ignores the timing of cash flows entirely. If the LIBOR yield curve
is flat, then Z-Spread is exactly the same as I-Spread. This is because all the zero-
29
Intraday movement in the swap curve may cause slight differentials in spreads between screens.
coupon LIBOR rates coincide with the LIBOR swap rates. However, when the LIBOR
When the LIBOR yield yield curve is upward sloping, Z-Spread tends to be higher than I-Spread. This is
curve is upward sloping, because on balance, zero rates are lower than the yield-to-maturity used in I-spread. For
Z-Spread tends to be example, Z-spread may discount the coupon due in six months at 3.10% plus the Z-
higher than I-Spread spread, and the coupon due in one year at 3.25% plus the Z-spread. Ordinarily, the
lower discount rate on the coupon due in six months would cause the present value of
the cash flows to rise. To keep the present value equal to the bond price, the Z-spread
widens; i.e., Z-Spread adjusts upward to keep the present value of the cash flows equal
to the price of the bond. The opposite is true when the yield curve is downward sloping.
A Note of Caution: Callable/Puttable Bonds
The preceding analysis has looked solely at bullet bonds. For bonds with options, an
investor should relax Z-spread’s assumption of zero volatility and look at OAS to
LIBOR. Figure 33 shows why it is important to relax the zero volatility assumption, for
a 2015-maturity bond that is callable in 2011:
Figure 33. Comparing OAS to LIBOR with Z-Spread for a Callable Bond
Bond is Callable November 1, 2011 at $105.125
Source: Bloomberg.
The Z-spread is 495 bps. Although Z-spread does adjust for the shape of the LIBOR
For bonds with options, curve, it ignores the value of the call option completely. Calculating OAS to LIBOR
relax Z-spread’s assumption with a volatility of 22.6% gives an OAS to LIBOR of 557.5 bps. As another way to
of zero volatility, and look at think of this, the value of the call option is the 557.5-bp OAS to LIBOR minus the
OAS to LIBOR 495.2-bp Z-spread, or 62 bps. For relative value purposes, the 557-bp OAS to LIBOR
should be compared with the CDS spread.
Par CDS Equivalent Spread
All of the measures illustrated above ignore the value of a bond’s premium or discount.
For example, consider an underlying cash bond that trades at a premium, say $120.
Should there be a Credit Event with a 40% recovery rate, the bond investor’s actual
recovery rate will be lower. In this case, the investor will recover $40 on an initial $120
investment, or 33%. By contrast, in a single-name credit default swap, the investor will
Par CDS equivalent recover $40 on an initial par ($100) investment, or 40%.
spread adjusts the Z-
spread for a bond’s The Par CDS equivalent spread adjusts the Z-spread for a bond’s premium or discount.
premium or discount For example, adjusting for the difference in recovery rates between cash and CDS for
the $120 bond, 150 bps of Z-spread in the cash bond may provide just as much
compensation for risk as, say, 143 bps of CDS spread. So in reality, the investor is
indifferent between the 150 bps of Z-spread for the cash bond and the 143 bps of CDS
spread. A spread of 143 bps for the cash bond is therefore called the Par CDS
equivalent spread.
For bonds trading at a For bonds trading at a premium, Par CDS equivalent spread is the Z-spread minus a
premium, Par CDS recovery adjustment. Namely, Par CDS equivalent spread adjusts the Z-spread
equivalent spread is the downward for a premium bond to more accurately reflect the recovery rate in the event
Z-spread minus a of default. Similarly, for cash bonds trading at discount (say an $80 price), Par CDS
recovery adjustment equivalent spread is higher than the Z-spread.
If the underlying cash bond is trading at par ($100 price), the difference in recovery
rate becomes a non-issue, because both cash and CDS are based on par. Consequently,
for cash bonds trading at par, Par CDS equivalent spread is the same as the Z-Spread,
ignoring day count and other operational conventions.
Par CDS equivalent Par CDS equivalent spread does not adjust for optionality, and therefore should be used
spread should be used only for bullet bonds.
only for bullet bonds Details on Par CDS Equivalent Spreads
In this section, we show how to calculate par CDS equivalent spread to LIBOR, from
the pricing of a cash bond. We look at the General Motors Corporation 7.7% 2016 as
an example. In April 2008, the bond was bid at $78, for a spread of 874 bps over the 10
year Treasury and a Z-spread of 802 bps over Swaps. To calculate the par CDS
equivalent spread, we look for the spread for which the present value of expected cash
flows equals the bond price. Figure 34 illustrates the mechanics:
7.0 902 bps 34.92% 2.73% $3.85 $2.49 4.08% 75.39% $1.88
7.5 902 bps 32.39% 2.53% $3.85 $2.31 4.13% 73.59% $1.70
8.0 902 bps 30.05% 2.35% $103.85 $32.19 4.18% 71.80% $23.11
For each coupon period, calculate the present value of the expected cash flow as
follows. First, look at the marginal probability of default; that is, the probability that an
issuer defaults during a particular coupon period. This probability rises as par CDS
equivalent spread widens. Mathematically, the marginal probability of default is the
probability that the issuer does not default in the prior coupon period (i.e., survives the
prior period), minus the probability that the issuer does not default in the current
30
coupon period.
Second, look at the expected cash flow during a particular coupon period. Provided the
issuer does not default, the investor receives the bond coupon, or at maturity, par plus
the coupon. However, if the issuer defaults, the investor receives recovery plus half the
coupon. The reason for including half the coupon is that, by market convention, we
31
assume that default occurs halfway through a coupon period. Since we are looking at
the spread that makes a bond equivalent to a CDS contract, we include accrued interest.
Mathematically, expected cash flow is ( Probability of Not Defaulting ) x Coupon +
Marginal Probability of Default x ( Recovery + ½ x Coupon ).
Third, discount the cash flow by LIBOR. Add up the present value of expected cash
flows across coupon periods. Then solve for the spread for which the present value of
expected cash flows equals the bond price. This is the par CDS equivalent spread.
30
The one-year probability of default is the spread, divided by one minus the expected recovery rate. For details, see the section “Implied
Probability of Default” on page 100 of the main text.
31
More realistically, we would expect an issuer to default shortly before (or after) the end of a coupon period, because there is little incentive for
to default well before a coupon payment or principal is due. In this case, approximately all of the coupon would be missed.
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 Bond Expected PV of
of Not Probability Cash Cash Discount Expected
Years Z-Spread Defaulting of Default Flow Flow LIBOR Factor Cash Flow
exp( -[ Spread ] / Probability of ( Probability of Not ( 1 + LIBOR )^ Expected Cashflow *
[ 1 - Recovery ] * Not Defaulting Defaulting ) * ( -Years ) Discount Factor
Years ) in Prior Bond Cash Flow +
Coupon Period - Marginal Prob
Probability of of Default *
Not Defaulting ( Recovery +
in Current 1/2 * Coupon )
Coupon Period
0.5 802 bps 93.54% 6.46% $3.85 $6.31 3.04% 98.50% $6.22
1.0 802 bps 87.49% 6.05% $3.85 $5.90 3.11% 96.96% $5.72
1.5 802 bps 81.83% 5.66% $3.85 $5.52 3.11% 95.48% $5.27
7.0 802 bps 39.23% 2.71% $3.85 $2.65 4.08% 75.39% $2.00
7.5 802 bps 36.70% 2.54% $3.85 $2.48 4.13% 73.59% $1.82
8.0 802 bps 34.32% 2.37% $103.85 $36.64 4.18% 71.80% $26.31
Sum of PV of Expected Cash Flows ≠ Bond Price $81.13
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.
Maturity Differences
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.
For relative value comparisons, an investor often will look at the interpolated CDS
Matched-maturity versus spread (average of 3- and 5-year CDS quotes) versus the cash-bond quote. To keep the
benchmark relative value trade as liquid as possible, historically basis trades usually were executed with five-
year 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
expires on the quarterly roll date (March, June, September, or December 20) following
32
the maturity of the cash bond.
32
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.
Figure 36. The Evidence of Things Unseen: Enron Basis Trades Perpetually Wide in 2001
Relative Basis
30%
20%
10%
0%
-10%
-20%
18-May-01 25-May-01 1-Jun-01 8-Jun-01
Source: Banc of America Securities LLC estimates.
In Figure 36, we show the relationship of the relative CDS basis (defined as the CDS-
cash 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.
Differential Liquidity
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.
34
This general observation may not apply to a specific user of CDS, 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).
Cheapest-to-Deliver Option
Less relevant in today’s Less relevant in today’s CDS market, the delivery option may impact the CDS—cash
CDS market, the basis. The protection Buyer in a CDS transaction has an option to deliver the cheapest
cheapest-to-deliver option deliverable instrument he can find in the cash market. In the US, Modified
may cause CDS to Restructuring terminology has greatly limited, although not completely eliminated, the
underperform cheapest-to-deliver option. In certain cases, this may cause CDS spreads to widen
relative to cash.
Technical Conditions
CDS settles with accrued CDS trades on an Actual/360 day-count convention, while cash trades on a 30/360
interest following a convention. Additionally, CDS settles with accrued interest following a Credit Event
Credit Event, while cash (up to and including the Event Determination Date), while cash settles without accrued
settles without accrued interest.
interest
Convertible Bonds
CDS spreads may widen CDS spreads may widen after the announcement of a new convertible issue, driving the
after the announcement CDS—cash basis wider. There are two main reasons.
of a new convertible
The first reason is temporary supply and demand imbalance. In 2001, the rapidly
issue
expanding convertible market was driven primarily by issuers tapping an alternative
source of low-cost financing (in a deteriorating equity market), and the demand created
from convertible arbitrage funds’ purchase of cheap equity options. To strip the
perceived cheap equity option from convertible issues, convertible arbitrage traders
needed to buy credit protection in the CDS market. This pushed CDS spreads wider.
The second reason is a perception of lower recovery rates on convertibles. According to
35
a 2001 study conducted by Moody’s, there is a 7% price difference between straight
and convertible bond issues, with the same seniority, after Credit Events. To account
for the greater potential loss following a Credit Event, protection Sellers demand a
wider spread.
35
For more details, please see BAS research report, “Impact of Convertible Bond Issuance on the Credit Default Swap Market,” October 19,
2001 and Moody’s Investors Service, “Default and Recovery Rates of Convertible Bond Issuers: 1970—2000,” July 2001.
36
CDX IG, HVOL, and XO roll on March 20th and September 20th. CDX HY rolls on March 27th and September 27th. LCDX rolls on April 3rd
and October 3rd.
37
For eligibility in the investment grade index, at least 2 out of 3 ratings (Moody’s, S&P, and Fitch) must be investment grade, at index
inception. For the high yield index, at least 2 out of 3 ratings must be high yield, at index inception. For the crossover index, ratings must be
either double-B by all three agencies, or triple-B by one agency and double-B by the other two agencies, at index inception.
plus 8 Reference Entities at different levels of the capital structure (operating vs.
38
holding company).
X The corresponding European indices are iTraxx Main (investment grade), iTraxx
HVOL (HVOL), iTraxx Financials (two indices, one senior and one subordinated),
iTraxx XO (high yield, not to be confused with the North American definition of
39
XO), and LevX (leveraged loans).
Please see the Chapter Appendix on page 57 for more detail on the construction of the
indices and index rolls.
Current
Index
Spread
Index
Coupon
Up Front
Payment
Made By
Seller of
Index
Protection
Source: Bloomberg.
38
Eight Reference Entities trade at different parts of the organizational structure in LCDX vs. CDX HY Series 10 (current on-the-run index):
Alltel Corp is in CDX HY and ALLTEL Communications Inc is in LCDX; Charter Communications Holdings LLC is in CDX HY and
Charter Communications Operating LLC is in LCDX; Intelsat Ltd is in CDX HY and Intelsat Corp is in LCDX; RH Donnelley Corp is in
CDX HY and RH Donnelley Inc is in LCDX; Sabre Holdings Corp is in CDX HY and Sabre Inc is in LCDX; Six Flags Inc is in CDX HY
and SIX Flags Theme Parks is in LCDX; Toys R US Inc is in CDX HY and Toys R US – Delaware Inc is in LCDX; Owens-Illinois Inc is in
CDX HY and Owens-Illinois Group Inc is in LCDX. See the Chapter Appendix on page 60 for a full list of Reference Entities.
39
Technically, a North American IG Financials subindex exists, but the iTraxx version is far more liquid.
The index trades at 155 bps (right hand side of the screen), but the coupon is fixed at
102 bps running (“deal spread”). In this case, 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). The
upfront payment equals $242,654 (“market value”) per $10 million notional, plus
$13,778 accrued interest, for a total payment of $256,432 (“total value”). Note that this
is equivalent to a price of $102.43 (“price”).
Note that, while the investment grade indices are quoted in spread (“102 bps”), the high
yield indices are quoted in dollar price (“$96.50”). This syncs the high yield indices
with the traditional price- (not spread-) based high yield cash market.
Ratings
Although the indices are not rated, we estimate the credit quality of IG10 (investment
grade index, Series 10) at Baa2. HVOL10 (high volatility index, Series 10) is estimated
at Baa3, XOVER10 (crossover index, Series 10) at Ba2, HY10 (high yield index,
Series 10) at B3 and LCDX10 (leveraged loan index, Series 10) at B2.
Credit Linked Notes – DJCDX <CORP> <GO> Funded versions of the High Yield CDX Index
The CDX high-yield index Although not as liquid, the CDX.NA.HY index is also available in funded form, using a
is also available in Special Purpose Vehicle structure. These investment vehicles are a type of Credit
funded form Linked Note. Investors who would not otherwise invest in derivatives can gain
exposure to the credit default swap market, because they require no ISDA contracts and
operationally work in the same manner as trading in cash bonds. Since the notes
incorporate an interest-rate swap, they effectively add interest rate exposure (through
the swap rate) to the CDS spread, to replicate the price movement of a fixed rate bond.
40
Liquidity is significantly lower in funded indices versus their unfunded counterparts.
40
Although the definition of a Credit Event is the same for the CDX HY unfunded and funded products, there is a difference in settlement
mechanics. The unfunded index is technically physically settled, although in practice most counterparties have agreed to cash settle. By
contrast, the funded note settles through a three-part dealer auction. Investors in the funded note receive a cash settlement price based on the
auction results. This leaves the investor exposed to basis risk between the funded and unfunded versions of the indices.
Figure 38. CDX.NA.HY Series 10 Trades in Both Funded and Unfunded From
Version Issuer CUSIP Coupon (%) Maturity Price Movements
Unfunded - - 5 20-Jun-13 Spread Only
Funded CDX HY 10 T 12514TAA8 8.875 20-Jun-13 Spread + Swap Rate
To view details regarding the unfunded CDX HY index on Bloomberg, type CDX10 CDS <Corp> <Go>, then select the corresponding index.
To view details regarding the funded CDX HY index on Bloomberg, type DJCDX <Corp> <GO>, then select the corresponding issuer,.
Sources: Bloomberg; Banc of America Securities LLC estimates.
Figure 39. Actual Present Value of Single-Name CDS Versus Estimated Present Value
Ignoring Convexity
Based on a notional of $10 million
For five-year CDS, the spread on Goodyear is 330 bps and the spread on Beazer Homes
is 1075 bps. This produces an average spread of 703 bps. Notice, however, that the
average present value is $2,380,549. Converting this back to spread gives an implied
41
spread for the portfolio (intrinsic spread) of just 651 bps. 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, take a DV01 weighted-average of the underlying spreads. In this example, the DV01-weighted average is ( 330
x 4169 + 1075 x 3149 ) / (4169 + 3149 ), or 650 bps. Also, note that Beazer Homes trades as 18 points upfront + 500 bps running. We show
the equivalent running spread of 1075 bps for illustrative purposes.
Figure 40. Including convexity reduces the actual intrinsic spread to 651 bps. The
greater the dispersion of credit spreads within an index, the greater the effect of
convexity.
20 Average: $47mm
Standard Deviation: $120mm
Percent of days (%)
15
10
0
-70 -50 -30 -10 10 30 50 70 90 110 130 150 170
Actual IG Hedge ($mm) to offset $10mm CDX HY
On-the-run indices.
Source: Banc of America Securities LLC estimates.
For example, Figure 41 illustrates the realized hedge ratio between CDX IG
(investment grade) and CDX HY (high yield), using weekly data between January 2006
and April 2008. On average, $47 million of investment grade protection was needed to
offset $10 million of high yield index exposure. However, on any given day, the hedge
ratio ranged from –$60 million to $180 million. As such, investors should understand
that P&L between two indices is unlikely to be fully hedged on any particular day.
Instead, look for P&L to average out over time. Indeed, in 2007, some investors were
stop-lossed out of CDX IG—HVOL pair trades amid substantial mark-to-market
42
losses.
42
Moreover, just because a particular hedge ratio was realized historically does not mean it will be realized in the future. Past performance is not
indicative of future results.
A complicating factor in index vs. intrinsics relative value is that single-name CDS and
the indices have different durations. To adjust for this risk, in 2008, index arbitrage
investors have begun to adjust the notionals of single-name CDS, to keep them DV01-
neutral to the overall index.
Consider an investor who bought protection on an index and sold protection on each
underlying constituent in single-name CDS, notional-neutral. Although the investor
43
would be hedged against Credit Events, he would be exposed to some duration risk,
because the coupons of single-name CDS differ from the fixed coupon of the index.
For the CDX HVOL Series 10 index, Figure 42 shows the difference in DV01 of
single-name CDS, relative to the DV01 of the single-name using the index coupon, as
44
of April 2008. Consider Radian, which trades at 16 points upfront + 500 bps running
in single-name CDS, and has a DV01 of $3,180 per $10mm notional. But at the index
strike of 350 bps (a deeper discount), the DV01 would fall to $2,999 per $10mm
notional.
In general, for wide-spread credits, single-name CDS has a higher DV01, because it
trades at a higher dollar price than the same single name struck at the index coupon.
For tight-spread credits, the single name struck at the index coupon has a higher DV01,
because it trades at a premium.
43
Assuming a Bankruptcy or Failure to Pay. In the event of a Modified Restructuring (“MR”), the investor would lose money if he sold single-
name CDS or make money if he bought single-name CDS. The reason is that Modified Restructuring is a Credit Event in single-name CDS
(for selected Reference Entities), but not in the CDX indices. For iTraxx, Modified-Modified Restructuring (“MMR”) is a Credit Event for
both single-name CDS and the indices, so payments would cancel out, similar to a Bankruptcy or Failure to Pay in CDX. For more on
Restructuring clauses, please see “Restructuring Alternatives” on page 153.
44
For our analysis, we assume that all single names where 5y CDS trades wider than 700 bps trade in points upfront + 500 bps running. We
assume that all other single names trade at par (all running spread).
Figure 42. DV01 Calculated Using Single Name Strike, 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 5 Tightest
0.2
0.0
-0.2
-0.4
-0.6
MBIA
SFI
DRI
WY
CTL
RDN
FON
MDC
FO
CIT
The DV01 differential from Figure 42 suggests that notional-neutral index arbitrage
leaves an investor exposed to mark-to-market risk. For example, consider an investor
who sells single-name protection and buys index protection, and then Fortune Brands
(FO) widens, sending the overall index wider. For Fortune Brands, the CDS at the
index strike has a higher DV01 than at the single-name strike. As such, 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.
Hedging the DV01 Mismatch
In 2008, investors have been hedging DV01 mismatch between the index and
underlying single names, by adjusting the single-name notional. Based on Figure 42,
Figure 43 shows the adjusted notional for single names, to give them the same DV01 as
the single name struck at the index coupon (350 bps for HVOL10).
5 Widest 5 Tightest
11.5
11.0
Notional ($ Millions) 10.5
10.0
9.5
9.0
8.5
8.0
MBIA
CTL
KSS
DRI
SFI
CIT
FON
MWV
RDN
FO
As of April 11, 2008.
Source: Banc of America Securities LLC estimates.
