A CREDITFLUX PRIMER. Credit derivative and structure credit. Essentials. Published in association with

Transcription

1 A CREDITFLUX PRIMER Credit derivative and structure credit Essentials Published in association with

2 A CREDITFLUX PRIMER Credit derivative and stuctured credit Essentials Written and edited by Michael Peterson in collaboration with Terri Duhon and Anu Munshi of B&B Structured Finance Limited, with contributions by Euan Hagger and Dan Alderson Design by Julian Knott Published by Creditflux Limited 63 Clerkenwell Road London EC1M 5NP United Kingdom ISBN: Creditflux Limited, July 2006

3 About the authors Michael Peterson Michael Peterson has been reporting on the structured credit and credit derivative markets since the late 1990s, first as a freelance journalist and, since 2001, as editor of Creditflux, a subscriptiononly print and web publication. Creditflux provides unrivalled news and analysis of the global market for credit derivatives and structured credit, and is widely regarded as the industry s leading publication. Terri Duhon Terri Duhon has 12 years of experience in the derivatives market, starting as an interest rate derivatives trader at JP Morgan in In 1998, Terri set up the exotic credit derivative trading book at JP Morgan and was instrumental in the Bistro product, which pioneered synthetic securitisation. In 2000, she helped to build JP Morgan s European structured finance business, later moving to ABN Amro to help build its global structured credit business. Terri founded B&B Structured Finance in Anu Munshi Anu Munshi has 7.5 years of experience in the structured credit market at JP Morgan in the US, Asia and Europe. Her roles at JP Morgan included structuring and marketing emerging market and credit derivatives, educating investors on credit derivatives, ABS and CDOs, and developing some of the recent credit derivative products such as CDS options and CMCDS. Anu joined B&B Structured Finance as partner in 2005.

4 Contents CHAPTER ONE The background CHAPTER TWO The products Single name credit default swaps Credit indices Nth-to-default baskets Collateralised debt obligations Index tranches Asset-backed credit default swaps Other credit derivatives CHAPTER THREE The practicalities Pricing and valuation Market conventions Confirmation and settlement List of illustrations Structured Credit and Credit Derivatives: Essentials 3

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6 CHAPTER ONE The background CREDIT RISK Credit risk is the risk that a borrower is unable or unwilling to make payments as they become due What is credit? Two main factors determine the value of bonds and loans. One is the prevailing rate of interest usually set by a central bank such as the US Federal Reserve or the European Central Bank. The interest paid on bonds or loans may rise or fall in line with prevailing interest rates or it may be fixed in which case the value of the asset rises and falls as interest rates change. The other factor is credit risk, the risk that the borrower is unable or unwilling to make payments as they become due. When the government of France or the United States issues bonds, the credit risk involved is minimal. What investors need to worry about is interest rates. But when companies or emerging market governments borrow, investors are exposed to both interest rate and credit risk. The credit market, as defined in this primer, is the business of trading, structuring and investing in the credit risk of large companies, emerging market countries and structured finance bonds, either through cash instruments (bonds and loans) or through credit derivatives. Structured Credit and Credit Derivatives: Essentials 5

7 CHAPTER ONE THE BACKGROUND Credit derivative outstandings $bn 2001 June 631 December June 1,600 December 2, June 2,690 December 3, June 5,440 December 8, June ,400 December ,300 Source: Isda What are credit derivatives? Credit derivatives were first traded sporadically at the end of the 1980s but it was not until the early 1990s that a real market for these products began to emerge. In the late 1990s and the first half of the next decade, credit derivatives grew rapidly to achieve a central role in the financial markets. The purpose of a credit derivative is to transfer only the credit risk of a borrower and not the associated interest rate risk. The fact that credit risk can be traded in isolation makes credit derivatives a very powerful tool. The main types of credit derivative products are single name credit default swaps, credit derivative indices, index tranches, synthetic CDOs and CPPI.(See the products, page 17). Unlike bonds and loans, which are financial contracts between a borrower and a lender, credit derivatives are contracts between any two counterparties which reference a specific borrower (the reference entity ). Very often neither counterparty is a lender to the reference entity. The reference entity is rarely involved in the trade and usually has no reason to know that the credit derivative contract exists. All credit derivatives traded to date (mid-2006) have been over-the-counter (OTC) derivatives. Unlike many equity or commodity options and futures, they are not traded on an exchange but are simply private contracts between two counterparties one of which is usually a dealer (also called a market maker). 6 Credit derivative and structured credit essentials

