sign in sign up
<<
Home , Bond market, Corporate bond, Credit default swap, Credit derivative, Derivatives market, Derivative (finance)

technical update extra SWAPS technical update extra CREDIT DEFAULT SWAPS

ISSUERS, AS MUCH AS , Fig 1. Credit Basics WILL NEED TO UNDERSTAND THE The relationship between Credit Default Swaps (CDS) are the basic building block of the credit derivatives . They DRIVERS OF BASIS STARTING WITH allow investors to isolate and transfer credit , with a protection buyer transferring credit THOSE WHICH ARE CREDIT, exposure on a reference credit to a protection seller. In exchange for this transfer, OR SPECIFIC, AND the protection buyer pays the seller a periodic fee. If the credit experiences a Credit Event, the buyer receives a payout reflecting the loss experienced by holders of defaulted MOVING ONTO OTHERS WHICH obligations of that credit. Credit Events are standardised definitions of events that constitute a INFLUENCE THE TRADING CDS and bond spreads default, and vary geographically. RELATIONSHIPS SEEN ACROSS THE We consider the credit risk taken by a protection seller as being equivalent to that of owning a similar maturity bond or , and conversely, the credit protection buyer’s risk profile as MARKET. Understanding the drivers of basis between Credit Default Swaps (CDS) and bond spreads is being equivalent to an who has sold a bond or loan of that credit. However, whereas a bond or loan is a funded instrument with principal payment and repayment at start important in correctly interpreting from each market. Daniel Berman from JPMorgan and finish, a CDS is an unfunded , i.e. it is a . The credit risk that CDS references explains. is not limited to a particular bond or loan, but common across many debt obligations of a specified credit. Growth in the market means that over the reference , increasingly While the swap spread is the most A CDS is a bilateral contract, so it can be of any maturity, or size that the two the CDS has become crucial to corporates as they investors use the swap curve as their risk free common measure of a bond’s credit risk, it suffers parties wish to with one another, irrespective of the ’s outstanding obligations. seek to understand the bond markets and monitor reference, and therefore measure a bond’s credit distortion when the bond is significantly Trading bonds and CDS both involve almost identical credit risk, so we find that the premium investor appetite for funding opportunities or spread as its spread over swaps. Still there are above or below par. In the current low rate paid for transferring credit risk through each is very similar. buybacks. This review discusses the pricing more choices – between the , z- and environment, many corporate bonds currently methodology of the basic , the i-spread of a bond (i.e. over the zero or trade significantly in excess of par. As a result, we package trade for many investors), and positive redeemed early, the CDS, along with other bonds upgraded, its step up/down bonds will trade equivalent spread measure for corporate bonds, interest bearing curves). Each uses a slightly use z-spread as it takes the bond’s cash price into basis does not generally represent a pure containing less restrictive covenant language, will relatively cheap to CDS, reflecting the expected considers how CDS and bond spreads relate to different methodology to compute the credit risk account. Although there are further technical opportunity in the same way. be exposed to greater credit risk. This uncertainty reduction in coupon. one another, and how CDS may on occasion drive premium over the risk-free rate. differences between z- and CDS spreads, the Basis in general is an important indicator of – the risk of change to both corporate and bond spreads. market is comfortable using these measures as a relative value between bond and CDS markets, funding structures – increases with maturity. While and Failure basis for comparison. and a key trade and profitability driver for Similarly, bonds can contain conditional investor to Pay are likely to have equal economic impact COMPARING CDS AND BOND SPREADS Credit Executive summary investors. Implicitly, any investor whose remit puts or issuer calls. The for holders of credit on bonds and CDS, the third Credit Event in spreads reflect the market’s perception of credit THE BASIS BETWEEN BONDS AND CDS While allows investment in either bonds or CDS, is risk through bonds and CDS in these European CDS , Modified Modified I A credit default swap (CDS) is analogous risk. In any efficient market the return for taking a z- and CDS spreads measure very similar credit always either or short basis, depending on circumstances can diverge. A topical example is Restructuring does not have an equivalent in to an contract, with the buyer risk must equal the loss expected as a result of risks, we frequently see them trade at different the composition of their portfolio between bonds Sainsbury’s bonds which contain an investor put standard bond or loan documentation. This gives of credit protection paying a periodic fee that risk. If this not the case, for instance, were levels in the market for the same issuer and and CDS. From a corporate perspective, at par following a ratings downgrade in certain CDS protection higher value as it can trigger a in return for receiving compensation the expected loss under a CDS contract to be maturity. This differential is called “basis”, and is understanding investors’ actions and credit circumstances, including a change of control. As payout in circumstances where any one of the should the specified reference entity lower than the spread paid for the protection, experience a credit event during the calculated by subtracting the z-spread from the appetite requires analysis of the relevant there is no equivalent language in Sainsbury’s issuer’s bonds and have been restructured. there would be a pure arbitrage opportunity. Given contract’s life. CDS spread. To the extent the credit risks investment alternatives. As CDS moves centre CDS (as it is a standard contract), we would this efficiency axiom, we can calculate the reflected in each spread are very similar, they stage, the drivers of the differential between it and expect, and