For wide spread credits, single-name CDS has a higher DV01 than the single name
struck at the index coupon. To make the DV01s the same, the investor sells protection
on a lower single-name CDS notional.
After applying the DV01 neutral notionals to each name, calculate the underlying
intrinsics. Since the whole point of index arbitrage is that the intrinsics differ from the
index, the overall intrinsics (even after applying the DV01 neutral notionals) will have
a different duration from the index. For example, if the intrinsics are 295 bps versus the
index at 280 bps, Figure 44 shows the difference in overall DV01s. As such, Figure 45
scales the total notional of intrinsic protection (in the same proportions as Figure 43), to
keep the overall DV01s the same between intrinsics and the index.
133 312
310
($ Thousands Per $300mm)
Index or Intrinsics DV01
132 308
Notional ($ Millions)
306
131 304
302
130 300
298
129 296
CDX HVOL Index CDX HVOL Intrinsics Index Notional Total Intrinsics Notional
Jump-to-Default Risk
After hedging out DV01 risk, the investor is left with potential risk following a Credit
Event. Recall that, in DV01 neutral index arbitrage, an investor uses less notional on
wide-spread single names. As such, if an investor sells protection on single-name CDS,
and buys protection on the index, he will have net bought protection on the credit. This
will leave him with positive P&L for a wide-spread credit post-Credit Event.
Figure 46 shows a more complete jump-to-default payoff profile:
Index Rolls
Approximately every six Approximately every six months (March and September), the indices roll to a new on-
months, the indices roll the-run version. This results in a “roll,” or difference in spread between the old and
to a new on-the-run new on-the-run indices. We estimate the roll in three parts: (1) the change in credit
version quality, (2) an adjustment for intrinsics trading with Modified Restructuring, but the
index trading with No Restructuring, and (3) a six-month maturity extension.
For example, consider the roll between IG9 and IG10 in March 2008. Eight credits
dropped out of the on-the-run CDX IG index. Figure 47 shows the details. Notice that
credits being added to the index traded at a tighter spread than credits being deleted,
which should reduce the overall IG10 index spread:
Mid Mid
Deletions (bps) Additions (bps)
Comcast Cable Communications LLC 200 Black & Decker Corp 207
IAC/InterActiveCorp 275 MDC Holdings Inc 210
Belo Corp 400 Comcast Corp 210
Pulte Homes Inc 435 Viacom Inc 220
Jones Apparel Group Inc 460 Kohl's Corp 220
Centex Corp 570 Brunswick Corp/DE 326
Countrywide Home Loans Inc 730 Masco Corp 340
Lennar Corp 740 New York Times Co/The 390
Sources: CDX; Bloomberg; Banc of America Securities LLC estimates.
When performing this analysis, we assumed the same basis between intrinsics
(underlying single-name CDS components) and the index, for IG9 and IG10. More
realistically, we expected that a portion of index shorts (with buy protection positions)
would want to roll to the Series 10 (new) index, as a way to both reduce carry and,
perhaps more importantly, maintain maximum liquidity. To execute the roll, these
investors needed to sell protection on Series 9 indices (driving spreads tighter), and buy
protection on Series 10 indices (driving spreads wider). This would tend to reduce the
roll versus the estimate in Figure 48.
Mid
Description (bps)
IG9 Intrinsics to 20 Dec 12 198
IG10 Intrinsics to 20 Dec 12 187
Credit Quality Roll -10.8
To December 20, 2012, the maturity date of the five-year IG9 index, IG9 intrinsics
were 198 bps, compared to IG10 intrinsics at 187 bps. That is, solely due to improved
credit quality, the IG10 index should trade 10.8 bps tighter than IG9. However, single-
name CDS trades with Modified Restructuring, while the CDX indices trade without
Restructuring. To assess this factor, we used a 2% haircut, bringing the roll to –11 bps.
That is, based solely on credit quality, our estimate was that Series 10 IG should trade
11 bps tighter than Series 9.
Next, there is a six-month maturity extension for rolling from December 2012 to June
2013. Since investment grade credit curves were flat around the roll date, the effect of
the maturity extension was negligible.
Adding up the credit quality, Modified Restructuring vs. No Restructuring, and
maturity extension components suggested that Series 10 IG should trade 11 bps tighter
than Series 9. We also thought that a short base in IG9, rolling to IG10, would result in
IG10 trading cheaper to intrinsics, reducing the roll. The actual roll was IG10 trading 5
bps tighter than IG9.
Special Issues for HY Index Rolls
Since the high yield index trades in dollar price, an investor also must consider the
In high yield, also coupon differential between the old and new indices, to estimate the roll. For example,
consider the coupon suppose that a new on-the-run high yield index should trade 40 bps wider than the old
differential between the index. If the old index trades at par and the coupon on the new index is set 40 bps wider
old and new indices than the old index, the roll should be $0. This is because, with both indices trading at
par, the spread differential will be 40 bps.
For most HY rolls, the roll trades cheap to the methodology in Figure 48. For example,
we estimated a fair value roll of 40 bps ($2 5/16) from HY8 to HY9, versus an actual
roll of 60 bps ($1 1/2). We think this difference is largely due to lower liquidity of HY
underlyings, as compared to IG.
the index coupons at various maturities. The median of these spreads rounded up to the
nearest 5 bps will be the fixed rate for the new index.
CDS Operations
In general, to trade in credit derivatives, an investor must have an ISDA Master
Agreement in place, and a Bank of America, N.A. (for illustrative purposes only) credit
officer must approve a credit line. Credit exposure is granted in a risk equivalent. For
example, a $10 million credit line refers to the total allowable risk of a Counterparty,
not a notional number.
Main Documents
The new credit derivatives investor should be familiar with five main documents:
1. 2003 ISDA Credit Derivatives Definitions, which form the standard language for
CDS transactions.
2. ISDA Master Agreement. This agreement is negotiated between Bank of America,
N.A. (in this example) and a Counterparty to ensure enforcement of the CDS
confirmation document. It is negotiated only after Credit approves a Counterparty.
3. Schedule, which may replace part of the language on the ISDA Master Agreement.
The schedule has several parts:
X Termination provisions
X Tax representations
X Agreement to deliver documents
X Miscellaneous (such as addresses for correspondence)
X Other provisions (waiver of right to trial by jury, disclosure)
X Additional terms for foreign exchange
4. Credit Support Annex. This document is optional. Its main purpose is to pre-
determine when, and in what increments, margin requirements are due (initial
margin, variation margin, and threshold amounts). The text is much more account-
specific than the ISDA Master Agreement and Schedule.
5. Confirmation (Master and Long formats). The “Master” confirm is also called the
“Short” form. Confirms may note a CUSIP, which refer to the Reference
Obligation of the Reference Entity. Language is relatively standard.
Required Documentation
A hedge fund typically must submit the following documentation to begin the ISDA
process:
X Two years of audited financial statements
X Fund offering memorandum
X Monthly NAV (returns) since inception
45
http://www.markit.com/information/products/metrics.html
Give-Ups
“Give-ups” allow a It is sometimes possible for a Counterparty to trade in credit derivatives without an
Counterparty to trade in ISDA Master Agreement. This process is called a “give-up” and requires that (1) a
CDS without an ISDA Counterparty have prime brokerage service and (2) the Counterparty’s prime broker
Master Agreement has an ISDA Master Agreement with Bank of America, N.A. (for illustrative purposes
only).
In a give-up, Bank of America, N.A. and the Counterparty’s prime broker negotiate an
agreement that allows a client to trade. After a client states that he would like to
execute a trade, Bank of America, N.A. sends a request to the client’s prime broker. If
In a give-up, Bank of approved, Bank of America, N.A. faces the client’s prime broker as a Counterparty.
America, N.A. faces the The prime broker then faces the client in a separate trade. Figure 56 and Figure 57
client’s prime broker (not the compare a normal trade with a give-up:
client) as a Counterparty
46
http://www.newyorkfed.org/newsevents/news/markets/2008/an080327.pdf. “RED” denotes Reference Entity Database, which comprises a list
of standardized Reference Entities for CDS transactions.
47
Preliminary results of ISDA 2008 Operations Benchmarking Survey, and ISDA 2007 Operations Benchmarking Survey, available from
http://www.isda.org.
500 bps
running
Protection
Client's Counterparty Client's Counterparty
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
In a typical give-up agreement, the client’s prime broker will specify a credit line for
the client. The trade is automatically approved unless the prime broker declines the
trade within a pre-specified period of time; for example, within two hours. If the prime
broker declines the trade, the client remains responsible for any associated unwind
costs. For example, if a client sells CDS protection and spreads widen by the time a
prime broker declines a trade, the client will owe Bank of America, N.A. money for
unwinding the transaction. Should a client sell CDS protection and spreads tighten by
the time a prime broker declines a trade, the client will not receive the mark-to-market
gain.
Some investors with ISDA Some clients with ISDA Master Agreements prefer to trade CDS with give-ups, rather
Master Agreements than do new trades, because of more favorable margin requirements at the prime
prefer to trade CDS with broker. This reason for lower margin is that the prime broker should have a better sense
give-ups of a client’s overall risk profile than one particular dealer. So in return for lower
margin, the client may be willing to pay a per-trade give-up fee to the prime broker.
Since all give-ups transact through the prime broker, the client may incur significant
Counterparty risk; i.e., the risk of a Credit Event at the prime broker.
Counterparty Risk and Leverage
As an unfunded market, CDS market participants promise to exchange cash flows
following a potential Credit Event. There are no hard assets set aside to guarantee
payment. As such, should the protection Seller default on his obligation to pay the
required cash flows post-Credit Event, the protection Buyer simply becomes a general
48
creditor of the protection Seller.
Initial Margin
To reduce Counterparty risk, Counterparties are required to post collateral (margin). As
of year-end 2007, ISDA estimates that there was approximately $2.1 trillion in
48
For the United States. In Europe, credit default swaps may have a different seniority post-Bankruptcy.
collateral in circulation, up from $1.3 trillion in each of 2006 and 2005. These numbers
49
are across all derivatives transactions, not just credit derivatives.
There are two types of margin, initial and variation. Initial margin is based on both risk
of a particular trade and Counterparty creditworthiness. All Counterparties will pay
higher margin to sell protection at 500 bps than 200 bps. Regardless of spread, high-
risk Counterparties will pay more margin than low-risk Counterparties. Generally, only
50
hedge funds are required to post initial margin, and only when they sell protection.
For instance, suppose that a dealer believes it would take approximately two weeks to
discover that a Counterparty were no longer creditworthy, decide to unwind that
Counterparty, obtain the necessary approvals, and effect an unwind. Initial margin then
would reflect the dealer’s expected loss over a two-week period, with respect to that
Counterparty’s portfolio. 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.
The example in Figure 58 assumes that a dealer believes spreads could double during
the forced unwind period, with a loss of 8.2 points. The dealer scales that potential loss
by 80%, to reflect a lower likelihood of the Counterparty defaulting. Initial margin is
then 6.6 points (8.2 points potential loss x 80% scaling factor).
49
ISDA Margin Survey 2008, available from http://www.isda.org.
50
Although other investors may not be required to post initial margin, this is in part because the Counterparty is usually satisfied that investors’
internal regulations require the holding of (internal) reserves. Separately, hedge funds may be required to post initial margin when they buy
protection on wide-spread or risky credits (for example, wider than 500 bps), to reduce the risk that a hedge fund may not be able to meet
variation margin requirements.
Scenario
where
dealer
believes
spreads
could
double
Initial during
Spread potential
forced
unwind
period
Importantly, initial margin requirements assume that a Counterparty will not default at
the same time as a potential Credit Event. If a Counterparty and a Reference Entity
were to file for bankruptcy at about the same time, losses would be significantly higher.
For example, at 40% recovery, losses would be 60% of notional, far higher than the
6.6% collected in Figure 58.
Counterparties who share a greater portion of their portfolio with a particular dealer
may face better margin requirements because of offsetting risk. For example, suppose
that one hedge fund sells protection exclusively through one dealer but buys protection
exclusively to another dealer. That hedge fund will face relatively high margin
requirements on its sell-protection trades, because the relevant dealer will believe the
hedge fund is exclusively long risk. By contrast, a different hedge fund that has more
balanced sell- and buy-protection trades through dealers may face better margin
requirements, because dealers will be aware that the hedge fund’s portfolio is more
balanced.
Leverage
Since initial margin is significantly less than 100%, protection Sellers are able to
employ leverage. In principle, at 10% margin, a protection Seller is able to leverage
10x (1 / 10%). Figure 59 illustrates sample leverage that CDS protection Sellers may
use. Many investors hold additional, internal reserves, so actual leverage is likely to be
significantly lower.
Figure 59. Sample Leverage that Protection Sellers May Employ in Credit Derivatives
Leverage Estimated as 1 / Margin Requirement
Variation Margin
The second type of margin is variation margin. This type of collateral accounts for mark-
to-market P&L and is set in the Credit Support Annex, or “CSA,” discussed in the
operational overview on page 65. If an investor suffers mark-to-market losses beyond a
pre-established threshold, he is required to pay variation margin. For example, the
threshold may be zero for a higher-risk Counterparty and several million dollars for a
lower-risk Counterparty. These payments may be reimbursed, if the investor
subsequently realizes mark-to-market gains. All types of Counterparties, regardless of
whether they buy or sell protection, are subject to variation margin requirements.
Required Collateral
Required collateral is billed in cash (for example, $100,000), but may be posted with
securities at a certain ratio. For example, an investor may be allowed to post five-year
maturity Fannie Mae or Freddie Mac securities at a ratio of 98%. This means that, for
every $100,000 in required collateral, the investor must post $102,041 face value of
securities ($100,000 / 98%). Posted collateral earns interest at the Federal Funds rate.
Marks
As part of the margin process, CDS investors receive marks for outstanding trades.
51
Generally, marks are supplied via website at a pre-established frequency (e.g., daily).
51
Some investors also choose to purchase third-party data. Markit Group Ltd is one popular third-party data provider, although this should not
be construed as a recommendation.
Termination Events
If a Counterparty breaches any one of “termination event” criteria specified in the
ISDA Master Agreement, the other party may force an unwind of all existing trades.
Among the criteria are:
X Bankruptcy of the Counterparty
X Failure to Pay required payments, such as coupons or margin
X An event beyond a party’s control, such as a circumstance that makes it unlawful to
continue the CDS contract
X Note that Counterparties also may agree to an additional termination event based
on a material ratings downgrade; for example, to high yield or triple-B
Following a forced unwind, Counterparties are required to exchange the net P&L at
current marks (a “close-out” amount). The non-defaulting party may obtain marks from
53
third-party dealer quotes, or if such information is not available, an internal model.
The non-defaulting party must supply details of its calculations to its Counterparty.
The close-out amount is calculated on the same day for all types of trades covered by
the ISDA Master Agreement—for instance, credit derivatives, equity derivatives, and
interest rate derivatives. The net close-out amount across all products is offset against
any collateral (margin) held by the non-defaulting party. If there is any collateral
shortfall, payment may be due as soon as the same business day.
As one might imagine, practically, implementing this process may prove difficult and
disruptive, and is one reason why the CDS market is working on the development of a
clearinghouse, discussed below.
52
ISDA Master Agreements often are based on standardized 1992 or 2002 forms, as published by the International Swaps and Derivatives
Association, Inc. (ISDA).
53
This is just one method for determining a close-out amount. The actual method used depends on the ISDA Master Agreement. For example, in
the 1992 ISDA Master Agreement, 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), for replacement trades with identical terms to the trades being terminated. The close-out amount is based on an
average of these quotes, or if no quotes are obtained, then (ii) use internal models or third-party quotes, including costs such as terminating
hedges and funding. In some cases, (ii) may be chosen as the initial method. The 2002 ISDA Master Agreement specifies a combination of the
two approaches from the 1992 ISDA Master Agreement.
54
For the United States. In Europe, credit default swaps may have a different seniority post-Bankruptcy.
55
The allocation of losses applies only if a member of the clearinghouse were to fail. If a member (for example, a bank or broker-dealer)
processes a trade for a non-member (for example, a medium-sized hedge fund), that member would be responsible for all losses attributed to
Counterparty exposure. In its early stages, this proposal may take effect for a small
number of trades, among a small number of counterparties, toward the end of 2008.
Exchange-Traded CDS
Currently, essentially all CDS trading volume is over-the-counter, but it is possible to
trade credit default swaps on an exchange, with the exchange as a Counterparty.
Broadly speaking, exchange-traded CDS is a fixed recovery swap that trades in
present-value terms. For example, rather than paying 100 bps running for five years,
the protection Buyer makes a single up-front payment for the present value of the swap.
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. Figure 60
summarizes the major features of exchange-traded CDS versus over-the-counter CDS.
the non-member. In the extreme case, if such losses were to cause the clearinghouse member to fail, such losses could be allocated among
remaning clearinghouse members.
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
before the December 20 roll, the first coupon will be on March 20. At that time, the
56
protection Buyer will pay a coupon for four months (November—March).
The last coupon period will include the Scheduled Termination Date (maturity), and
runs from March 20, 2015 to (including) June 20, 2015. However, if a Credit Event
occurs, the protection Buyer must pay accrued interest up to and including the Event
Determination Date (usually the same day as the Credit Event, or the next Business
Day). Then coupon payments will stop and the Counterparties must settle the contract.
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, N.A. (for example) at 680 bps. On
$4 million notional, Bank of America, N.A. must pay $531,240 to execute the trade:
56
The reason for a long first coupon dates to earlier years of CDS, when Counterparties settled trades by facsimile and agreed upon quarterly
coupon payments by spreadsheet. The market needed time to complete these tasks and therefore moved to a long first coupon one month
before a roll.
Attached to the trade recap are the calculations for the $531,240 unwind fee, shown in
Figure 63:
Notional
Dates
Unwind
Spread
Original
Spread
Unwind
Effective
Date
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, N.A. (for example) at 50 bps. On
$8 million notional, the client will receive $109,796. This is because Bank of America,
N.A. buys protection at 50 bps, but will only pay 20 bps running to the original
(“Remaining”) Party. Bank of America, N.A. 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, less accrued interest, for a total of
$109,796.
Attached to the trade recap are the calculations for the $109,796 assignment fee, shown
in Figure 65:
Notional
Dates
Original Assign-
Spread ment
Spread
Paid by
Buyer
occur before the assignment backlog is completed, the Remaining Party may contact
the wrong Counterparty for payment. Moreover, should either the Transferor or
Transferee file for Bankruptcy, the Remaining Party may not know its exact credit
exposure for some time.
In September 2005, the Federal Reserve and 14 dealers met to discuss risks to the credit
derivatives market. On October 24, 2004, the 2005 Novation Protocol took effect for
the CDS market. This Protocol requires the following:
The Transferee must receive consent from the Remaining Party by 6pm, in the location
The 2005 Novation of the Transferee, on the day an assignment is agreed to. If the Transferee does not
Protocol requires that the receive consent by 6pm, the assignment will instead be booked as a new trade. That is,
Transferee receive instead of the mechanics of Figure 90, the trade would follow Figure 89.
consent by 6pm on the
trade date. Otherwise, The 2005 Novation Protocol is interpreted as an amendment to the ISDA Master
the assignment will be Agreement and is irrevocable. Clients who do not participate in the Protocol must
booked as a new trade obtain permission from the Remaining Party before attempting to assign (also called
“novate”) a trade.
As part of the 2005 Novation Protocol, below is a sample e-mail or Bloomberg
message from the Transferor to the Remaining Counterparty, required to execute an
assignment. In a March 2008 letter to the Federal Reserve, dealers stated plans to
implement a way for novation requests to be submitted by electronic platform, rather
57
than e-mail, beginning in late 2008.
57
http://www.newyorkfed.org/newsevents/news/markets/2008/an080327.pdf.
We have agreed with the proposed Transferee to the transfer by novation of the transaction described below (the “Transaction”), subject to your consent to
such transfer.
