technical update extra CREDIT DEFAULT SWAPS technical update extra CREDIT DEFAULT SWAPS ISSUERS, AS MUCH AS INVESTORS, Fig 1. Credit Derivative Basics WILL NEED TO UNDERSTAND THE The relationship between Credit Default Swaps (CDS) are the basic building block of the credit derivatives market. They DRIVERS OF BASIS STARTING WITH allow investors to isolate and transfer credit risk, with a protection buyer transferring credit THOSE WHICH ARE CREDIT, BOND exposure on a reference credit to a protection seller. In exchange for this credit risk transfer, OR MATURITY SPECIFIC, AND the protection buyer pays the seller a periodic fee. If the credit experiences a Credit Event, the buyer receives a cash payout reflecting the loss experienced by holders of defaulted debt 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 loan, 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 investor who has sold short 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 prices from each market. Daniel Berman from JPMorgan and finish, a CDS is an unfunded contract, i.e. it is a swap. 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 credit derivative market means that over the reference government bond, increasingly While the asset swap spread is the most A CDS is a bilateral contract, so it can be of any maturity, currency 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 trade with one another, irrespective of the issuer’s outstanding obligations. seek to understand the bond markets and monitor reference, and therefore measure a bond’s credit distortion when the bond price 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 interest rate paid for transferring credit risk through each is very similar. buybacks. This review discusses the pricing more choices – between the asset swap, z- and environment, many corporate bonds currently methodology of the basic credit default swap, the i-spread of a bond (i.e. over the zero coupon 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 yield 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 arbitrage 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. RESTRUCTURING While Bankruptcy 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 risks 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 contracts, 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 long or short basis, depending on circumstances can diverge. A topical example is Restructuring does not have an equivalent in to an insurance 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 loans 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 Issuers, 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 trades 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 bond market 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.