do, observe that Sainsbury bonds DEBT BUYBACKS If a company repurchases I Although CDS and bonds measure expected loss under a contract directly from its equivalent credit risk, there are many should represent a relative value trading more traditional corporate credit products become trade expensively (i.e. a lower spread) compared outstanding bonds before maturity, for example market price. factors which can cause their prices to opportunity. As we discuss below, we don’t a key component in this equation. to its CDS. Investors comparing Sainsbury’s bonds through a formal tender process, holders normally Taking a practical example, if Sainsbury 5 year diverge. This difference between them is consider these as being pure arbitrage , as much as investors, will need to and CDS as investment alternatives are giving receive a premium to the current market level as credit protection is trading at 100 bps mid- called ‘basis’, and is calculated by opportunities as there are real differences understand the drivers of basis starting with those value to the possibility that this put is exercisable. an incentive for selling their holdings. While all of market, the loss expected under a 5 year CDS subtracting the bond spread from the between bond and CDS instruments as means for which are credit, bond or maturity specific, and This characteristic of the bonds is an important the company’s bonds and CDS levels will benefit contract equals approximately the sum of the matched maturity CDS spread. taking or hedging credit risk. moving onto others which influence the trading driver of the basis. To make it more complicated, from this action reducing total debt, holders of the premia received over the contract’s life, i.e. I Credit specific factors such as Market convention is that we describe the basis relationships seen across the market. the value of the documentation differences bond being repurchased stand to gain most. As a 500bps. Adjusting for positive interest rates and documentation, convertible issuance and as negative when CDS inside (tighter) than between Sainsbury’s bonds and CDS will likely CDS does not reference specific bonds, but rather the time value of money, a more accurate present the market’s expectation of debt the bond spread for the same maturity. When BOND COVENANTS CDS and bond vary over time, as it depends on a number of a category of credit obligation, CDS prices are value calculation of these periodic payments gives buybacks, as well as macro factors such there is a negative basis an investor who is able documentation are similar but not identical. CDS factors, including: unlikely to benefit to the same extent as the us a 4.8% expected loss by going long on as liquidity differences and segmentation to trade both CDS and bonds can earn a near- is a commoditised instrument with little I Interest rates: as interest rates rally, fixed rate buyback target, assuming that other debt of the Sainsbury credit risk through a 5 year CDS between markets, low riskless return by buying a bond and credit customisation dependent on the referenced credit, Sainsbury bonds will appreciate in value. This company remains outstanding. This implies that if contract. supply and structured credit flows can all protection of the same maturity in equal notional whereas bond terms and conditions are a function decreases the potential value of the put which is the market has a high expectation of specific This is in fact no different to the information exert different pressures on bond and amounts. This is a ’negative basis package’”. of issuance strategy, credit strength, investor fixed at a cash price of par, rather than calculated bond buybacks, CDS should trade at a greater contained in bond prices. However, as a typical CDS spreads. Conversely if the CDS spread is higher than the demand and market timing. An obvious example as a spread over Gilts or swaps. positive basis to these bonds, as bond holders fixed rate corporate bundles interest I Basis can be either positive or negative. bond spread for the same maturity, an investor of this is significant differences in negative pledge I Sainsbury’s credit quality: as Sainsbury’s credit themselves for early redemption and a rate together with credit risk, it takes a little Depending on its causes, it may present a should prefer to sell credit protection rather than language for investment grade issuers, which can improves, the likelihood of investors gaining the resulting windfall payment. further work to reach the same conclusions. short-term relative value opportunity for own the bond. We don’t really consider the latter a result in varying levels of credit risk between opportunity to the par put decreases, Specifically, before using bond prices to derive investors, or alternatively be long lasting. tradable package as the inefficiencies of the repo different bonds of the same issuer, despite each thus reducing the value of this potential . LIQUIDITY AND MARKET SEGMENTATION expected loss, we must decide which bond spread I Understanding these factors will improve market for corporate bonds can make it difficult being labelled senior unsecured. Similarly, the relationship of step up/down Although a credit investor can equally obtain long metric by which to measure the portion of a the ability of corporates to synthesize and expensive to borrow bonds in to be able An investor who is long credit risk through CDS bonds, whose coupon levels are dependent on credit exposure by buying a funded product such bond’s return due to credit risk. While traditionally information from CDS and bond markets to sell them short. will gain comfort from outstanding bonds of the ratings, to CDS will depend on the market’s as a , or by selling credit protection US Dollar and Sterling corporate bond markets as they interpret investor appetite. Significant negative basis opportunities are issuer which have strong negative pledge expectation of future coupon settings. For on the same entity, they may have a preference have relied upon the spread of a corporate bond generally short-term (as they are an attractive language. However, should these bonds be example, if investors expect a telecom credit to be for one of these options. A possible reason is that