Transferor: [ ]
Proposed Transferee: [ ]
Novation Trade Date: [ ]
Trade Date: [ ]
Novated Amount: [ ]
Please advise promptly as to your consent to the transfer by novation of this Transaction, by replying to all addressees of this email and indicating your
decision regarding consent.
Indicative sample, for illustrative purposes only.
Source: ISDA.
Give-Up
In a give-up, Bank of America, N.A. (for example) faces a client’s prime broker as a
Counterparty, as discussed on page 67. The prime broker then faces the client in a
separate trade. Give-ups may be done for margining purposes (the prime broker sees
the client’s entire portfolio, resulting in potentially lower margin) or because a client
only has one ISDA Master Agreement in place (with the prime broker, as opposed to
with each bank and broker-dealer). Figure 66 shows a sample trade recap.
Figure 66. Sample Trade Recap for a Give-Up
Notice of Publicly Available Must contain a copy of the relevant Publicly Available Information
Information
Sources must be internationally recognized, 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.
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], when [Reference Entity] filed a petition for voluntary Chapter 11
protection in the U.S. Bankruptcy Court in the [applicable bankruptcy court] (the
“Bankruptcy Filing”).
This letter also comprises our Notice of Publicly Available Information with respect to
this Credit Event. Accordingly, we provide the Publicly Available Information attached
hereto.
Nothing in this letter shall be construed as a waiver of any rights we may have with
respect to the Transaction(s).
Sincerely,
Bank
_______SAMPLE_______
Name:
Title:
ANNEX A
Scheduled Fixed
Trade Effective Floating Rate
Bank Reference Number Termination Rate Index
Date Date Payer
Date Payer
[Date]
[Counterparty Address and Contact Information]
[Non-Party Calculation Agent Address and Contact Information]
Outstanding Principal
Balance to be
Issuer Coupon Maturity CUSIP ISIN Delivered 58
USD
USD
USD
Sincerely,
Bank
_______SAMPLE_______
Name:
Title:
ANNEX A
Fixed
Effective Scheduled Floating Rate
Bank Reference Number Trade Date Rate Index
Date Termination Date Payer
Payer
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. This notice assumes all Deliverable Obligations will be denominated in USD.
Single-Name CDS
Figure 68 shows a sample single-name CDS trader run. Notice that the bid-offer spread
is 20 bps for a standard five-year maturity (in this case, 6/20/2013), usually the most
liquid part of the CDS curve. In this case, the bid-offer spread widens to 30 bps for
shorter-dated maturities (6/20/2010).
Keep in mind that this example is for a relatively widespread credit (475/495 bps in
five-year CDS). For investment grade credits, the bid-offer spread is typically 4 bps to
10 bps in five-year CDS.
CDX Indices
The CDX indices are available on Bloomberg at CDSI <GO> or CDX10 CDS <Corp>
<GO> (CDX9 for Series 9, CDX8 for Series 8, etc.). To use the customized CDSW
screen, select one of the indices (or sub-indices) and type CDSW <GO>.
The Reference Entity composition of the selected index or sub-index may be viewed on
Bloomberg by typing MEMB<GO>, after selecting the relevant index. Alternatively,
on the CDSW (“Credit Default SWap”) screen, click the red “Members” icon.
Figure 69 illustrates a sample trader CDX.NA.IG Series 10 run. The rows denote the
maturity (June 20, 2013 for 5Y and June 20, 2018 for 10Y). The bid-offer spread is 1
bp in 5Y IG and 2 bps in 10Y.
Prior to the credit crunch beginning summer 2007, bid-offer spread was approx 0.25 bp
in IG, 0.50 bp in HVOL, and 3 bps in HY.
Keep in mind that because the CDX indices are composed of credit default swaps, the
pricing convention is reversed from the cash market for investment grade. That is,
when quoted in spread, the bid is lower than the offer.
Figure 70 shows the relevant CDSW screen for an investor who sells IG10 (Investment
Grade index, Series 10) protection at 102 bps (dealer bids 102 bps). Since the index
trades with a fixed coupon of 155 bps, the protection Seller pays $256,560 upfront
(based on a $10 million notional) and receives 155 bps running. This is different from
single-name CDS, where the fixed coupon usually equals the running spread (i.e., at
inception, single-name CDS usually trades at par).
Notional
Sell
Coupon Protection
At 102
Settle bps
Paid by
Seller
Sources: Bloomberg; Banc of America Securities LLC estimates.
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). Since the indices
trade in dollar price, and price and spread are inversely related, the bid is higher than
the offer in spread terms. That is, an investor may buy the CDX HY Series 10 index at
$96 7/8 in dollar price or 582 bps in spread.
Figure 71. Bloomberg Screen of Sample CDX.NA.HY and LCDX.NA Trader Run
CDS Rolls
Every three months, To help make execution straightforward, credit default swaps have standardized
single-name CDS “rolls” maturities. For example, a “five-year” trade executed on April 1, 2008 matures on June
to a new standard 20, 2013, which is just over five years. Every three months, single-name CDS “rolls” to
maturity date a new standard maturity date. The CDX indices roll every six months:
Figure 72. New Maturities for CDX Indices, versus Single-Name CDS
Roll Occurs on the 20th Day of the Month
New Maturity
Month of Roll CDX Indices Single-Name CDS
March June June
June No Roll September
September December December
December No Roll March
Single-name CDS rolls on March 20th, June
20th, September 20th,and December 20th. CDX IG, HVOL, and XO roll on March 20th and September
20th. CDX HY rolls on March 27th and September 27th. LCDX rolls on April 3rd and October 3rd. For more details, please see Figure 74.
Source: Banc of America Securities LLC estimates.
For single-name CDS, this results in a potential mismatch between actual and quoted
maturities, as detailed in Figure 73:
Figure 73. Don’t Be Confused by Market Convention
March 20, 2008 Roll Date
On the roll date, “five-Year” CDS matures in 5.25 years. “4.75-Year” CDS matures in 5 years.
That is, on the roll date, “five-year” CDS actually matures in 5.25 years. Over the
following three months, single-name CDS rolls down from 5.25 years to 5 years (center
column of Figure 73). But by CDS market convention, this is referred to as rolling
down from the “5 year” point on the curve to the “4.75 year” point on the curve (far
right column of Figure 73).
Typically, investors roll to maintain liquidity; that is, the on-the-run five-year contract
Typically, investors roll to is usually the most liquid point on the credit default curve. Other investors sell 7-year
maintain liquidity credit default protection and let their contracts roll down to the 5-year point on the
curve, at which time they look to unwind contracts. For more on CDS rolls, please see
the Chapter Appendix on page 113.
No Roll
10,000 June 0.50 N/A 80 116 151 -40 111 2.2%
Sources: Bloomberg; Banc of America Securities LLC estimates.
Buyer of Protection Rolls, With All Spread Widening Occurring After the Roll
In the first scenario, CDS stays constant at 80 bps over the first three months. As such,
the investor earns zero principal over the first three months, but pays $20,000 in carry
(80 bps x $10 million notional x 0.25 years).
The roll costs the investor 4 bps. Mechanically, the investor unwinds the original trade
at 80 bps, and enters into a new trade at 84 bps. A new confirm, not an amendment to
the original confirm, is issued. Accordingly, the roll increases the cost of carry to 84
bps per annum.
Figure 76 shows the CDSW screen that an investor would use to project profit on the
new trade, assuming that 5-year CDS will widen to 120 bps. The investor would earn
$159,000 in principal, as shown in the “Principal” line of Figure 76 (toward the
bottom-left). The investor also pays $21,000 in carry (84 bps x $10 million notional x
0.25 years).
To project forward P&L, the effective date is one calendar day (T+1) following the roll.
th
Since the investor rolls on June 20 , the new trade would be effective on June 21, 2008
and mature September 20, 2013. Lastly, the valuation date (toward the bottom-left) is
the date on which the investor expects to unwind the trade, in this case September 20,
2008.
Effective
Date of
New
Trade Current
Market
Maturity Spread
of New
Trade
Strike of
New
Trade
Expected
Unwind
Date
Over the six-month life of the trade, the investor earns $118,000 ($159,000 principal –
$20,000 carry in the first three months – $21,000 carry in the second three months).
The total return is 2.4% ($118,000 / $10 million notional / 0.50 years).
Buyer of Protection Rolls, With All Spread Widening Occurring Before the Roll
The middle section of Figure 75 shows the scenario in which protection still widens to
120 bps, but now all spread widening occurs before the roll. In this case, the investor
still earns $159,000 principal, but in two parts. Over the first three months, CDS
widens from 80 bps to 120 bps, resulting in a principal gain of $176,000. Then, a 4-bp
roll means that the investor enters into a new contract at 124 bps. With credit quality
constant, this contract rolls down to 120 bps over the second three months, resulting in
a $17,000 principal loss.
The main difference between the first two scenarios lies in the cost of carry. In the first
scenario, where spreads widen after the roll, carry is 80 bps ($20,000) during the first
three months and 84 bps ($21,000) during the second three months. In the second
scenario, where spreads widen before the roll, carry is the same 80 bps ($20,000)
during the first three months, but increases to 124 bps ($31,000) during the second
three months.
Lower carry reduces net P&L from $118,000 in the spreads-widen-after-the-roll
scenario, to $108,000 in the spreads-widen-before-the-roll case. Returns are 2.4% and
59
2.2%, respectively.
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, the investor unwinds a 4.75-year
contract after three months. In this case, there is a tradeoff for P&L:
The investor does not increase the cost of carry by the 4-bp roll, which benefits P&L.
However, since CDS has a three-month shorter maturity than the on-the-run contract,
spreads only widen to 116 bps, not 120 bps. Moreover, since CDS rolls down from 5-
to 4.75-years, the duration shortens. This reduces P&L from spread widening. Rather
than earning $158,000 in principal (roughly calculated as 36 bps spread widening, from
84 bps after the roll to 120 bps, x 4.319 duration), the investor earns $151,000 (roughly
calculated as 36 bps spread widening, from 80 bps to 116 bps, x 4.143 duration).
Net P&L is therefore $111,000 ($151,000 principal – $40,000 carry). This results in a
return of 2.2% ($111,000 / $10 million / 0.5 years).
Overall Tradeoff for the Buyer of Protection
Overall, there is a tradeoff between carry and duration. If an investor rolls, he pays a
For protection Buyers, higher cost of carry (the roll fee) but keeps a roughly constant duration. If an investor
rolls result in a tradeoff does not roll, he saves the roll fee, but suffers from a progressively shortening duration.
between carry and In addition, the investor risks reduced liquidity by not maintaining an on-the-run
duration contract.
59
The annualized return is calculated as $118,000 net P&L / $10 million notional / 0.50 years (first scenario) or $108,000 net P&L / $10 million
notional / 0.50 years (second scenario).
No Roll
10,000 June 0.50 N/A 80 36 190 40 230 4.6%
Sources: Bloomberg; Banc of America Securities LLC estimates.
Notice that, for spread tightening scenarios, the protection Seller does at least as well
In spread tightening by rolling to a new on-the-run contract. This is both because the investor receives a
scenarios, protection premium for rolling (in this case, 4 bps) and because duration extends.
60
40 25%
30 20%
20 15%
10 10%
0 5%
1 2 3 4 5 0%
Tenor (Years) Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
5y Implied Probability of Default is based on Par CDS Equivalent Spread to LIBOR for Baa-rated
Assumes flat credit curve and 40% recovery rate. cash bonds (not CDS) in the Banc of America Securities High Grade Broad Market Index,
Source: Banc of America Securities LLC estimates. Assumes flat credit curve and 40% recovery rate.
5y Realized Default Rate and 5y Long-Term Average Default Rate (1920-2007) obtained
from Moody’s Investors Service, “Corporate Default and Recovery Rats, 1920-2007,”
February 2008.
Sources: Moody’s; Banc of America Securities LLC estimates.
Implied default Naturally, the market prices factors other than default risk into pricing, such as liquidity
probabilities trade wide and mark-to-market risks. The implied probability of default extracted from CDS
to historic default rates spreads includes these other factors. As Figure 78 suggests, investors should realize
61
If there is a default, the Seller of protection loses notional minus recovery. This is because the protection Seller owes notional on the CDS
contract but receives a bond from the protection Buyer. The likelihood that this event will occur is simply the probability of default.
62
At longer horizons, the probability of default is 1 – exp( -[ Spread ] / [ 1 – Recovery ] x [ Horizon ] ). For example, with a CDS spread of 800
bps and an expected recovery rate of 40%, the five-year implied probability of default is 1 – exp( – 0.08 / ( 1 – 0.4 ) x 5 ), or 49%.
that the actual probability of default is typically far lower than that implied by CDS
63
spreads.
20
13.9
15
10
P&L (Points)
5
0
-5 -2.3
-10
-15
-20 -16.2
Buy 400, Unwind 800 Buy 800, Unwind 400 Net
“Buy 400, Unwind 800” discounted at L + 800 / ( 1 – 40% Recovery Rate).
“Buy 800, Unwind 400” discounted at L + 400 / ( 1 – 40% Recovery Rate).
Sources: Bloomberg; Banc of America Securities LLC estimates.
63
For near-distressed credits, the implied probability of default becomes more meaningful because default risk starts to dwarf liquidity and
mark-to-market risk factors.
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>.
Sources: Bloomberg; Banc of America Securities LLC estimates.
In Figure 81, an investor executes a CDS trade at 100 bps. This is the “Deal Spread”
section on the left-hand side of the screen. (Sometimes, deal spread is referred to as
“coupon” or “strike.”) Since we are analyzing the trade at inception, the current (mark-
to-market) spread is also 100 bps, as illustrated in the circled portion on the right-hand
side of the screen. Spread DV01 is shown in the “Sprd DV01” portion toward the
bottom-center of the screen. For example, at a 100-bp starting spread, a 1 bp spread
change will result in approximately $4,572 of P&L, for a $10 million notional position.
64
Cash bond investors frequently refer to this number as a duration of 4.572.
As illustrated in Figure 82, duration varies inversely with spreads. Intuitively, a 1 bp
move on a credit trading at 10 bps is more significant than a 1 bp move on a credit
trading at 1,000 bps.
64
The calculation is $4,572 DV01 / $10 million notional x 10,000. The multiplication by 10,000 occurs because DV01 refers to the change in
P&L per basis point, and a basis point is 1/10,000 of a dollar. Also note, we show a flat credit curve of 100 bps on the right side of Figure 81,
but the market is slowly moving toward using a full credit curve (different spread for different maturities), particularly in Europe.
5.00 5,000
Duration
4.25 4,250
4.00 4,000
3.75 3,750
3.50 3,500
3.25 3,250
3.00 3,000
0 100 200 300 400 500 600 700 800 900 1000
5y CDS
Source: Banc of America Securities LLC estimates.
As a rule-of-thumb, durations are approximately 4.0 – 4.5 for five-year CDS, 5.0 – 6.0
for seven-year CDS, and 6.25 – 7.75 for ten-year CDS.
65
A note regarding analytics: To adjust for the absolute level of spreads, the CDS market often looks at credit curves in percent. A higher
number means a flatter credit curve—for example, 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).
(small spread changes) and more worried about jump-to-default risk (large spread
changes, or an outright Credit Event).
For example, an investor with a bullish view may sell $10 million of five-year
protection and buy $10 million of one-year protection. The investor will be long
duration, because he sells protection on the longer duration asset (five-year protection).
This supports the investor’s bullish view. However, if the investor is wrong and the
Reference Entity suffers a Credit Event (in the first year), the investor will be hedged,
because gains on the short-maturity leg will exactly offset losses on the long-maturity
66
leg.
Butterfly Trades
With a curve trade, an investor may hedge one risk, either small spread moves (DV01-
neutral) or jump-to-default moves (notional-neutral). “Butterfly trades” combine two
curve trades to hedge both extremes. For example, an investor may sell five-year
protection and buy both three- and ten-year protection. Both the 3s/5s and 5s/10s legs
are DV01 neutral. The investor would still be exposed to moderate spread moves,
which fall between the extremes of a small, parallel curve move and outright default.
66
Assuming a Bankruptcy or Failure to Pay Credit Event. The investor may not be fully hedged following a Modified Restructuring. For details,
please see Chapter VI – CDS Case Studies and Legal Issues on page 152, especially the section “Practical Trading Considerations Following a
Restructuring” on page 157.
Sell 5y CDS
Sell 3y CDS, and then in three years, sell 2y CDS at implied forward
Implied Forward
250
200
Spread (bps)
150
100
50
0
1 2 3 4 5
Year
Assumes 40% recovery rate.
Source: Banc of America Securities LLC estimates.
An investor who believes the implied forward spread is too high may execute a curve
flattener. To do this, the investor would sell longer-dated protection and buy shorter-
dated protection. Figure 84 illustrates how to calculate the implied forward spread in
Bloomberg:
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>.
Sources: Bloomberg; Banc of America Securities LLC estimates.
Figure 85. Unprecedented Flattening (And Inversion) in CDS Curves Since Summer 2007
On-the-Run CDX IG 5s/10s Curve (bps)
40
30
Figure 86. Mechanics for a Credit Event Occurring on Effective Date of Single-Name CDS Trade
$10 Million Notional, 40% Recovery Rate, and 16.4 Points Upfront + 5% Running Coupon
Five-Year CDS
Since summer 2007, points upfront have affected the automobile, homebuilder, media,
monoline insurer, and paper sectors. For more details, please see the Chapter Appendix
on page 115.
Client Client
Unwind
CDS unwinds occur when The investor may unwind his position with the original Counterparty, as illustrated in
an investor terminates a Figure 88. To terminate the trade, unwinds are settled in present value (points upfront).
trade with the original In this case, the unwind spread is 1000 bps, and the deal (also called original, or
Counterparty running) spread is 500 bps. 1000 bps is equivalent to 16.4 points upfront plus 500 bps
running.
So, the client owes 500 bps, and the Counterparty owes 16.4 points upfront plus 500
bps running. The running coupons cancel out, so that the client simply receives 16.4
67
points upfront, less accrued interest. The original trade is then terminated.
Figure 89. A New Trade Requires Client to Post Margin… Figure 90. …An Assignment Adds Risk
Investor Sells Protection with A New Counterparty at 1000 bps Investor Sells Protection at 1000 bps, on Assignment from 500 bps
Investor faces both BANA and original Counterparty Client does not post margin. BANA faces additional risk.
16.4 points
Margin 1000 bps upfront
running Protection
Client Client
500 bps Protection
running
500 bps
running
Protection
Client's Counterparty Client's Original Counterparty
Payments are made quarterly. Payments are made quarterly.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
New Trade
To terminate a CDS trade Naturally, the original Counterparty may not always have the most favorable market. If
with a different the client instead wants to take profits through a new counterparty, one way is to
Counterparty, a new simply sell protection at 1000 bps. As Figure 89 shows, the client receives 1000 bps
trade often requires the running from the new Counterparty (BANA) and pays 500 bps running to the original
investor to post margin counterparty. The client keeps the difference, realizing profit over the remaining life of
the trade.
There are two main disadvantages that make new trades unpopular in the marketplace.
First, while an unwind allows the client to terminate the original trade, now the client
has two trades, one with the original Counterparty and one with the new Counterparty.
This adds complexity from an operational and risk perspective. Moreover, because the
client is selling protection to the new Counterparty, he will likely be required to post
margin (collateral).
Assignment
The client may avoid The client may avoid posting margin, and terminate the original trade, by selling
posting margin, and protection to the new Counterparty on assignment (sometimes called “novation”).
terminate the original Figure 90 shows the setup. The new Counterparty pays the client 16.4 points upfront.
trade, by trading with a Moreover, the original trade is amended, so that going forward, the original
new counterparty on Counterparty faces the new Counterparty (BANA). The client’s name is removed from
assignment the trade; i.e., from the client’s perspective, the original trade is terminated. Going
forward, BANA pays the original Counterparty 500 bps running.
67
If the original trade were at 300 bps, and the unwind still at 1000 bps, the appropriate conversion would be to 22.9 points upfront + 300 bps
running (assuming 40% recovery). Now the client would owe 300 bps running, and the counterparty would owe 22.9 points upfront plus 300
bps running. The running coupon would cancel out, so that the client would simply receive 22.9 points upfront, less accrued interest.
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 is worth
1000 bps running in the current market. The present value of the 500 bps running depends on the timing of default, and is calculated based on
market expectations. For example, suppose a Credit Event never occurs. Then the market applied too high a discount rate in calculating the
15.7 points upfront, and the new Counterparty was better off having traded the credit at 15.7 points upfront + 500 bps running (total payment:
15.7 + 5 x 5 years = 15.7 + 25 = 40.7 points) than it would have been at 1000 bps running (10 x 5 years = 50 points). But if a Credit Event
occurs immediately, the market applied too low a discount rate in calculating the points upfront, 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 15.7 points upfront + 500 bps running (15.7
+ 5 x 1 day’s accrued interest = 15.71 points).
69
This risk exists in any CDS trading in points upfront. “Jump to Default Risk” accounts for the difference in quoting CDS protection in points
upfront vs. running spread, 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.
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
5000
4000
3000
2000
1000
0
-1000
0 200 400 600 800 1000 1200 1400 1600 1800 2000
5y CDS
Sources: Bloomberg; Banc of America Securities LLC estimates.
Current
Spread
(Better to
Notional
use full
5y CDS credit
curve)
Coupon
Result
Depends
on
Protection Seller Gains Protection Seller Loses Recovery
$2,682.49 per 1 bp Spread $361.72 per 1 bp Parallel Rate
Tightening Tightening in the LIBOR curve
Sources: Bloomberg; Banc of America Securities LLC estimates.
years (e.g., March). If the 4s/5s curve is not available, we look at the 3s/5s curve and
divide by eight quarters.
We then regress this “estimated roll” against five-year credit default spreads. To
In general, to model the account for the tendency of credit curves to flatten (in percentage terms) at wider
single-name CDS roll, spreads, we use a logarithmic regression. We recognize that in most credit
look at the value of three environments—not that of summer 2007 and early 2008—four-year CDS may trade at
months on the 4s/5s (or 90% of five-year CDS, for Reference Entities with five-year spreads wider than 200
3s/5s) CDS credit curve
bps. But for Reference Entities with five-year spreads tighter than 50 bps, four-year
CDS may trade at just 75% of five-year CDS.
Figure 94 shows the results for February 2007, as compared with February 2008 in
Figure 95. In both cases, we only look at Reference Entities with five-year CDS trading
350 bps or tighter. Notice that the model worked significantly better in 2007.
traders may refer to this situation by saying that the market captured 75% of the roll (6
bps actual / 8 bps predicted).
Not surprisingly, the model is not perfect and will work less well for Reference Entities
with flatter credit curves or liquidity concerns, such as those seen since summer 2007.
Do not use the model for very unusual sectors, such as the autos and auto parts.
5y CDS at
1000 bps
(Better to
use full
5y CDS credit
curve)
500 bps
Running
Result
Depends
Heavily on
$1,638,370 / $10mm Notional = Recovery
16.4 Points Upfront + 5% Running Spread Rate
This is about equal to 1000 bps all running spread
Source: Bloomberg; Banc of America Securities LLC estimates.
The circled fields show major points of which to take note. For the maturity date, we
have chosen five-year CDS, but simply enter the actual maturity date of the credit
default swap. Set the deal spread equal to 500 bps to reflect the 5% running coupon. On
the far-right portion of the screen, enter the credit curve. We have chosen to keep the
credit curve flat at 1000 bps (the five-year CDS spread), although it would be more
accurate to enter a full credit curve. In the bottom-right hand corner, enter the assumed
recovery rate; we have chosen 40%.
Now look near the bottom-left hand corner, in the field marked “Principal.” Notice that
the resulting value of the credit default swap is $1,638,370. On $10 million notional,
this is equivalent to 16.4 points upfront. In other words, a five-year CDS spread of
1000 bps is about equal to 16.4 points upfront, plus a 5% running coupon.
Recovery Rate and Credit Curve Matter
The conversion between Raising the assumed recovery rate reduces points upfront. Intuitively, a protection
spread and points Buyer will pay less for credit risk with a higher recovery rate. This is because the
upfront depends on the protection Buyer is entitled to par minus recovery, following a Credit Event.
assumed recovery rate A steeper credit curve increases points upfront. This is because front-end cash flows
and credit curve will have a lower discount rate, lowering the present value.
Similarly, an inverted credit curve decreases points upfront. This is because front-end
cash flows will have a higher discount rate, raising the present value.
Figure 97. Major Issues to Consider When Converting Spread to Points Upfront
Effect on Points Upfront + 5% Running Coupon
Risk Factor for a Given Spread
Figure 98. Converting from Points Upfront + 500 Bps Running Coupon to All Running Spread
In Bloomberg, Type <TICKER> Corp CDSW <GO>
In Five-Year CDS, 20 Points Upfront Plus 5% Running Coupon Is About the Same as 1142 Bps All Running Spread (Flat Curve)
Equivalent
Running
5y CDS Spread
20 Points
Upfront +
500 Bps
Running
40%
Recovery
Change Mode to calculate spread Rate
(input points upfront, output spread)
Sources: Bloomberg; Banc of America Securities LLC estimates.
70
The present value of trades in points upfront versus running spread is identical. The only difference is the timing of cash flows. However,
because all cash flows in an unwind are exchanged immediately (more accurately, at T+3 calendar days), the distinction between points
upfront and running spread is not meaningful. As such, just convert points upfront + 500 bps running to all running spread, and then calculate
the unwind as normal.
Figure 99. Unwinding a Trade in Points Upfront, Which Was Executed in Running Spread: Part I
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Enter Points Upfront + 500 Bps Running (Deal Spread), to Obtain Equivalent Running Spread
Points
Upfront
Level is for
a Trade
Effective
T+1
(4/11/08),
at a Given Equivalent
Maturity Running
Spread
10 Points
Upfront +
500 Bps
Running
40%
Recovery
Change Mode to calculate spread Rate
(input points upfront, output spread)
Sources: Bloomberg; Banc of America Securities LLC estimates.
Figure 100. Unwinding a Trade in Points Upfront, Which Was Executed in Running Spread: Part II
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Enter Original (Deal) Spread and Equivalent Running Spread on Unwind
Notional,
Effective
Date, and
Maturity
Date
Equivalent
Running
Spread on
Unwind
(From
Original Part I)
Spread
40%
Recovery
Protection Buyer Receives $644,662.12 Change Mode to calculate price Rate
less $33,333.33 accrued interest = (input spread, output present value)
$611,328.79
Sources: Bloomberg; Banc of America Securities LLC estimates.
Figure 101. Unwinding a Trade in Points Upfront, Which Was Executed in Points Upfront
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Deal Spread is 500 Bps Running, Upfront Fee is the Unwind Level
Notional,
Effective
Date, and
Maturity
Date
Both
Original
Trade
and
Unwind
Use 500
Bps
Running
40%
Recovery
Protection Buyer Receives $2,000,000 less Change Mode to calculate spread Rate
$27,777.78 accrued interest = (input points upfront)
$1,972,222.22
Sources: Bloomberg; Banc of America Securities LLC estimates.
71
To a one-year horizon, the discount rate is L + 400 bps unwind spread / ( 1 – 40% assumed recovery rate ). For details, please see the section
“Implied Probability of Default” on page 100.
Figure 102. Unwinding a Trade in Running Spread, Which Was Executed in Points Upfront
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Enter Original Coupon (Deal Spread) of 500 Bps and Unwind Spread
Points
Upfront
Were
Exchanged
at
Notional, Inception,
Effective So
Date, and Irrelevant
Maturity Upon
Date Unwind
Original
Trade Unwind
Uses 500 Spread
Bps
Running
Coupon
40%
Recovery
Protection Seller Receives $411,760.36 Change Mode to calculate price Rate
plus $27,777.78 accrued interest = (input spread, output present value)
$439,538.14
Sources: Bloomberg; Banc of America Securities LLC estimates.
plus a running coupon. If a Credit Event occurs after the breakeven, the investor would
have been better off selling protection in running spread.
Should a Credit Event occur relatively late in the trade (or not at all), ex-post the
investor learns that he should have applied a lower discount rate to the cash flows. That
is, the investor should have received fewer points upfront for selling protection.
Our setup is identical to an investor who originally bought protection at 500 bps, and
now wants to unwind at 1000 bps. If the investor implements a new trade, he sells
protection at 1000 bps running spread. If the investor trades on assignment, the
assignee (bank or broker-dealer to whom the trade is being assigned) pays the investor
16.4 points upfront. The assignee then pays the original (“Remaining”) Party 500 bps
running coupon.
The difference in cash flows is called “jump risk,” and is described more fully on page
123 in this Appendix.
Figure 104. 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. Points upfront are certain.
investor. Accordingly, issuer exposure would only decline the normal $6 million, less
the $1.4 million payout to the investor. In other words, buying protection on
unwind/assignment becomes less valuable to the bank or broker-dealer, because it
72
serves as less of a hedge against fundamental default risk. See Figure 105.
Buy $10mm Protection at 450 bps Buy $10mm Protection at 450 bps
Change in Issuer Exposure from - New Trade - Assignment/Unwind from 85 bps
Buying Protection ($ MM) 0
-1
-2
-3
-4
-5
-6
$10mm x ( 1 - Recovery )
-7 minus Initial $1.4mm Payment
$10mm x ( 1 - Recovery )
Source: Banc of America Securities LLC estimates.
Figure 106 illustrates jump risk across a range of five-year CDS spreads, for an
investor who originally bought protection at 85 bps:
25
20
15
10
5
0
0 100 200 300 400 500 600 700 800 900 1000
5y CDS (bps)
Source: Banc of America Securities LLC estimates.
72
By “default risk,” we mean the Credit Events specified in North American corporate CDS contracts: Bankruptcy, Failure to Pay, and for
selected Reference Entities, Modified Restructuring.
Figure 107. Cash Flows on a New Trade, versus an Unwind (or Assignment)
New Trade at 450 bps vs. Unwind or Assignment Struck at 85 bps
Jump risk is 14 points at trade inception, but declines to zero just before maturity
25
20
15 Breakeven just
Jump Risk
10 before maturity
at Trade
5 Inception
0
0 1 2 3 4 5
Calendar Year
Five-year CDS matures after 5.25 calendar years, assuming trade inception on a quarterly roll date.
Original trade (85 bps coupon) adjusted to reflect loss of reinvestment income on jump risk, assuming reinvestment at 3-month LIBOR.
Source: Banc of America Securities LLC estimates.
To hedge jump risk, the bank or broker-dealer may buy front-dated protection. Assume
$10 million of five-year CDS notional. Then:
X At trade inception (year 0), jump risk is $1.39 million (13.9 points x $10 million
notional). The bank or broker-dealer buys $2.31 million of one-year protection at
500 bps, with a present value of $124,577.
The reason for buying $2.31 million notional is that, with an expected recovery rate
of 40%, expected P&L post-potential Credit Event would be $2.31 million x (1 –
40%), or $1.39 million, the same as initial jump risk. Figure 108 shows jump risk
by year (the difference between the two lines in Figure 107), while Figure 109
shows the notional needed to hedge that jump risk, based on the expected recovery
rate.
X Jump risk declines over the life of the trade, but remains positive until year 4.75,
when the unwind breaks even with a new trade. To hedge, the bank or broker-
dealer buys smaller amounts of one year protection at the beginning of years one–
three. By “the beginning of year one,” we mean one year after trade inception.
X After the breakeven in year 4.75, the dealer effectively has negative jump risk; that
is, the cumulative payout on a new trade would exceed the cumulative payout on
the unwind. To make the two trades equivalent, the bank or broker-dealer would, in
theory, sell a small amount of three-month protection at the beginning of year 4.75.
Of course, in reality, such short maturities do not trade. The present value of all
73
protection purchased, as a hedge to jump-to-default risk, is $255,492.
X To compensate for the cost of buying protection, the bank or broker-dealer
subtracts $255,492 from the $1.39 million that normally would be paid upon a
CDS unwind (from 85 bps to 450 bps), for a total payment of $1.13 million.
This payout is equivalent to a CDS unwind at 372 bps. As such, while a new trade
would be quoted at 450 bps, an unwind or assignment (strike 85 bps) would be quoted
at 372 bps. Although 372 bps is the fair value for an unwind in this model, we caution
that, in practice, the market does not use this model. Actual quotes may vary
substantially.
Notional to Hedge
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
0 1 2 3 4 0 1 2 3 4
Beginning of Year 1y Protection Needed in Beginning of Year
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
Jump Risk is Far More Important for CDS Widening than for CDS Tightening
Importantly, jump risk is far more important for CDS widening than for CDS
tightening. The reason is simple: as CDS tightens, the implied likelihood of a Credit
Event decreases. Consider the reverse of the previous trade, where an investor now
sells protection at 450 bps and wishes to unwind at 85 bps.
73
Net, the bank or broker-dealer buys $2.31 million of one year protection (present value $124,577), $1.79 million of one year protection
beginning in one year (present value $73,092), $1.26 million of one year protection beginning in two years (present value $37,609), $0.71
million of one year protection beginning in three years (present value $15,590), and $0.13 million of one year protection beginning in four
years (present value $4,372). The total present value of all protection purchased is $255,241. Assumed credit curve: 6m: 500 bps, 1y: 500 bps,
2y: 490 bps, 3y: 475 bps, 4y: 460 bps, 5y: 450 bps.
With improved credit quality, it costs the bank or broker-dealer substantially less to
hedge jump risk. For example, while one-year CDS was 500 bps in our earlier example,
74
at improved credit quality, we assume that one-year CDS tightens to just 65 bps. A
lower cost to hedge jump risk means a lower adjustment to “fair value” on an unwind.
As illustrated in Figure 110, the “fair value” unwind haircut for CDS widening is 78
bps (CDS widens from 85 bps to 450 bps, but unwind at 372 bps). But as shown in
Figure 111, the unwind haircut for CDS tightening is just 3 bps (CDS tightens from 450
75
bps to 85 bps, but unwind at 88 bps).
Figure 110. Haircut is Greater When Credit Deteriorates… Figure 111. …Than When Credit Improves
5y CDS, Adjusted for Unwind from 85 Bps 5y CDS, Adjusted for Unwind from 450 Bps
Investor Bought Protection Investor Sold Protection
450 450
400 400
350 350
Strike (bps)
Strike (bps)
300 3 bps
300
250 250 Haircut
200 78 bps 200
150 Haircut 150
100 100
50 50
0 0
0 75 150 225 300 375 450 0 75 150 225 300 375 450
5y CDS (bps) 5y CDS (bps)
Assumed credit curve: 6m: 500 bps, 1y: 500 bps, 2y: 490 bps, 3y: 475 bps, 4y: 460 bps, 5y: Note that the five-year CDS (red-dashed line) is in the figure; it is hard to see simply because it
450 bps. is so close to adjusted CDS (thick gray line).
Source: Banc of America Securities LLC estimates. Assumed credit curve: 6m: 65 bps, 1y: 65 bps, 2y: 70 bps, 3y: 75 bps, 4y: 80 bps, 5y:
85 bps.
Source: Banc of America Securities LLC estimates.
74
We assume one-year CDS at 65 bps, two-year CDS at 70 bps, three-year CDS at 75 bps, four-year CDS at 80 bps, and five-year CDS at 85
bps.
75
Note that the five-year CDS (red-dashed line) is in Figure 111; it is hard to see simply because it is so close to adjusted CDS (thick gray line),
in our improving credit scenario.
investor who bought protection at 85 bps, but unwound and then immediately re-
bought CDS every 150 bps of widening, would have paid extra bid-offer but
76
maintained substantially higher liquidity.
X Consider an offsetting new trade rather than an actual unwind. For example, rather
than unwinding CDS at 450 bps (from an original strike of 85 bps), sell protection
in a new trade at 450 bps. This will eliminate jump risk entirely, but give the
undesirable effect that payments are only accrued over time (450 bps per annum,
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, rather than leaving the entire bid-
offer payment for jump risk until the final trade unwind. However, paying at each smaller jump should improve liquidity, because more banks
or broker-dealers should be willing to transact at smaller jumps.
2008
Major Monoline As the market considers the possibility of a potential Credit ISDA organizes a 158
Insurers Event at a monoline insurer, wide disparity in the price of committee to address
potential Deliverable Obligations raises concern that typical CDS possible changes to CDS
(so called-”cash”) settlement protocols may not work. Moreover, (“cash”) settlement
proposed “good bank”/”bad bank” splits raise concerns about a protocols for monolines,
potential split of CDS contracts into one entity with structured and to plan for physical
finance assets and another entity with primarily municipals. settlement if necessary.
Tembec To avoid Bankruptcy, Tembec bondholders agree to cancel their Despite a payoff for 17
(TMBCN) existing notes in exchange for equity. Tembec had missed a bondholders that
coupon payment, but notes are canceled before the indenture’s resembles a default, CDS
grace period expires. Tembec borrows a new four-year term loan. contracts are not
triggered. Even if
protection Buyers were to
find a way to trigger, only
the new term loan would
be deliverable, resulting in
a presumed recovery rate
close to par.
2007
Domtar Domtar Inc. bondholders agree to exchange more than 75% of Domtar Inc. CDS succeeds 132
(DTC) outstanding debt into new Domtar Corp. notes. to Domtar Corp.
Equity Office In connection with an LBO by Blackstone Group LP, a tender Small notional remains of 21
Properties offer is announced for existing EOP bonds. Some protection EOP bonds, primarily by
(EOP) holders do not tender, to ensure a deliverable into CDS protection holders.
contracts.
Tyco (TYC) Tyco spins off into three separate divisions, with greater than Tyco International Ltd CDS 132
25% but less than 75% of original Tyco debt assumed by each and Tyco International
division. Group SA CDS each split
into three entities, with
1/3 of the original
notional per entity.
2006
Alltel (AT) AT spins off wireline business. To keep spin-off tax-free, a AT CDS splits 50% Alltel, 132
temporary spin-off company (SpinCo) exchanges more than 25% 50% Windstream.
of Alltel debt for new notes. SpinCo then merges with
Windstream.
Bombardier Bombardier announces that Bombardier Capital (OpCo) Bombardier Capital CDS 21
(BOMB) financials will be consolidated with Bombardier Inc (HoldCo). expected to become near-
Bombardier states that no new debt will be issued out of worthless after last bond
Bombardier Capital. matures, in May 2009,
due to lack of a
Deliverable Obligation.
CarrAmerica Blackstone acquires CRE. Some protection buyers buy CRE CDS becomes near- 21
(CRE) bonds and then refuse to accept a tender offer, to ensure a worthless.
Deliverable Obligation into CDS.
Major Cendant
(CD)
Following a spin-off of four divisions, Cendant Corp (later
renamed Avis Budget Group, Inc.) remains a HoldCo, with no
No Succession. Beginning
February 2007, OpCo debt
132
debt. In 2006, because Cendant Corp does not guarantee OpCo becomes deliverable into
Cendant Car Rental Group (later renamed Avis Budget Car HoldCo (Cendant Corp,
Rental, LLC) , new OpCo debt is not deliverable into existing renamed Avis Budget
Cendant Corp CDS contracts. However, in February 2007, a Group, Inc.) CDS.
guarantee is added, making new OpCo debt deliverable.
RJR RAI acquires Conwood. To overcome restrictive covenants in RJR CDS Succeeds to RJR. 132
(OpCo), RAI (HoldCo) exchanges existing RJR bonds for new RAI
bonds. RAI purposely structures transaction so that RJR CDS can
Succeed to RAI. Specifically, RAI does not guarantee existing
RJR debt.
Major Verizon (VZ) Verizon spins off directories business. The transaction structure
is similar to Alltel, but with the added twist that some existing
VZ CDS splits 50%
Verizon, 50% Idearc.