50 THE TREASURER MAY 2005 MAY 2005 THE TREASURER 51 technical update extra CREDIT DEFAULT SWAPS

FIGURE 2 ILLUSTRATES THE POWER Fig 2. Basis for European Corporate Bonds (bps) OF THESE MARKET-WIDE SUPPLY AND DEMAND FACTORS THROUGH 20 THE AVERAGE BASIS OF ALMOST

15 300 EUROPEAN CORPORATE BONDS TO CDS SINCE 2003. THE NET 10 EFFECT HAS BEEN BOTH POSITIVE

5 AND NEGATIVE OVER THE PERIOD. BETWEEN JULY AND NOVEMBER 0 4 4 3 3 4 3 5 5 4 3 4 3 4 3 4 3 4 3 4 4 4 3 3 3 4 3 2004 STRONG STRUCTURED CREDIT 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

l l t t r r r r v v y c y c g g n n b n b b n n p p u c u c a a p p e e a a o e a e e o a a e e u u u u J J FLOW PULLED CDS TIGHTER O O F J F F J J A A J J D D S S N N M M A -5 A M M RELATIVE TO BOND SPREADS, -10 REDUCING THE LEVEL OF POSITIVE

-15 BASIS.

-20

their investment mandates do not allow them to factors we have discussed, the best explanation demand for leveraged credit product. This flow of transact derivative products. Were every investor for this is a combination of European investors’ funds is almost exclusively invested as a long indifferent between gaining credit exposure high cash balances, and scarcity of Triple-A credit position rather than also expressing short through bonds or CDS, the market would corporate . views. The strong into this new eliminate any arbitrage by selling corporate bonds asset class has been a key driver of the CDS and selling credit protection until the prices CONVERTIBLES The issuance of convertible market’s rally, in that much of this structured converged and the arbitrage eliminated, or vice bonds can also provide a good illustration of credit product has been constructed using versa. However, today this is not the case. Given market segmentation. Many convertible accounts portfolios of single name CDS rather than that a significant percentage of the market is not make investments decisions based on the implied corporate bonds. This can result in cash spreads yet using CDS, we can expect arbitrage valuation of the embedded option. To lagging CDS following significant synthetic opportunities to exist between the two for some isolate this value, they often buy CDS protection to flows. time (although these should decrease as the remove the credit risk. As they do so, the price of The chart illustrates the power of these market- market integration continues). Funds that cannot protection will increase. If, for the reasons wide supply and demand factors through the access CDS drag cash bonds tighter, but do not discussed above, this does not induce sufficient average basis of almost 300 European corporate directly impact CDS spreads. When the positive bond holders to take advantage by switching out bonds to CDS since 2003. The net effect has basis becomes sufficiently large, we would expect of tighter trading bonds and into a long credit been both positive and negative over the period. trading desks and relative value long-short players position through CDS, a wider basis between Between July and November 2004 strong who can use derivatives to take advantage. bonds and CDS may be long lasting. structured credit flow pulled CDS tighter relative to However, as noted earlier, the inefficiency of the bond spreads, reducing the level of positive basis. corporate bond repo market makes it difficult to LOW BOND MARKET SUPPLY With corporate Since then the structured pipeline has extract value from positive basis except by taking bond issuance having decreased significantly over disappointed, and consequently the basis has a net long credit position, and therefore, in the the past 18 months, bonds have become an even widened. absence of sufficient weight of investors selling more scarce in the secondary In increasingly integrated credit markets, CDS CDS protection outright, positive basis differentials markets. Managers of real money funds need to prices are a key indicator of risk appetite. Used may be relatively long lasting. This efficiency earn a total return on invested cash. This means by loan, bond and convertible market investors, impediment to the efficient of credit risk they need to earn an return in they provide a single measure which is less across markets is likely to be a permanent driver addition to a credit premium. Thus, they will only prone to the technical distortions of each market. of basis, as it is in equity markets where the sell credit protection if they can also find a high- Understanding the factors driving basis is key to -borrow cost has significant influence on rated asset yielding the swap rate. In the current investors’ relative value decisions, and to cash and derivative prices. market environment, without the ability to use corporates’ ability to synthesise information from An example of positive basis in the primary derivatives, finding triple or even double-A assets the CDS and bond markets as they try to market is GECC’s ¤1.25bn 7 year to replicate the total return needed is very difficult. interpret investors’ appetite and consequent issue in February of this year. While at that time funding or buyback opportunities. 5yr GECC CDS was being quoted 22/24 bps and THE BID FOR STRUCTURED CREDIT A supply- 7 years a few bps wider, the bond was priced at demand imbalance which has been exerting the Daniel Berman mid-swaps +11 bps. That means that European opposite pressure on the conventional tendency Vice President, Credit Derivatives Marketing investors bought the new issue at least 11 bps for positive basis over the last 12 months is the [email protected] through the CDS of the same maturity. Of the “bid for structured credit”. This term refers to the www.jpmorgan.com

52 THE TREASURER MAY 2005