132
Wendy’s Wendy’s sells Tim Hortons, which generates more than half of No Succession. WEN CDS 132
(WEN) Wendy’s EBITDA. However, only assets, not debt, move to Tim widens to reflect increased
Hortons. leverage.
2005
Major Calpine Calpine files for Bankruptcy. Although convertible bonds Parties adhering to the 19,
(CPN) normally are deliverable into CDS trades (see Railtrack case CDS (so-called “cash”) 143
(Part I) study in 2000), two Calpine convertibles are expressly settlement protocol agree
subordinated to the prior payment, in full, of all Calpine secured that only the convertible
debt. One of those convertibles is also expressly subordinated to which is not expressly
five Calpine senior unsecured notes. None of those notes is the subordinated to the five
Reference Obligation. This raises a question of whether the senior unsecured notes
convertibles are pari passu or better in seniority to the Reference will be deliverable. Parties
Obligation, making them deliverable into CDS contracts, or who do not agree must
subordinated to the Reference Obligation, making them not either physically settle or
deliverable into CDS contracts. reach a bilateral
agreement with an
individual dealer.
Major Calpine
(CPN)
Calpine files for Bankruptcy at 10:57 pm New York time on
December 20, 2005, after the 11:59pm GMT expiration time of
No Succession.
December 20, 2005
19
(Part II) CDS contracts with a December 20, 2005 maturity. maturity CDS protection
holders cannot trigger a
Credit Event.
Major Delphi
(DPH)
Delphi files for Bankruptcy. Bonds short squeeze on concern that
protection buyers may not be able to find a Deliverable
CDS market adopts a
voluntary CDS (so-called
22,
143
Obligation because of the large notional of CDS. “cash”) settlement
protocol. Standard CDS
contracts continue to
specify physical
settlement, but market
begins to expect an option
to cash settle in the
future.
Federated Federated Department Stores, Inc. (FD) acquires The May MAY and FD CDS succeed 132
(FD)—May Department Stores Company (MAY), including all of MAY’s debt. to Federated Retail
(MAY) On the same day, FD’s debt is transferred to Federated Retail Holdings, Inc.
Holdings, Inc.
Hertz (HTZ) In connection with a HTZ LBO, HTZ announces a $2.3 BB tender No Succession. 132
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.
2002
Major Xerox (XRX) Xerox extends the maturity of a syndicated bank loan facility, Obligations payable in 152
triggering a Modified Restructuring Credit Event. Sellers of USD, GBP, EUR, CAD,
protection suffer when Buyers deliver JPY-denominated bonds CHF, and JPY are
that trade significantly below USD bonds. deliverable into CDS
contracts.
2000
(CNO) credit, some protection buyers trigger a Credit Event and deliver (North America) or
long-maturity bonds that trade significantly below par. Protection Modified-Modified
sellers suffer significant losses. Restructuring (Europe),
which significantly
shortens the maximum
maturity of obligations
deliverable following a
restructuring.
Major Railtrack
(RAITRA)
Railtrack, Britain’s national rail-system owner, files for
Bankruptcy. The cheapest-to-deliver is a convertible bond, which
ISDA issues a memo and
legal opinion suggesting
47
leads to debate about whether convertible bonds are deliverable that the convertible bond
into CDS contracts. is deliverable. Later, the
2003 ISDA Credit
Derivatives Definitions
generally allow
convertibles to be
delivered 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.
77
protection and $5 million in Ford Motor Credit protection. Relevant Obligations
78
included Hertz Bonds and Loans outstanding immediately prior to the exchange date.
Importantly, Relevant Obligations excluded debt outstanding between Hertz and its
Affiliates, as determined by the Calculation Agent.
By contrast, if Ford Motor Credit succeeded to 25% or less of the Relevant Obligations
of Hertz, there would be no succession. All of the original Hertz CDS notional would
have continued to reference Hertz debt.
Figure 112 shows an analysis of possible scenarios for Ford Motor Credit succeeding
Hertz. Overall, it looked likely that Ford Motor Credit would have succeeded to more
than 25% of Hertz, which prompted Hertz spreads to widen following the exchange
offer announcement. However, depending on the calculation method—and this is
subject to interpretation—Ford would have been either slightly above or below the 25%
threshold.
As an important note, the 2003 ISDA Definitions suggest that total debt should be
calculated as of the date immediately prior to the exchange. This means that, should the
tender and exchange have occurred simultaneously, total debt may have still included
the tendered notes. The denominator would be larger, making it harder for Ford Motor
Credit to succeed Hertz.
77
In the extreme case, if Ford Motor Credit were to succeed to 75% or more of Hertz debt, then CDS contracts would simply reference Ford
Motor Credit. That is, $10 million notional of original Hertz protection would become $10 million notional of Ford Motor Credit protection.
78
The exchange date may be referred to as the Succession Event date.
Figure 112. Would Ford Motor Credit Have Succeeded to More than 25% of Hertz?
Based on 10-Q, June 2005
Dollars
Based on all Hertz debt outstanding, Ford Motor Credit only would have succeeded to
22.3% of Hertz debt, meaning that all notional protection would stay with Hertz. This
is the second column of Figure 112.
However, the two right columns subtract Affiliate debt, which is how the actual 25%
threshold is determined. ISDA Definitions are broad regarding the definition of
Affiliate debt, so we include two scenarios, one which excludes a note between Ford
79
and Hertz, and one which also subtracts foreign subsidiary debt. Under both of these
scenarios, Ford Motor Credit would have succeeded to more than 25% of Hertz debt,
meaning that half of notional protection would have remained with Hertz and half
would have become Ford Motor Credit protection. 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.
A Caveat: What Happens If There Is No Reference Obligation
Moreover, for Hertz protection, we note a caveat: the combination tender-exchange, as
A tender or exchange announced at the time, would have taken out all senior unsecured debt. This left the
offer may result in no question of what Hertz CDS would reference:
Reference Obligation for
a CDS contract 1. Provided that Hertz issued new senior unsecured debt under the LBO’d entity, the
Reference Obligation would change to reflect the new issuance. We would expect
Hertz spreads to trade wider to reflect higher leverage at the new company.
79
Our initial belief was that foreign subsidiary debt should be excluded, but we show both scenarios to emphasize that the results are subject to
interpretation.
2. In the less-likely scenario that Hertz did not issue senior unsecured debt under the
new parent company, there would be no Reference Obligation for the Hertz
protection. Should a Credit Event have occurred, the Buyer of protection would be
forced to deliver an obligation structurally senior to senior unsecured debt (e.g.,
secured debt). That obligation would be likely to have a higher recovery rate than
senior unsecured debt, which would make credit default protection less valuable.
For example, if senior unsecured debt had a recovery rate of 40%, the protection
Buyer would profit $3 million post-Credit Event ($5 million notional – $2 million
recovery). But if there were no senior unsecured debt and the protection Buyer
were forced to deliver a more senior obligation, say with a recovery rate of 50%,
the protection Buyer would profit only $2.5 million post-Credit Event ($5 million
notional – $2.5 million recovery).
80
Less valuable protection would suggest potentially tighter Hertz spreads. If Hertz
later had issued senior unsecured debt under the LBO’d entity, credit default
spreads should have widened back out to reflect senior unsecured recovery rates.
CDS Follows Debt, Not Equity
Succession language is Notice that CDS Succession language is based on debt, not equity. For example, in
based on debt, not equity 2006, Wendy’s sold Tim Hortons, which generated more than half of Wendy’s
EBITDA. However, Tim Hortons did not assume any of Wendy’s existing debt. As
such, all CDS notional remained with Wendy’s. Spreads widened to reflect higher
leverage; that is, the same amount of debt but fewer assets.
80
There are two counteracting factors: wider spreads from a new parent company with higher leverage, and tighter spreads from the Buyer of
protection only being able to deliver debt structurally senior to senior unsecured.
With Real Estate and Travel combined representing about 70% of EBITDA and an
expected investment grade rating for both entities, the CDS spread would not have
widened significantly.
What We Saw in the Market
As shown in Figure 114, the market initially placed the greatest weight on Scenario 1,
assuming that Cendant would repay its debt before the company split. In turn,
protection would succeed to Car Rental (Avis). This caused CDS to widen
approximately 20 bps in the immediate aftermath of the news (an effective downgrade
from triple-B to double-B). By contrast, cash bonds tightened approximately 30 bps in
anticipation of an early repayment of debt.
81
On the opposite extreme, if Car Rental never issued new debt, CDS should tighten to zero because protection references no debt. This is not a
particularly realistic scenario following an LBO.
Figure 114. Cendant Cash versus CDS, 1 June 2005 – 1 December 2005
CD 6.25% 2010 Interpolated CDS
110
100
90
Spread (bps)
80
70
60
50
40
30
1-Jun 1-Jul 1-Aug 1-Sep 1-Oct 1-Nov 1-Dec
Figure 115. Without a Downstream Guarantee, Cendant Car Rental Group Debt Would Not Be
Deliverable Into Cendant Corp CDS
Reference Entity Remains Cendant Corp
In February 2007, a Downstream Guarantee was added, making Cendant Car Rental Group Deliverable into
Cendant CDS
Initially,
No Guarantee X Intermediate
Holding Cos
...
Cendant Corporation later changed its name to Avis Budget Group, Inc. Cendant Car Rental Group, LLC later changed its name to Avis Budget
Car Rental, LLC.
Sources: Cendant; Banc of America Securities LLC estimates.
82
We note that, in Cendant Corp.’s case, CDS later widened on LBO concerns at the new (post-spinoff) entity.
The reason for the discrepancy is precedent for U.S. courts to declare upstream (and
sideways) guarantees invalid, after Bankruptcy proceedings begin. For a guarantee to
be valid, the entity providing the guarantee must receive sufficient consideration.
For example, suppose that, in exchange for an upstream guarantee, the parent provides
a downstream guarantee to the subsidiary. If the parent has significant assets that
improve the overall credit profile of the subsidiary, the upstream guarantee should be
valid because the subsidiary received a clear benefit. By contrast, if the parent has no
assets, the upstream guarantee may be declared invalid post-Bankruptcy because the
subsidiary received no clear benefit. Owing to this uncertainty, upstream guarantees are
not taken into account for CDS contracts on North American Reference Entities.
Downstream guarantees are taken into account because anything benefiting a majority-
owned subsidiary also benefits the parent company.
When ISDA Definitions were last written in 2003, the general view of the CDS
community was that guarantees were more likely to be upheld in European courts. In
particular, the view was that European courts would tend to look at benefits to the
organization as a whole, rather than each distinct corporate entity. As such, a broader
class of guarantees applies to CDS contracts on Reference Entities located in Europe,
83
as illustrated in Figure 116.
A CDS contract on an operating company that has no Deliverable Obligation is
sometimes called “orphaned CDS.” For example, 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.
83
To implement these issues, confirmations for Reference Entities located in North America state: “All Guarantees: Not Applicable,” regardless
of where the trade occurs. Confirmations for Reference Entities located in Europe state: “All Guarantees: Applicable.” Globally, a guarantee
must be unconditional and irrevocable, to be taken into account for CDS contracts.
Unless the operating company issues new debt, there will be no Deliverable Obligation
into CDS contracts and CDS will become near-worthless.
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
Similarly, in December 2005, Temple Inland added step-up provisions to new issue
bonds, effectively giving investors a cushion should the company later be LBO’d. If the
company is downgraded to high yield, bondholders receive a 25-bp step-up per one
notch downgrade by either Moody’s or S&P, up to a maximum of 200 bps. Such a
downgrade would be likely to cause bonds to outperform CDS, as bonds would benefit
from step-ups while CDS would not. (In particular, on LBO news, CDS should widen
to reflect the capital structure of the new LBO’d entity.)
spun-off its $3.9 billion wireline business to Windstream. Had Windstream simply paid
Alltel $3.9 billion in cash, the transaction would have triggered a capital gain for Alltel.
Instead, Alltel created a temporary spinoff company (SpinCo). SpinCo issued a roughly
$2.4 billion special dividend to Alltel, which represented Alltel’s tax basis. In addition,
SpinCo exchanged approximately $1.5 billion in Alltel debt. As a debt-for-debt
exchange, the $1.5 billion was not taxable to Alltel. SpinCo then merged with Valor
Communications Group. The merged entity then was renamed Windstream.
The $1.5 billion exchange represented 26.2% of the Relevant Obligations of Alltel, just
above the 25% threshold. As such, $10 million Alltel CDS notional split into $5 million
Alltel and $5 million Windstream.
Example
For example, a Succession Event occurred on July 17, 2006 in Alltel Corporation,
which caused trades to split 50% Alltel Corporation / 50% Windstream Corporation. At
the time, the CDX IG6 was the on-the-run investment grade index, of which Alltel
Corporation was a member.
Single-Name Trades
A single-name trade in Alltel Corporation must have occurred on or prior to July 16,
2006 (effective July 17, 2006) to split. An investor would now have two trades, both
with the original fixed coupon, for half of the original notional. Although the
Calculation Agent will update its internal systems to reflect the new position, the trade
will not immediately be rebooked in DTCC. The investor would reference the original
trade with its original trade number.
Should the investor later wish to modify the trade—for example, partially or
completely unwind, or assign—then at that time, the Calculation Agent will terminate
the original trade in DTCC and book two new trades, each with a new trade number.
The new trades would reflect the new position in each of Alltel and Windstream.
Index Trades
However, index trades in CDX IG6 always split, regardless of the trade date. Alltel
Corporation, which had an original weight of 0.8% (1 / 125 Reference Entities), will
now have an effective weight of 50% x 0.8% = 0.4%. Windstream Corporation will
effectively be added to the index, also with a weight of 0.4%. The original trade will
retain its original trade number, and will not be rebooked by the Calculation Agent.
This is because the Index Name is unchanged—for example, CDX IG6—even though
84
the weightings in the index change.
84
The formal Index Name for five-year CDX IG6 is DOW JONES CDX.NA.IG.6 06/11.
The Alltel Corporation weight in CDX IG7 and later series will not split, because the
indices started trading (were effective) after the Succession Event occurred.
85
Fifteen dealers is an expectation. The process requires that a minimum number of dealers (e.g., 8) submit markets. The exact minimum
depends on how widely traded the relevant Reference Entity is. Similarly, the $10 million x $10 million market size may change, depending
on the Reference Entity.
Figure 118. Dealer $10mm x $10mm Markets Submitted into CDS Settlement Auction
Dealer May be Required to Buy $10mm Bonds at its Bid, or Sell $10mm Bonds at its Offer
For example, “Dealer 1” submitted a 67/69 market
Price ($)
67
66
65
64
63
62
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Dealer Number
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.
An indication from The “inside market midpoint” forms a baseline for determining the final cash
dealers regarding fair settlement price. This level is an indication from dealers regarding the fair value of the
value forms a baseline cheapest-to-deliver obligation for the relevant Reference Entity.
for determining the final Figure 119 uses the dealer markets submitted to settle Delphi, to illustrate the
cash settlement price calculation of the inside market midpoint. There are three parts:
Price ($)
67
66
65
64
63
62
10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Size ($ MM)
Best Half of Non-Tradeable
Tradeable Markets: Markets: Worst Half:
Excluded from calculation Inside Market Midpoint = $66 Excluded from
of inside market midpoint. Average of bids and offers in calculation of inside
Some dealers who the best half. market midpoint.
submitted these markets If there is no demand to No penalty.
pay a penalty to ISDA. physically settle contracts,
the auction settles here.
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.
A “tradeable market” is a market submitted by one dealer that is inconsistent with that
submitted by another dealer. Specifically, 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, while the offerer may have been trying to drive the price below fair
value. These markets are excluded from the calculation of the inside market midpoint
and may be subject to a penalty, as described in the section “Incentive for Dealers to
Accurately Portray Markets.”
86
The remaining non-tradeable markets are divided into two halves. The “best half” is
the lowest half of sorted offers and the highest half of sorted bids. The average of all
these bids and offers forms the inside market midpoint. In Figure 119, the inside market
87
midpoint is $66.
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, but there is no penalty.
86
If there is an odd number of non-tradeable markets, the best half is the average, rounded up. In Figure 119, there are 11 non-tradeable markets.
The best 6 form the “best half,” and the worst 5 form the “worst half.”
87
$66 is the average of bids $65.50, $65.50, $65, $65, $65, and $64.50, and offers $66, $66.50, $67, $67, $67, and $67.50, rounded to the
nearest eighth.
If there is no demand If there is no demand from market participants to physically settle any CDS trades, then
from market participants the final cash settlement price is the inside market midpoint. However, in most cases
to physically settle any there will be at least some investors who wish to physically settle. For example, a
CDS trades, the final traditional investor may have bought protection as a hedge against an existing bond
cash settlement price is position, and now wish to deliver those bonds to physically settle CDS. In such cases,
the inside market the final cash settlement price will be adjusted to reflect the net demand of market
midpoint participants to physically settle.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
In the cash portion, the protection Seller pays the protection Buyer the notional of the
trade, less recovery.
In the physical portion, the protection Buyer delivers bonds. Since the dealer entered an
order to sell bonds, the investor also receives those proceeds, which is simply recovery.
Net, the protection Buyer delivers bonds and receives the notional of the trade. These
net cash flows are the same as those exchanged in physical settlement.
Any investor may enter a request to physically settle, up to his net notional position in
CDS. For example, if an investor is long $20 million of a credit in single-name CDS,
and short $5 million of the same credit in the CDX indices, that investor may request
physical settlement on $15 million or less. These requests are fulfilled, to the extent
88
that some other market participant is willing to take the opposite position.
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.”
The net desire of the If more protection Buyers than protection Sellers want to physically settle, there will be
market to buy or sell net demand to sell bonds in the cash settlement protocol: the cash settlement price is
bonds as a result of the likely to be lower than then-current cash bond prices. This is in contrast to recent Credit
Credit Event is called Events, where the requirement to physically settle single-name CDS sent protection
“net open interest” Buyers scrambling to buy bonds, resulting in a short squeeze.
Similarly, if more protection Sellers than protection Buyers want to physically settle,
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 net open interest is released roughly 30 minutes after dealers submit their $10mm x
$10mm markets. Since the credit market (including dealers) does not know beforehand
whether the net open interest will be to buy or sell bonds, it is less likely that bond
prices will move in advance. Naturally, it is possible that cash bond prices will move
after the net open interest has been released.
88
Dealers are required to accept a request for physical settlement that reflects the CDS position of a client with that dealer. Dealers may, but are
not required, to accept a larger order, provided the client states that the order reflects his net position across dealers.
89
All dealers’ $10mm x $10mm markets are used, not just the “Best Half of Tradeable Markets” described in Figure 119.
90
If the investor’s order is filled, then he will pay the final cash settlement price. For example, if the final cash settlement price is, $63, the
investor would expect to earn 7 point profit (70% ultimate recovery minus $63 purchase price). If the auction settles at $65, the investor may
be partially filled on his $2mm order.
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, the auction may be cancelled for that day. The entire auction process, including new
$10mm x $10mm markets, would be repeated one business day later.
Figure 122 illustrates the calculation of the final price, using data from the settlement
of Delphi, in which there was $99mm of net open interest to sell bonds. Notice, more
protection Buyers than Sellers wanted to physically settle. Those protection Buyers
deliver bonds, which then need to be sold in the auction:
64
63
62
61
60
0 25 50 75 100 125 150 175
Size ($ MM)
Cash Settlement Price:
Bid that clears the $99mm
of bonds that CDS market
participants wanted to sell
as a result of the Credit Event.
In this example, the first four orders filled come from dealers’ $10mm x $10mm
markets. The next two orders filled come from limit orders, and so on. The final cash
settlement price is the bid that clears the $99mm in net open interest.
In this case, the final price is $63.375. The participant who bid $63.375 is partially
filled, to the extent necessary to clear the net open interest. All orders that are filled are
done so at the final price (i.e., the participant who bid $65 only pays $63.375).
Limit orders are Limit orders are important to the overall success of the cash settlement auction.
important to the overall Consider the case where 15 dealers submit $10mm x $10mm markets. This provides
success of the CDS baseline liquidity of $150mm.
settlement auction 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. Provided there are enough limit orders, this is not a
problem, as illustrated in the example above (Figure 122). However, if there are not
enough limit orders, the final cash settlement price will be zero.
Similarly, 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
addition to the dealers’ $10mm x $10mm markets. If there are not enough limit orders,
the final cash settlement price will be 100.
If there is a significant Accordingly, if there is a significant net open interest, market participants should
net open interest, market seriously consider placing limit orders to avoid a final zero or 100 settlement price.
participants should Additionally, notice that an insufficient volume of limit orders means that participants
seriously consider who requested physical settlement will be unable to do so. That is, not enough market
placing limit orders to participants were willing to take the opposite side of the Counterparty requesting
avoid a final zero or 100 physical settlement. In this case, requests for physical settlement will be filled on a pro
settlement price rata basis, against dealer $10mm x $10mm and limit orders that were received.
Preventing Unexpected Results
A provision to help The auction also contains a provision to prevent extreme scenarios from a small net
prevent extreme open interest. For example, if there is a net open interest to sell bonds, there is a general
scenarios expectation that the final auction price will be below the inside market midpoint,
established in the dealers’ $10mm x $10mm markets. But now suppose there were a
very small net open interest to sell just $5 million in bonds. Then, as illustrated in
Figure 123, it is possible that just one limit order, with a relatively high bid, will be
filled. That limit bid would normally become the final price, resulting in an
unexpectedly high recovery rate. To guard against this scenario, if there is a net open
interest to sell bonds, the maximum final price is capped at the inside market midpoint
plus 1% of par.
Bid ($)
66
64
62
60
0 25 50 75 100 125 150 175
Size ($ MM)
Hypothetical data. Difference from Figure 122 is the level of limit bids and the size of the open interest.
Source: Banc of America Securities LLC estimates.
Similarly, if there is a net open interest to buy bonds, there is an expectation that the
final auction price will exceed the inside market midpoint. Should there be a very small
open interest that would otherwise result in a significant price decline, the maximum
final price will be floored at the inside market midpoint minus 1% of par.
Deliverable Obligations
Dealers are working on a We have said that the auction is on “bonds.” Technically, counterparties that trade
permanent protocol that “bonds” in the auction enter into a single-name CDS contract on the relevant Reference
could be used to settle Entity and may settle that contract with any obligation that is on a publicly available,
all Credit Events pre-specified list of Deliverable Obligations. There is a general expectation that the
92
cheapest-to-deliver obligation would be exchanged.
As such, the recent (since 2005) process of arranging an ad hoc CDS settlement
protocol, post-Credit Event, allows adherents to know which obligations will be
deliverable, before entering into the auction.
Longer term, should a similar protocol be incorporated into standard CDS
documentation, a procedure for determining the Deliverable Obligations (and potential
disputes) would need to be added to the protocol. This is because market participants
would bind themselves to the protocol at trade inception, even though the list of
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Deliverable Obligations would not be determined until after a Credit Event. (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.)
An inter-dealer committee is working on a solution to potential disputes surrounding
Deliverable Obligations.
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The Buyer of bonds (Participating Bidder) enters into a contract to sell credit default protection, and must deliver a Notice of Physical
Settlement, as with any CDS contract. Additionally, we note that loans are also deliverable into credit default protection. But in practice, they
are rarely delivered, because loans usually trade at a much higher price than bonds post-Credit Event. This means that a loan is rarely, if ever,
the cheapest-to-deliver obligation.
93
More accurately, market participants would bind themselves to the protocol through the ISDA Master Agreement, or an amendment thereof.
66.75
66.50
66.25
66.00
65.75
0 1 2 3 4 5
Markets Subject to a Penalty
Bidding Dealer Pays Bidding Dealer Pays
1 Point Penalty to 1/2 Point Penalty to
ISDA, on $10mm ISDA, on $10mm
($100,000 Penalty) ($50,000 Penalty)
Bidding Dealer Pays No Penalty Because
1 Point Penalty to Bid is Equal to (or Less
ISDA, on $10mm Than) the Inside
($100,000 Penalty) Market Midpoint
A penalty is only paid if it is positive. For example, if there were a net open interest to sell bonds. and the bid minus the inside market midpoint
were negative, then the bidding dealer would pay no penalty. Similarly, if there were a net open interest to buy bonds, and the inside
market midpoint minus the offer were negative, then the offering dealer would pay no penalty.
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol. However, the method for calculating a penalty
has since changed. This figure shows the calculation of the penalty under the current protocol.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.
Similarly, if there is a net open interest to buy bonds, the offering dealer pays the
penalty to ISDA. The logic is that the offering dealer may have attempted to drive the
price below fair value. The penalty would be the difference between the inside market
midpoint and the relevant offer. Proceeds from the penalty are used to defray auction
94
costs.
Restructuring Criteria
Bankruptcy and Restructuring
The table below summarizes the five Restructuring criteria. Any one of these criteria
causes a Restructuring Credit Event to occur. Once this happens, parties may begin the
CDS settlement process.
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Penalties are only due if they are positive. For example, if the net open interest were to sell bonds, and the bid minus the inside market
midpoint were negative, the bidding dealer would pay no penalty. Similarly, if the net open interest were to buy bonds, and the inside market
midpoint minus the offer were negative, the offering dealer would pay no penalty.
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, 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
Events that do not directly or indirectly result from a deterioration in the creditworthiness or financial condition of the Reference Entity
Restructuring Alternatives
The differences between There are four Restructuring alternatives from which the counterparties choose when
various Restructuring setting up the CDS: No Restructuring, Restructuring, Modified Restructuring, and
Criteria Modified-Modified Restructuring.
In the US and Europe, plain vanilla Restructuring—sometimes called “Old
95
Restructuring”—has been rarely used since the Conseco Restructuring in 2000.
Instead:
X For single-name CDS contracts on US investment grade and many fallen angel
Reference Entities, the market standard is Modified Restructuring.
X For other CDS contracts on US Reference Entities, such as single-name high yield
CDS, some single-name rising-star CDS and the CDX indices, the standard is No
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Restructuring.
X For CDS contracts on European Reference Entities, investment grade and high
yield, single-name and index, the standard is Modified-Modified Restructuring.
X Recently, for European leveraged loan CDS contracts, the standard has become
97
Old Restructuring.
The primary differences between Modified Restructuring and Modified-Modified
Restructuring lie in the maturities and transferability of Deliverable Obligations, as
95
Please see the Case Histories section on page 129 for details. Additionally, note that Old Restructuring continues to be used for Reference
Entities in emerging markets.
96
By fallen angel CDS, we mean a Reference Entity that was investment grade when it originally started trading in CDS and subsequently was
downgraded to high yield. Similarly, by rising-star CDS, we mean a Reference Entity that was high yield when it originally started trading in
CDS and subsequently was upgraded to investment grade.
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. With the universe of Deliverable Obligations already limited, it seemed unnecessary to
include the additional maturity limitation of Modified-Modified Restructuring. For more details, please see page 169.
For Modified-Modified Restructuring (Europe): The maximum maturity of the Deliverable Obligation submitted by
the protection Buyer is 60 months (for restructured bonds or loans) or 30 months (for all other Deliverable
Obligations) following the Restructuring Date, or the Scheduled Termination Date of the CDS contract, whichever
is later.
Fully Transferable Obligation (North For Modified Restructuring (North America): Obligation must be fully transferable to an eligible assignee.
America) or Conditionally Transferable Essentially, this limits Deliverable Obligations to bonds (not loans).
Obligation (Europe)
For Modified-Modified Restructuring (Europe): The Deliverable Obligation must be transferable to any entity that
regularly engages in loan and securities markets, either without consent, or with consent of the Reference Entity,
not to be unreasonably withheld.
Multiple Holder Obligation Restructuring Credit Events are triggered only by Multiple Holder Obligations (MHOs). This prevents parties from
profiting by triggering bilateral loans. MHOs have at least 4 unaffiliated lenders, two-thirds of which consent to
the Restructuring. For the two-thirds consent, each holder has one vote, even if affiliated with another holder.
For Reference Entities based in North America, the two-thirds consent is deemed automatically satisfied if the
restructured obligation is a bond. 99
Source: 2003 ISDA Credit Derivatives Definitions.
Figure 127 and Figure 128 show two examples of which obligations may be delivered
following a Restructuring, assuming that the protection Buyer declares a Credit Event:
98
If multiple Credit Events are declared—for example, Modified Restructuring and Failure to Pay—the limitations of Modified Restructuring
and Modified-Modified Restructuring do not apply.
99
Per the May 2003 Supplement to the 2003 ISDA Credit Derivatives Definitions.
0 1 2 3 4 5
Figure 128. Second Example of Which Obligations May Be Delivered Following a Restructuring
Remaining Maturity of CDS Contract is One Year
Under MR, the protection Buyer may deliver an obligation with a maturity of up to 30 months after the
Restructuring date
0 1 2 3 4 5
Modified Restructuring An investor may think of Modified Restructuring as an American option. Assume that a
resembles an American company’s bonds would trade at $70 post-Restructuring, or $40 post-default. If the
option protection Buyer declares a Restructuring, he stops paying the CDS premium and
receives 30 points (100% par – 70% post-Restructuring price).
Alternatively, 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. At that time, the
investor would expect to receive 60 points (100% par – 40% post-default price).
To be clear, the protection Buyer has a choice on when to trigger CDS--that is, when to
declare a Credit Event. He may do so anytime from the date of the Modified
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Restructuring up to and including 14 calendar days after CDS contract maturity.
These payoff scenarios are illustrated in Figure 129. If the protection Buyer believes
that, once a company has restructured its debt, its probability of default rises
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significantly, he is likely to wait to trigger CDS.
Figure 129. Restructuring as an American Option
Sample Discounted P&L from Perspective of Protection Buyer, 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
40 Potential benefit of
waiting to trigger CDS
20
0
0 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, or 40% post-Bankruptcy. Discounted by LIBOR.
Source: Banc of America Securities LLC Estimates.
From about 2005 until summer 2007, 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. More recently, the
perceived value of Restructuring provisions has increased, in part because of
deterioration in the overall macroeconomic environment.
Exception: CDS—Cash Basis Packages
One exception is CDS—cash basis packages, where the protection Buyer already owns
a bond, and thereby has locked in a recovery rate. Provided that CDS matures later than
the bond, the bond will be deliverable under Modified Restructuring criteria. In this
case, one should generally expect the protection Buyer to trigger a Modified
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Technically, the timing option also exists following Bankruptcy and Failure to Pay Credit Events. However, because either the protection
Buyer or Seller may trigger CDS and the Deliverable Obligations are the same regardless of who triggers, it should be to one party’s
advantage to immediately declare a Credit Event. As such, the timing option is essentially irrelevant following a Bankruptcy or Failure to Pay.
However, because following a Modified Restructuring, the protection Seller will lose the advantage of the maturity limitation if he triggers,
presumably the protection Seller will not trigger a Modified Restructuring. This creates a meaningful timing option for the protection Buyer.
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Naturally, the closer a CDS contract is to maturity, the more likely the protection Buyer is to trigger Modified Restructuring immediately.
102
For example, suppose that a bond traded at $70, but CDS traded at par (all running spread, as opposed to points upfront). The low dollar price
of the cash bond would make a buy CDS—buy bond trade look attractive. Post-Credit Event, the investor would receive par on CDS with a
locked-in recovery rate of 70%, resulting in a 30 point profit. Assuming CDS matures later than the bond, the investor could deliver the bond
following a Modified Restructuring.
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CDS contracts discount at LIBOR plus the implied probability of default, which changes post-Modified Restructuring. Using the
methodology in the “Implied Probability of Default” section on page 100, CDS contracts (including the CDSW screen on Bloomberg)
typically derive the implied probability of default, to a one-year horizon, 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 ]
But post-Modified Restructuring, the protection Seller’s minimum expected Loss rises from zero to [ 1 – Recovery post-Modified
Restructuring ]. Accordingly, 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, CDS mark-to-market profits and trade unwinds should use LIBOR plus this new implied probability of default.
The protection Buyer may Monoline CDS contracts are governed by the usual 2003 ISDA Credit Derivatives
deliver debt that is Definitions plus a 2005 Monoline Supplement. This supplement allows the protection
wrapped by the monoline, Buyer to deliver debt that is wrapped by the monoline insurer, such as a municipal
in addition to bonds and bond or super senior CDO tranche. These Deliverable Obligations are in addition to the
loans. direct debt of a Reference Entity—i.e., bond or loan—that is deliverable under standard
CDS contract language.
Should an investor want Should an investor want to deliver a CDO tranche—for example, a super senior—that
to deliver a CDO tranche, tranche must be guaranteed directly by the monoline, so that the insured instrument
it must be guaranteed (i.e., the tranche) is Borrowed Money. Quoting from the ISDA 2005 Monoline
directly by the 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 ...”
Typically, monolines Typically, monolines issued a financial guarantee (wrap) on CDS on super senior
issued a financial tranches, not the underlying super senior tranche. This was done for two main reasons.
guarantee on CDS on First, dealers were not in the business of marking and trading financial guarantees,
CDO tranches, not the whereas they are accustomed to trading CDS. More importantly, CDS is typically
underlying tranche. marked-to-market daily, whereas our understanding is that financial guarantees need
not be re-marked unless they become impaired—namely, unless the tranche suffers a
loss of principal. Since dealers owned the underlying CDO tranche and wanted to be
able to offset potential (now actual) mark-to-market losses, CDS was more attractive
than a direct financial guarantee.
Figure 131 shows a sample structure that would allow for effective insurance from a
monoline but would not be deliverable into CDS contracts. In this structure, a bank
owns a CDO tranche. The bank buys protection from a special purpose vehicle (SPV).
In exchange, the bank receives CDS protection from the SPV. At the same time, a
premium is paid to the monoline, in exchange for a financial guarantee on the CDS.
The bank is thus protected against lost of principal and interest payments.
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A Failure to Pay is a Reference Entity’s failure to make due payments. Usually applies to Borrowed Money, a broader category than simply
Bonds and Loans. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days in the U.S.—and
usually sets a minimum threshold of USD 1 million.
Figure 131. Example of CDO Tranche Which Would Not Be Deliverable into Monoline CDS
Monoline Financial Guarantee is on CDS Written by the SPV on the Tranche, Not on the Tranche Itself
Monoline
insurer
We think it would be As we discussed in the section “Risk of a Short Squeeze” on page 22, investors have
difficult, though not come to generally expect an option to cash settle of CDS contracts. However, currently,
necessarily impossible, cash settlement is only an expectation, not a requirement. If a monoline were to suffer a
to cash settle a Credit Event, we think it would be very difficult to cash settle.
monoline. The reason is that, as we discussed on page 143 in this Chapter, CDS settlement
protocols (commonly called “cash settlement”) are actually an auction, the mechanics
of which resemble a Treasury auction. Roughly speaking, approximately 15 dealers
submit a market on, say, $10 million bonds, with a 2 point bid-offer spread. Dealers
may be required to trade bonds at their submitted levels, which provides incentive for
106
the submission of reasonable quotes.
105
http://www.mbia.com/investor/investor_inquiries_faqs.html. Frequently Asked Question “What is LaCrosse Financial Products?” in Category
“Derivatives & Mark-to-Market.”
106
This is only an approximate, and incomplete, description of CDS (so-called “cash”) settlement protocols. For further details, please see “CDS
Settlement Protocols” on page 143.
Before the beginning of the Before the beginning of the auction, a list of Deliverable Obligations is established, and
auction, a list of any of those obligations may be delivered/received if a dealer is required to trade. For
Deliverable Obligations is example, in the Delphi auction, the 6.55% June 2006, 6.50% May 2009, 6.50% August
established. That is far 2013, and 7.125% May 2009 all were Deliverable Obligations. Similar to CDS, dealers
more straightforward for participating in the auction quote markets assuming they will exchange the cheapest-to-
non-monolines, where only deliver.
bonds and loans are Deliverable Obligation Challenges
deliverable
To assemble a list of Deliverable Obligations for a monoline:
1. The dealer community would have to agree that the each proposed Deliverable
Obligation is indeed deliverable into CDS contracts. This is possible but time-
consuming.
2. Each dealer then would have to value each Deliverable Obligation to
determine the cheapest-to-deliver obligation. This would be a time-consuming
and difficult process, which could impede on the 30 calendar days within
which parties normally settle credit default swaps.
Recovery Rate Risk
Moreover, if even a small Moreover, suppose that the bulk of Deliverable Obligations have a price of $60 to $80,
portion of Deliverable but a few Deliverable Obligations have a price of $10-$20. To clarify, these figures are
Obligations have a very just an example, not a recovery value estimate. Then, the CDS settlement auction
low recovery rate, the would be likely to result in a cash settlement price in the $10-$20 range, because each
auction could result in a dealer would recognize that he may receive the lowest price Deliverable Obligation. As
very low cash settlement such, a CDS settlement protocol, using the to-date methodology, would have a
price substantial risk of realizing a very low recovery rate, in our view.
Potential Solutions
To address these issues, To address these issues, ISDA assembled a working group in February 2008. ISDA
ISDA has assembled a subsequently published a list of obligations that dealers viewed as potentially likely to
working group be delivered into monoline CDS contracts, should a Credit Event occur. 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,” and is not intended to be definitive. 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.
107
For details, please see http://www.isda.org.
For a monoline, if For a monoline, if between 25% and 75% of financial-guaranteed obligations are
between 25% and 75% transferred to a new division, existing CDS contracts would split 50% / 50% notional
of financial-guaranteed between the original and the new entity. For example, a $10 million notional contract
obligations are referencing MBIA Insurance Corp. would split into two contracts of $5 million
transferred to a new notional each, one referencing the municipals division and one referencing the
division, then existing structured finance division. At the extreme, if 75% or more of financial-guaranteed
CDS contracts would obligations are transferred to a new division, the original monoline Reference Entity
split 50% / 50% would be deleted entirely and replaced with the new division. These Succession rules
include financial-guaranteed obligations, unlike Succession rules for non-monoline
Reference Entities..
However, as one might imagine, the 25% and 75% thresholds are not clear-cut for
monolines. Figure 132 shows pertinent statistics, prepared by our insurance analyst
Michael Barry. 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.
For these early estimates, we exclude CDOs entirely, because many of these products
would neither be deliverable into CDS contracts nor counted for Succession
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purposes. In reality, some portion of CDOs should be included and some portion
excluded, but we do not yet have a sense of this proportion. We also exclude
international financial guarantees because many of these products were written as
reinsurance, which also would not be counted for Succession purposes, in our early
view.
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There are circumstances in which obligations may not be deliverable into CDS contracts but would be considered for Succession purposes.
For example, CDOs with a direct financial guarantee but a maturity greater than 30 years would not be deliverable, but would be counted for
Succession purposes. Similarly, although not applicable for monolines, a subordinated bond would not be deliverable into a senior unsecured
CDS contract, but would be considered for Succession purposes.
$ Millions
ABK FGIC MBIA SCA
Total Net Par Outstanding 556,173 314,814 672,934 154,164
Would CDS Succeed to Municipals Division? 50% / 50% Split Full Succession Full Succession 50% / 50% Split
Based on Preliminary Information and Data But Borderline (*)
Estimates as of September 30, 2007. We believe that results have not changed materially since then.
(*) For FGIC, the international portion of CDOs is not available, so for our preliminary purposes, we assume it to be zero. A determination of the actual exposure may result in different implications
for CDS.
“Est. 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, but not
deliverable into CDS contracts. For example, CDOs with a direct financial guarantee but a maturity greater than 30 years would be considered for Succession purposes, but would not be deliverable
following a potential Credit Event.
Sources: Company reports; Banc of America Securities LLC estimates.
Actual results would Figure 132 suggests the following implications for monoline CDS. To be clear, these
depend on obligations results are simply preliminary estimates based on financial guarantee disclosures by the
outstanding as of one monolines. Actual results would depend on the universe of Relevant Obligations
day prior to the potential (Bonds and Loans with a direct financial guarantee) as of one day prior to the potential
Succession event Succession event—in this case, likely one day prior to the Dinallo “good bank” / “bad
bank” plan going through—so the final result may differ substantially.
Moreover, we assume that all existing financial guarantees relevant to a particular
division (municipals or structured finance) would be transferred. It is entirely possible
that the transaction would be constructed in a different way, making our estimates
invalid.
Ambac and SCA
Our preliminary estimates suggest that existing notional on CDS would split 50% /
50% between the municipals and structured finance divisions. Particularly for Ambac,
these results are borderline—we estimate that 70% of obligations considered for CDS
Succession purposes would travel with the municipals, but if the actual number turned
out to be at least 75%, CDS would succeed entirely to the municipals division.
FGIC and MBIA
Our preliminary estimates suggest that existing CDS notional would succeed entirely to
the municipals division with corresponding spread tightening. However, we again
caution that Figure 132 excludes CDOs entirely. In reality, 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, rather than a full succession.
Additionally, for FGIC, we have assumed that all CDOs are US exposure because of
lack of information. Determination of the international portion of CDOs may change
the denominator in the CDS Succession calculation.
25
20
15
10
5
-
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Distributed tranches excluding identifiable super seniors.
Identifiable super seniors defined as transactions with an attachment point higher than 20%, an exhaustion point of at least 50%, or a
super senior notation in Credit Flux data.
Sources: CreditFlux; Banc of America Securities LLC estimates.
However, during 2007, losses in subprime mortgages and traditional cash CDOs caused
synthetic CDO volumes to plummet. See Figure 133. Correlation desks’ until-then
persistent demand to sell protection dried up, shrinking the cushion that had prevented
credit default swap spreads from moving wider.
Potentially, should such structures ever unwind en masse, CDS spreads could move
notably wider, particularly at popular seven- and ten-year maturities. For a further
introduction to the structured credit market, please see the Chapter Appendix on page
179.
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To sell single-name protection on a large number of Reference Entities in different notionals, correlation desks (groups responsible for
managing structured credit risk and banks and broker-dealers) often use lists known as “Bid Wanted in Competition (BWIC).” Each recipient
of the BWIC is responsible for entering a bid on trades in which it is interested. Typically, either the best bid wins a particular trade or the
flow desk bidding the best overall wins the entire list. By contrast, an OWIC is an Offer Wanted in Competition and signals the desire to buy
single-name protection.
Credit Events
If an issuer defaults on LCDS Credit Events are Bankruptcy and Failure to Pay. Importantly, these Credit
just Bonds (not Loans), Events may occur anywhere within Borrowed Money, which includes Loans and
there is a Credit Event in
LCDS
Bonds. In other words, if an issuer defaults on just its Bonds (not Loans), there still will
be a Credit Event in LCDS.
Settlement
Unlike senior unsecured Unlike senior unsecured CDS trades, LCDS cash settles, using an auction process that
CDS, leveraged loan CDS resembles recent protocols for senior unsecured CDS settlement. That process is
cash settles using an described in Chapter VI – CDS Case Studies and Legal Issues on page 143. Investors
auction process who wish to physically settle may do so through the settlement process, provided that
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another market participant is willing to take the opposite position.
Succession Language
LCDS Succession
language is based on Like senior unsecured CDS, Succession language refers to potential changes in CDS
Syndicated Secured contracts if the Reference Entity is merged, acquired, or undergoes some other change
Loans to its corporate structure. However, in senior unsecured CDS, Succession criteria are
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Post-Credit Event, the protection Buyer’s expected profit is par – recovery. Accordingly, higher recovery rates reduce expected profit.
111
A Syndicated Secured List helps determine Deliverable Obligations into LCDS contracts. The list is based on dealer polls and is administered
by Markit Group Ltd.
based on all Bonds and Loans outstanding. LCDS Succession language is based solely
on Syndicated Secured Loans outstanding.
For example, suppose all Syndicated Secured Loans succeed to a new entity, but this
represents 25% or less of all Bonds and Loans outstanding at the Reference Entity.
Only LCDS contracts will succeed. Senior unsecured CDS trades will remain with the
original Reference Entity.
For more details on Succession language, please see Chapter VI – CDS Case Studies
and Legal Issues on page 132.
Secured CDS
Secured CDS seeks to limit Secured CDS seeks to limit Deliverable Obligations to debt (usually bonds) that
Deliverable Obligations to contain particular security. For example, in 2006, the market introduced secured CDS
those bonds that contain contracts on HCA, with the intention that the only Deliverable Obligation would be
particular security
second lien HCA bonds.
The reason for secured CDS language is that, in senior unsecured CDS, the Reference
Obligation determines only the seniority, not the security, of the Deliverable
Obligation. For example, if the Reference Obligation is a senior secured bond, the
protection Buyer may deliver a senior unsecured bond, following a Credit Event.
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The North American Deliverable Obligation still must be a loan of the Designated Priority (e.g., first lien) based on a trading standard.
113
In Europe, currently, cash settlement is possible under some circumstances but is based on an auction conducted by the Calculation Agent (in
some cases, the protection Buyer) rather than a market-wide cash settlement price. A group is working on the development of ELCDS market-
wide cash settlement mechanics. In North America, if for some reason there is no LCDS (commonly called cash settlement) auction, or the
auction fails to result in a final price, trades may revert to physical settlement.
Secured CDS therefore makes two changes from senior unsecured contracts. First, the
Reference Obligation is changed to a secured bond from a senior unsecured bond.
Second, “secured” is added to the list of Deliverable Obligation Characteristics. 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
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Reference Obligation.
Similar to senior unsecured CDS, should all Deliverable Obligations cease to exist—for
example, through a tender offer--then secured CDS would become near-worthless. 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, should there later be a Credit
115
Event.
If the security were to be By contrast, an opposite result occurs if the security goes away. For example, suppose
released, a secured CDS the secured Reference Obligation were to be refinanced and the collateral package
trade would revert to simultaneously released. In this case, the trade would revert to senior unsecured
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senior unsecured CDS CDS. A regular senior unsecured CDS bond would become deliverable, should there
be a Credit Event.
Recovery Locks
Recovery locks, sometimes called recovery swaps, allow an investor to take a view on
recovery rates rather than outright default risk. For example, if an investor buys a
recovery lock at 50% and realized recovery is 60% post-Credit Event, the investor
profits 10 points.
Mark-to-market profits are based on the change in recovery rate relative to the implied
probability of default. For example, suppose an investor buys a recovery lock at 50%
and a Credit Event does not occur. But the market’s expectation for recovery increases
to 60% and the spread remains constant. Figure 135 illustrates that the investor’s mark-
117
to-market profit is $440,399 per $10 million notional.
114
“Additional Provisions for a Secured Deliverable Obligation Characteristic,” ISDA, June 16, 2006. Relevant CDS confirms specify, “Secured
Deliverable Obligation Characteristic: Applicable.”
115
We say near-worthless because, should such an obligation be issued before contract maturity, that obligation would immediately become
deliverable. We note that, in some nonstandard CDS trades, a clause “Substitute Failure Termination Date: Applicable” is inserted into a
confirm, which essentially causes the trade to be ripped up, should there be no Deliverable Obligation.
116
Formally, the Deliverable Obligation Characteristic “Secured” would no longer apply.
117
A wide bid-offer spread makes it difficult to realize mark-to-market gains on recovery swaps.
Figure 135. 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. Input original (“strike”) recovery rate on left side. Input current recovery rate in bottom-right corner. Both Deal Spread and Par
CDS Spread equal the current market spread.
Current
Spread
(Better to
Notional
use full
5y CDS credit
curve)
Original
Recovery
Rate and
Current
Spread
Current
Market
Recovery Swap Buyer Current Recovery
Profit $440,399 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%. Notice that the mark-to-market is higher than in
Figure 135. This is because a wider spread implies that a Credit Event is more likely.
As the probability of default increases, the chance that the investor realizes the 10 point
differential between the fixed recovery rate (50%) and the market recovery rate (60%)
increases.
Figure 136. Calculating Mark-to-Market on Recovery Locks with Widening CDS Spread
Set Curve Recovery to False. Input original (“strike”) recovery rate on left side. Input current recovery rate in bottom-right corner. Both Deal Spread and Par
CDS Spread equal the current market spread.
Current
Spread
(Better to
Notional
use full
5y CDS credit
curve)
Original
Recovery
Rate and
Current
Spread
Current
Market
Recovery Swap Buyer Current Recovery
Profit $576,928 Rate
Generally, recovery locks are far less liquid than single-name CDS.
CDS on ABS
CDS on ABS was decimated Credit default swaps on asset-backed securities (CDS on ABS) became popular in 2006
in price during 2007 before being decimated in price during 2007. Below, in the section, “The Decline of
ABX,” we will discuss 2007-early 2008 performance. But first we provide an overview
of CDS on ABS more generally, including Credit Events and mechanics as compared
CDS on ABS is primarily
with CDS on corporate Reference Entities.
designed for “soft” Credit
Events, such as write-downs Instead of focusing on outright default risk, CDS on ABS is primarily designed for
and shortfalls “soft” Credit Events, such as write-downs and shortfalls. The resulting structure,
illustrated in Figure 137, is called “Pay as You Go (PAUG)” CDS.
The protection Seller
must make the Buyer The protection Buyer pays a premium with the same frequency as an underlying
whole for any soft Credit Reference Obligation (denoted by a specific CUSIP in the term sheet), typically
Event monthly. In turn, the protection Seller must make the Buyer whole for any write-downs
or shortfalls. Should the underlying Reference Obligation later repay a shortfall, the
Following a soft Credit protection Buyer reimburses the Seller, with interest compounded at LIBOR.
Event, the protection Buyer
Following a soft Credit Event, the protection Buyer continues to pay the protection
continues to pay the
premium, but on a reduced notional. For example, if the CDS notional was $10 million
protection premium, but on
a reduced notional
and an interest shortfall amounted to 5%, the protection Buyer would receive $500,000
($10 million x 5%). The protection Buyer then would pay a coupon going forward on
$9.5 million notional ($10 million – $500,000).
Alternatively, following any soft Credit Event, the protection Buyer has the option to
Alternatively, the protection force Physical Settlement, as illustrated in Figure 138. Similar to CDS on corporate
Buyer has the option to credit, the protection Buyer delivers an ABS bond (the specific Reference Obligation
force Physical Settlement noted on the term sheet) and the protection Seller pays the notional amount of
protection.
Although the ability to physically settle technically exists, we note that it may be
difficult to execute, as the underlying Reference Obligation in ABS is often not
sufficiently liquid in large quantity. Growth in the CDS on ABS market during 2006
brought the market to a more Pay As You Go-focused system.
Figure 137. Pay As You Go (PAUG) CDS Figure 138. Optional Physical Settlement
Seller Provides Protection for “Soft” Credit Events Difficult to Execute, Because Hard to Get the Bond
Premium
Shortfall Reimbursement
See Figure 139 for details on Credit Events. Source: Banc of America Securities LLC estimates.
Payments are made with the same frequency as the underlying Reference
Obligation, typically monthly.
Source: Banc of America Securities LLC estimates.
Figure 139. Comparison of CDS on Corporate Credit, versus CDS on ABS (Pay as You Go)
PAUG CDS Generally Provides Protection for “Soft” Credit Events
In the case of No Credit Event, the protection Buyer pays 150 bps and the Seller pays
nothing. Following an Interest Shortfall of 100 bps, the Seller pays the Buyer 100 bps
for both types of cap. This is because the Interest Shortfall is less than the annual
protection premium.
While a fixed cap limits However, should there be an Interest Shortfall of 200 bps, the protection Seller pays the
liability to the annual Buyer only 150 bps, because liability is capped at the annual premium. Under a
protection premium, a variable cap, the protection Seller pays the Buyer the full 200 bps. (We assume that
variable cap limits liability LIBOR is at least 0.50%. Otherwise, the protection Seller would pay the Buyer LIBOR
to LIBOR plus the annual + 150 bps. LIBOR is typically set at a one-month maturity.)
protection premium
118
Unlike single-name CDS of ABS, the protection Buyer does not have the option to force physical settlement following a soft Credit Event.
100
80
Index Price ($)
60
40
20
0
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08
Sources: Markit; Banc of America Securities LLC estimates.
Owing to the collapse in subprime securities, 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. 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.
119
The BB index began with the 06-2 series; that is, the second CMBX series issued in 2006.
X AAA index references the bond from each deal that is composed of the most credit
120
enhanced tranche, with the longest average life.
X AAA index must reference publicly issued securities. AA, A, BBB, and BBB-
indices may reference publicly or privately issued securities.
X Must be rated by at least two of Moody’s, S&P, and Fitch. The weakest of all
ratings applies.
CDS on CLOs
CDS on CLOs also Traditionally, risk exposure on CLOs was limited to long positions, by either holding a
focuses on soft Credit cash position or using a total return swap. CDS on CLOs allows an investor to take an
Events unfunded long or short position and focuses on soft, Pay As You Go Credit Events.
CDS on CLOs largely focuses on recent vintage single-A to double-B tranches.
Protection Sellers include CLO asset managers, hedge funds, principal finance groups,
and trading desks.
Protection Buyers include dealers, to hedge new issue origination and pipeline risk;
traditional cash CLO buyers, to hedge tranche-specific risk; and hedge funds, principal
finance groups, and trading desks.
X Receive at least partial treatment as equity from at least one U.S. nationally
recognized ratings agency.
The protection Buyer pays quarterly coupons in exchange for protection against hard
Credit Events, which include Bankruptcy, Failure to Pay, Modified Restructuring (for
selected Reference Entities), and Deferral of Payment. “Deferral of Payment” means
that, after any applicable Grace Period expires, the Reference Entity or any Related
Trust Preferred Issuer:
X Fails to pay a dividend or other distribution, in whole or in part, or
X Fails to pay a dividend or other distribution in cash, but instead pays the dividend
in additional Preferred Securities, common stock, or other equity interests, or
X Otherwise defers a scheduled dividend or other distribution, in whole or in part.
Deferral of Payment applies only to Preferred Securities but occurs regardless of
whether any terms of the securities permit them to transpire. For example, 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. By contrast,
Preferred CDS triggers a Credit Event three Business Days after the first missed
dividend payment. As such, the PCDS protection Buyer has a benefit not afforded by
121
the underlying security.
For a Bankruptcy, Failure to Pay, or Modified Restructuring, Deliverable Obligations
are Preferred Securities, Bonds, and Loans. For a Deferral of Payment, Deliverable
122
Obligations are Preferred Securities only.
Not surprisingly, PCDS Succession criteria are limited to Preferred Securities
outstanding rather than the Bonds and Loans used in senior unsecured CDS. For more
details on Succession language, please see Chapter VI – CDS Case Studies and Legal
Issues on page 132.
121
Indentures for Preferred Securities typically do not specify a Grace Period for missed dividend payments, because the issuer is allowed to
miss them. In this case, Preferred CDS triggers a Credit Event three Business Days after the first missed dividend payment. However, if the
indenture specifies a Grace Period, that period must be breached before Preferred CDS triggers a Credit Event.
122
Assuming the protection Buyer triggers the contract and the only Credit Event is a Deferral of Payment, only Preferred Securities are
deliverable. The reason is that only the price of Preferred Securities (not senior unsecured bonds, for example) should be affected by a
Deferral of Payment. However, if the protection Seller triggers the contract, this limitation does not apply. The logic is that, because the
protection Seller forces the Buyer to settle, the protection Buyer should have the option to deliver obligations across the capital structure
(Preferred Securities, Bonds, and Loans). As such, the protection Seller islikely to prefer not to trigger a Deferral of Payment Credit Event.
123
Specifically, Private Institutional CDS affords protection against debt that falls under section 4(2) of the Securities Act of 1933, which states
that transactions by an issuer that do not involve any public offering are exempt from SEC registration requirements.
124
Under specific circumstances, such as a Succession Event, the protection Seller may be able to terminate a trade.
125
After delivery of a Notice of Physical Settlement, the protection Buyer has 30 Business Days to deliver a Bond or Loan. If the Protection
Buyer does not deliver a Bond or Loan, a 60 Business Day flip-flop procedure begins, in which the protection Seller and Buyer alternate every
10 Business Days as being the party responsible for locating a Bond or Loan. If neither party has located a Bond or Loan by this time, then a
poll is conducted across three secondary traders. The average of at least two quotes is used as a Cash Settlement price. If fewer than two
quotes are obtained, then protection becomes worthless.
126
7% subordination / 60% loss rate per Credit Event. 60% loss rate is par – 40% recovery rate.
Figure 143.
How CDX IG 7%–10% Tranche Principal Losses Compare with CDX IG Principal Losses
Dollar Losses on 7% − 10% Tranche vs. Dollar Losses on CDX IG
Assumes Notional of $100 million
CDX IG Index
CDX IG 7% - 10% Tranche
100
Loss ($ Millions) 80
60
40
20
0
0 10 20 30 40 50 60 70 80 90 100
LCDX Index Loss ($ Millions)
Investors with a high risk appetite and desire for yield may prefer tranches with little or
no subordination, while those with lower risk appetites may prefer higher levels of
subordination. Higher levels of subordination decrease the likelihood of principal loss,
and correspondingly, spread.
Market Participants
At senior level attachment points, longer-term, hold-to-maturity investors such as
insurers are large protection sellers. By contrast, at the equity (first loss) level, hedge
funds are large protection sellers. Equity tranche investors may hedge risk by buying
protection on single-name CDS, the credit default indices, or more senior tranches.
-200
-700
P&L (000) Initial leg lower reflected risk of
significant single-credit spread widening,
-1200
from LBOs, autos, and auto parts
-1700
Forced unwind accelerates losses in
mezzanine-hedged equity
-2200
1-Apr-05 10-Apr-05 19-Apr-05 28-Apr-05 7-May-05
The amount of spread One way to think of spread movements across the tranches is as follows. With the
available to other dramatic move lower in equity, more and more of the overall index spread widening
tranches declined, was allocated to the equity portion of the tranche structure. The total spread change
allowing mezzanine across the tranches must add up back to the index level. Hence, the amount of spread
tranche spreads to available to other tranches declined, allowing mezzanine tranche spreads to actually
actually tighten tighten. 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.
Spillover to the Broader Credit Market
We also saw clear spillover to the credit index markets. To see this impact, consider the
following chart:
Figure 145. Model Error: Model Forecasted vs. 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
IG index spread reflects on-the-run five-year index (Series 3 until 20 Mar 05, Series 4 beginning 21 Mar 05).
Source: Banc of America Securities LLC estimates.
The thin red line indicates the model forecasted spread change for the 7%–10%
(indicative AAA) tranche. The thick gray line indicates the actual 7%–10% tranche
spread, and the broken line illustrates the underlying investment grade index spread.
Based on model estimates, from March 16, 2005 to May 10, 2005 the expected spread
widening in the 7%–10% tranche was 54 bps (from 55 bps to 109 bps). During the
same time period, the underlying investment grade index widened 24 bps, implying an
expected leverage of about 2.25 times (54 bps divided by 24 bps). Now look at what
actually occurred. The 7%–10% tranche tightened, creating negative leverage, a highly
unexpected result.
Typically, long positions in higher-quality (senior) portions of the tranche market are
held by longer-term, hold-to-maturity investors such as insurers. The corresponding
short position is typically held by dealers and hedge funds. To offset their risk, dealers
127
(or hedge funds) typically sell protection on the CDX index. For example, at an
anticipated model leverage of 2.25x, dealers sold protection on about $22.5 million of
index protection for every $10 million in senior (7%–10%) tranche exposure. As a
source of positive carry, this position was naturally attractive to the dealer and hedge
fund community.
However, it turned out that rather than being 2.25x the risk of the index, the 7%–10%
At the extreme, not only tranche tightened as spreads widened. Hence, not only did dealers and hedge funds lose
was the hedge ratio off money on the short position in the tranche, they also lost money on the hedge position.
(too high), but it was the At the extreme, not only was the hedge ratio off (too high), it was the wrong sign. See
wrong sign Figure 146. On days when the overall market moved wider, senior tranches widened
less than expected, causing hedge mismatches on correlation books.
127
In reality, there is a mixture of index and single-name hedging. For simplicity, we focus on CDX index hedging.
Model-Predicted Empirical
40
35
30
Leverage (x)
25
20
15
10
5
0
-5
-10
Equity (0% - Mezzanine Senior (7% - 10% - 15% 15% - 30%
3%) (3% - 7%) 10%)
Dealers and hedge funds To adjust for the mishedge, the hedge ratio needed to be reduced. That is, dealers and
needed to reduce their long hedge funds needed to reduce their long position in the index, which led to significant
position in the index, which buying of protection. This is why we saw investment grade spreads move wider.
led to significant buying of
protection Leveraging Credit
Following the May 2005 correlation crisis, dealers examined the strategies that led to
losses. Some dealers turned their attention to traditional, hold-to-maturity investors and
more conservative hedging strategies. The then-extremely tight credit spread
environment, illustrated in Figure 147, caused traditional investors to search for yield
without hurting the ratings quality of their portfolio. Figure 148 illustrates that
structured credit appeared to offer that opportunity.
Structured Credit
400 Offers Yield Pick Up
400
300
300
200
100 200
0 100
Mar- Sep- Mar- Sep- Mar- Sep- 0
05 05 06 06 07 07 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07
Banc of America Securities High Grade Broad Market Index Source: Banc of America Securities LLC estimates.
Source: Banc of America Securities LLC estimates.
The search for yield while maintaining (then-) ratings led to the development of new
products. These products tended to mitigate default risk and increase mark-to-market
risk by adding leverage. Two such important products are the leveraged super senior
and Constant Proportion Debt Obligation (CPDO).
Leveraged Super Senior
A leveraged super senior breaks down risk into two components, default risk and mark-
A leveraged super senior to-market risk. Default risk works the same as the typical tranche subordination
breaks down risk into two structure—for example, the tranche begins to lose principal after 15% of the underlying
components, default risk portfolio has suffered losses. Mark-to-market risk is based on the weighted averaged
and mark-to-market risk spread of the underlying portfolio. If the underlying portfolio spread reaches a
predetermined threshold, either the trade is terminated at mark-to-market levels or the
investor increases cash collateral. If spreads then tighten back through the mark-to-
market trigger, the investor gets back the extra collateral. The mark-to-market trigger is
typically set so that the overall structure has a triple-A rating. Figure 149 shows a
sample structure:
Figure 149. 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
In the senior (7%–10%) tranche, losses begin at 7% of the underlying portfolio and all
tranche notional is exhausted after losses in 10% of the underlying portfolio. Similarly,
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, the leveraged super senior has a mark-to-market trigger identified by the
downward-sloping line. If in the first year there are no losses in the underlying
portfolio and the weighted average spread exceeds 320 bps, the investor loses principal.
Similarly, if losses are 4% in the first year, the investor loses principal if the weighted-
average spread exceeds 250 bps. The triggers are set so that the overall mark-to-market
loss on the portfolio is roughly constant throughout.
Particularly between 2005 and early 2007, Canadian conduits issued commercial paper
and used the proceeds to buy then-highly rated assets like triple-A CMBS, cash CDOs,
and leveraged super seniors. The commercial paper’s interest cost was less than the
spread paid by the assets held in the conduit, with the difference taken as a fee for the
128
conduit sponsor.
Figure 150 illustrates the underperformance of the CDX IG super senior (30% -100%)
tranche during the credit crunch. The underperformance of the senior portion of the
tranche capital strucucture caused some leveraged super seniors to breach or
renegotiate unwind triggers.
Figure 150. Super Senior Spreads Widen Significantly… Figure 151. … Causing Leveraged Super Seniors to Approach
Market Value Triggers
If the Leveraged Super Senior trips a market value trigger, the investor
may have to post more collateral
80 CDX IG 30%-100% Tranche
10y 10y CDX IG170
Index Leveraged Super Senior Price
70 Market Value Trigger
60
Estimated Leveraged
130
50
40 110 80
30 70
90
20
70 60
10
- 50 50
Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08
On-the-run CDX IG series. Example leveraged super senior product beginning March 22, 2007 with 10x leverage. We
Source: Banc of America Securities LLC estimates. estimate the tranche P&L by using the on-the-run 10y CDX IG index 30%-100% tranche
spread.
Market value trigger is an example; actual triggers vary by deal.
Source: Banc of America Securities LLC estimates.
128
There were also costs associated with creating and servicing the conduit.
bps, for net income (reserves) of approximately 230 bps. Reserves were made available
for potential losses from future defaults.
However, Figure 152 shows the historical 5 year CDX IG, 5 year iTraxx and the
blended spread between the two indices. When CPDOs were initially issued, the
blended spread was around 30 bps, but that during the wides in March of 2008, spreads
were closer to 175 bps. Figure 153 shows that the significant widening in IG and
iTraxx caused CPDOs to approach and, in some cases even breach, their forced unwind
triggers, which were set to an NAV of $10.
Figure 152. Historical 5y CDX IG, iTraxx and Blended CDX IG Figure 153. CPDOs Approached Unwind Levels
and iTraxx Spread
CPDOs performance based on the blended spread of CDX IG and iTraxx
From October 2, 2007 to April 15 , 2008
100
150 150
CPDO NAV ($)
80
100 60 100
40
50 50
20
0 0 0
Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.
th
Coupon Frequency (page 78) – Quarterly for corporate credit default swaps, on the 20 each of March, June, September,
and December. By market convention, one month before a quarterly CDS roll, single-name trades switch to a long coupon
(first coupon due in four months, rather than one coupon due in one month and a second coupon due in three months). On a
th th
coupon date, the protection Buyer must pay the premium from the 20 of the last roll month (e.g., March) through the 19
th
of the current roll month (e.g., June). However, the final coupon payment includes the maturity date (e.g. June 20 ).
Credit Default Swap (page 8) – Bilateral contracts used to transfer credit risk among market participants. 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.
2003 ISDA Credit Derivatives Definitions (page 9) – Standardized rules for CDS trades.
Credit Event (page 17) – A pre-agreed circumstance that allows parties to settle a credit default swap. For North American
corporate Reference Entities, usually includes Bankruptcy, Failure to Pay, and for selected Reference Entities, Modified
Restructuring. For European corporate Reference Entities, usually includes Bankruptcy, Failure to Pay, and Modified-
Modified Restructuring.
Credit Event Notice (page 86) – Notice served to argue that a Credit Event has occurred. Usually, can be served by
protection Buyer or protection Seller no later than 14 calendar days after the Scheduled Termination Date (maturity) of the
CDS contract. Usually delivered at the same time as a Notice of Publicly Available Information.
Credit Support Annex (page 65) – An optional document that pre-determines when, and in what increments, margin
requirements are due (initial margin, variation margin, and threshold amounts).
Day Count (page 93) – ACT/360 for standard credit default swaps.
Deal Spread (page 103) – Same as coupon and strike.
Deliverable Obligation (page 19) – Obligation, typically a bond or loan, that the protection Buyer may deliver (or cash
settle to) following a Credit Event.
Delta (page 181) – The hedge ratio for a duration-neutral trade. For example, 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.
Detachment Point (page 179) – Loss level in an underlying portfolio for which the remaining tranche principal is zero.
Same as exhaustion point.
Discount Factor (page 102) – LIBOR plus the implied probability of default. At a one-year horizon, approximately equal
to LIBOR plus ( spread / [ 1 – assumed recovery rate ] ).
Depository Trust and Clearing Corp (DTCC) (page 66) – System used to electronically confirm credit derivatives trades.
DV01 (page 103) – Sensitivity of the present value of a credit default swap to a 1 bp change in spread.
Early Termination (Cancelability) (page 168) – For North American Reference Entities, the ability to terminate an LCDS
contract early, if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. For Europe, depends
on the Reference Obligation and assets securing it. Also see Prepayment Event.
ELCDS (page 169) – CDS on European leveraged loans.
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. Typically within two business days of a Credit Event.
Exhaustion Point (page 179) – Loss level in an underlying portfolio for which the remaining tranche principal is zero.
Same as detachment point.
Failure to Pay (page 18) – A Reference Entity’s failure to pay interest or principal beyond any grace period specified in
the relevant indenture. Typically allows parties to trigger a Credit Event.
Fixed Cap (page 174) – Limits the protection Seller’s liability in Pay As You Go CDS to the annual protection premium.
Fully Transferable Obligation (page 154) – Only applies when the protection Buyer triggers a Modified Restructuring
Credit Event. Requires that the protection Buyer deliver an obligation that is fully transferable to an eligible assignee.
Essentially, limits Deliverable Obligation to bonds (not loans). For Europe, see Conditionally Transferable Obligation.
Funding Cost (page 33) – The price an investor pays to borrow capital and the appropriate metric for CDS—cash relative
value. For example, an investor who funds at LIBOR+50 bps should compare CDS to the cash bond spread to LIBOR+50
bps, rather than LIBOR flat.
Give Up (page 67) – Allows a Counterparty to trade CDS without an ISDA Master Agreement. A bank or broker-dealer
faces the Counterparty’s prime broker, who then faces the Counterparty in a separate CDS trade. Requires prime brokerage
service.
Guarantees (page 138) – For Reference Entities located in North America, if a holding company (parent) guarantees an
operating company (subsidiary), that operating company’s debt is deliverable into CDS on the holding company. The
guarantee must be unconditional and irrevocable, where the holding company owns a majority of the operating company.
For Reference Entities located in Europe, a broader class of guarantees applies.
Implied Forward Spread (page 105) – The market’s expectation of future spreads, based on the current (spot) credit
curve.
Implied Probability of Default (page 100) – The implied probability that a Reference Entity suffers a Credit Event, based
on CDS and an assumed recovery rate. Implicitly incorporates liquidity and mark-to-market risk, and therefore usually
overstates Credit Event risk.
Index Abitrage (page 51) – Strategy to trade the difference between an index and its underlying intrinsics.
Initial Margin (page 68) – Requirement that a Counterparty post collateral at trade inception. Usually applies to hedge
funds that sell protection (at any spread) or buy protection at wide spreads. Often agreed in a Credit Support Annex.
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. Used to form a baseline for the final price in a CDS Settlement
Protocol.
IR01 (page 111) – The impact of interest rates on the present value of CDS. For investors with a mark-to-market gain,
lower interest rates increase the present value of the gain. For investors with a mark-to-market loss, lower interest rates
increase the present value of the loss. Smaller impact that spread duration (DV01).
ISDA (page 9) – International Swaps and Derivatives Association, Inc. A trade association that represents participants in
the derivatives industry. Members include banks, broker-dealers, and investors.
ISDA Master Agreement (page 65) – A governing document usually signed during the approval process for derivatives
trading.
I-Spread (page 35) – Yield difference between a cash corporate bond and a matched-maturity swap yield. Based solely on
the yield and maturity of a bond, not cash flows. Also see Par CDS Equivalent Spread, Z-Spread, and Asset Swap Spread.
iTraxx (page 48) – Indices of credit default swaps referencing European corporate issuers. Includes iTraxx Main (125
investment grade), HVOL (30 high volatility investment grade), financials (25 senior or 25 subordinated), XO (50 high
yield), and LevX (75 senior or 45 subordinated leveraged loan). Additional series exist for Asia.
Jump to Default Risk (page 123) – Profit or loss resulting from a wide spread move or a Credit Event. Often results in a
haircut for protection Buyers who want to unwind or assign trades with significant profits.
LCDS (page 167) – CDS on leveraged loans.
Limit Order (page 147) – An order to buy or sell bonds at a specified price. Used to clear net open interest in CDS
Settlement Protocols.
Maturity Limitation Date (pages 77 and 154) – The maximum maturity of the obligation that a protection Buyer may
deliver following a Credit Event. Typically 30 years for a Bankruptcy or Failure to Pay, but may be shorter for a Modified
or Modified-Modified Restructuring.
Modified Restructuring (page 152) – Primarily used in single-name CDS for North American corporate Reference
Entities, which were rated investment grade when they began trading in the CDS market. Limits the maturity and
transferability of obligations that a protection Buyer may deliver following a Restructuring Credit Event. Also see Multiple
Holder Obligation.
Modified-Modified Restructuring (page 152) – Primarily used for European corporate Reference Entities. Limits the
maturity and transferability of obligations that a protection Buyer may deliver following a Restructuring Credit Event. Also
see Multiple Holder Obligation.
2005 Monoline Supplement (page 160) – Standardized rules for CDS on monoline insurers. Allows the protection Buyer
to deliver debt that is wrapped (guaranteed) by the monoline insurer, in addition to the direct debt of a Reference Entity—
i.e., bond or loan—that is deliverable under standard CDS contract language.
Multiple Holder Obligation (page 154) – Requirement to trigger a Modified or Modified-Modified Restructuring Credit
Event. Restructured obligation must have at least 4 unaffiliated lenders, two-thirds of which consent to the Restructuring.
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.
Net Open Interest (page 147) – The net desire of the CDS market to buy or sell bonds, as a result of a Credit Event. Used
in CDS Settlement Protocols.
Notice of Publicly Available Information (page 86) – Contains proof of a Credit Event, typically from two internationally
recognized, published or electronically displayed news sources. Usually delivered at the same time as a Credit Event
Notice.
Notice of Physical Settlement (page 86) – Details of the Deliverable Obligations that the protection Buyer will deliver to
the protection Seller for physical settlement. Must be delivered within 30 calendar days of the Event Determination Date.
Novation (page 110) – A trade transferred by an investor to another party. From the investor’s perspective, the trade is
terminated. In reality, the trade continues between the original Counterparty and the new party. Same as assignment.
2005 Novation Protocol (page 83) – Market procedure to reduce risk surrounding assignments. To execute an assignment,
the investor must receive consent from the original Counterparty by 6pm, in the location of the investor, on the day an
assignment is agreed to. If the investor does not receive consent by 6pm, the assignment will instead be booked as a new
trade.
OAS to LIBOR (page 40) – Option-adjusted spread to LIBOR, without an assumption of zero volatility. For bullet bonds,
OAS to LIBOR is the same as Z-spread.
Orhpaned CDS (page 138) – A CDS contract on a Reference Entity that has no Deliverable Obligation.
OWIC (page 166) – Offer wanted in competition. Signals wider spreads. Also see BWIC.
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. Assumes a recovery rate to keep total credit risk equal between the cash and CDS
markets. Not suitable for callable or putable bonds. Also see Z-Spread, Asset Swap Spread, and I-Spread.
Pay as You Go (PAUG) (page 172) – CDS contracts focusing on Soft Credit Events such as failure to pay principal,
writedown, distressed ratings downgrade, and maturity extension. Used in CDS on ABS.
PCDS (page 177) – CDS on preferred securities.
Physical Settlement (page 8) – Approximately 30 calendar days following a Credit Event, the protection Buyer delivers a
bond or loan to the protection Seller, and receives par. Standard CDS documentation requires physical settlement, but in
practice, market expectations are in the process of moving to cash settlement. Also see CDS Settlement Protocol.
Physical Settlement Matrix (page 77) – Document to clarify Credit Events, Deliverable Obligation Characteristics, and
similar features of CDS contracts. Referenced in standard CDS confirmations.
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. Usually takes effect once five-year CDS approaches the 700-
bp range. CDX and iTraxx indices use points upfront with different coupons.
Prepayment Event (page 168) – In LCDS, the event that causes Early Termination to occur. For North American
Reference Entities, may occur if a Syndicated Secured facility is canceled and not replaced within 30 Business Days. For
Europe, depends on the Reference Obligation and assets securing it. Also see Early Termination (Cancelability).
Protection Buyer (page 8) – The party that makes periodic fixed payments in exchange for being able to receive 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. Also see Protection Seller.
Protection Seller (page 8) – The party that receives periodic fixed payments in exchange for being required to make 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. 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, the mark-to-market on the cheapest-to-deliver obligation approximately 30
calendar days following a Credit Event. Protection Buyer profits (protection Seller loses) 100% minus the recovery rate,
times the trade notional.
REDL (page 17) – Screen in Bloomberg that often shows the market standard for Reference Entities and Reference
Obligations. Note: REDL is not always correct. Before entering into a trade, agree on a Reference Entity and Reference
Obligation with your Counterparty.
Reference Entity (page 19) – The legal entity on which a CDS contract is written.
Reference Obligation (page 19) – An obligation that establishes the seniority of CDS within the capital structure.
Typically a large and liquid bond issue, found on the REDL screen in Bloomberg. In plain-vanilla corporate CDS,
establishes only the seniority, not the security, of the trade.
Relevant Obligation (page 132) – Obligations considered for CDS Succession purposes. Often the same as Deliverable
Obligations but without a maturity limitation. Also see Succession.
Remaining Party (page 83) – In an assignment, the party that originally faced the Transferor but now faces the Transferee
as Counterparty.
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. Used in CDS Settlement Protocols.
Restructuring (page 152) – Usually refers to a reduction of interest or principal, maturity extension, or change in the
priority of payment of an obligation that causes the subordination of such obligation to any other obligation. Other criteria
also exist. May allow parties, particularly the protection Buyer, to trigger a Credit Event. See Modified Restructuring
(North America) and Modified-Modified Restructuring (Europe).
Roll (page 94) – The process of changing the on-the-run maturity date for CDS contracts. Quarterly for corporate single-
th
name (the 20 each of March, June, September, and December) and semiannual for indices.
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.
Settlement (page 8) – The process of exchanging cash flows after a Credit Event. See Physical Settlement, Cash
Settlement, and CDS Settlement Protocol.
Single-Tranche CDO (page 179) – A slice of risk on a pool of securities. Usually involves subordination (attachment
point) and a detachment point.
Soft Credit Events (page 172) – Credit Events designed to reflect a change in cash flows for an underlying Reference
Obligation rather than default risk. Soft Credit Events include failure to pay principal, writedown, distressed ratings
downgrade, and maturity extension. Used in CDS of ABS.
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. Used in both synthetic CDOs and cash structured products.
Succession (page 132) – Changes to a CDS contract that may occur when a Reference Entity is merged, acquired, or
undergoes some other change to its corporate structure. Also see Relevant Obligations.
Synthetic CDO (page 179) – A collateralized debt obligation referencing a pool of credit default swaps. Also see Single-
Tranche CDO.
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.
Threshold Amount (page 71) – The level of mark-to-market profits beyond which Counterparties are required to exchange
variation margin. Often agreed in a Credit Support Annex.
Tranche (page 179) – A slice of risk on a pool of securities. Usually involves subordination (attachment point) and a
detachment point. Also see Synthetic CDO.
Transferee (page 83) – In an assignment, the party to whom a trade is transferred. Also see Transferor and Remaining
Party.
Transferor (page 83) – In an assignment, the party that transfers a trade. Also see Transferee and Remaining Party.
Underlying Portfolio (page 179) – The pool of credit default swaps referenced in a synthetic CDO.
Unwind (page 109) – The termination of an existing trade with the original Counterparty. Settled in present value terms.
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. Often exchanged daily and agreed in a Credit Support Annex.
Z-Spread (page 38) – Option-adjusted spread to LIBOR under an assumption of zero volatility. Incorporates the shape of
the yield curve and the timing of cash flows, but ignores the different recovery rates of par, discount, and premium bonds.
Not suitable for callable or putable bonds. Also see Par CDS Equivalent Spread, Asset Swap Spread, and I-Spread.
Further information on any security or financial instrument mentioned herein is available upon request.
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