8 CHAPTER ONE THE BACKGROUND What is structured credit? The term structured credit has several different meanings. By one definition, it refers to a wide range of credit-derived products, including CDOs and credit derivatives. An alternative definition, and the one used in this primer, is that structured credit refers to tranched credit products. By this definition, a fully distributed cash CDO is a structured credit product but it is not a credit derivative. Single name credit default swaps are credit derivatives but not structured credit products. And single-tranche credit derivatives, index tranches and nth-to-default baskets fall within the definition of both structured credit and credit derivatives. How big is the market? Since credit derivatives are private contracts, it is difficult to calculate the size of the market with any accuracy. The task is also complicated by the different ways volumes are measured, problems of double-counting, and doubts about whether or not certain products should be considered as credit derivatives. As a result, estimates of the size of the market vary greatly. But all the various surveys on the size of the market agree that volumes have grown very rapidly since the beginning of the current century. The International Swaps and Derivatives Association (Isda), the trade association for dealers and users of over-the-counter derivatives, carries out a twice-yearly survey of the size of the market. It asks its members to calculate the total notional amount of all the derivatives they have outstanding. (In 2006, 86 firms provided information on their credit derivative positions, indicating that most big market participants are included in the survey.) According to Isda, the total face value of all outstanding credit derivatives at the end of 2005 was $17.3 trillion. That is a 27-fold increase on the $631 billion figure at the end of June 2001, when Isda first surveyed its members on their credit derivative positions (see table opposite). Even so, credit derivatives are still only a small part of the total derivatives market. According to the same Isda survey, the total of all outstanding over-the-counter derivatives Credit derivative and structured credit essentials

9 CHAPTER ONE THE BACKGROUND was $236 trillion, with interest rate derivatives taking the lion s share of that total. According to the Bank for International Settlements (BIS), the Baselbased central banks organisation, the total volume of outstanding credit derivatives at the end of 2005 stood at $13.7 trillion. These figures are based on data submitted by banks in the G10 group of largest economies to their central banks. CDO INFLUENCE Synthetic CDOs account for only a small portion of total credit derivative volumes, but they are a driving force behind the growth of the market What are the main products? Unlike Isda s survey, the BIS figures give a breakdown of the market by type of instrument. At the end of 2005, just under 73% of outstandings were for single-name contracts, with multi-name instruments (that is, baskets, index tranches and synthetic CDOs) accounting for the remainder. As this survey shows, synthetic CDOs (see page 40) are only a small part of the market in terms of volumes, but they are a big force driving the growth of the market. Dealers issue these investment vehicles to investors including banks, pension funds, insurers and individuals, and then hedge themselves by trading other credit derivatives such as single name credit default swaps, credit indices and index tranches, so increasing the amount of activity in all credit derivatives. Cashflow CDOs (see page 39) are not usually thought of as credit derivatives, but they are certainly structured credit products. And they play a similar role to synthetic CDOs of channelling investments into the broad credit market. According to figures compiled by Creditflux, there was a total of $469 billion of cashflow CDOs outstanding at the end of 2005, with $194 billion of new deals issued in 2005 alone. Who is involved? The credit derivatives business has historically been dominated by banks and investment banks. This is not surprising when you consider the major roles that banks and investment banks play in the credit business. Commercial banks are the main type of institution involved in lending money to companies using loans. Credit derivative and structured credit essentials

10 CHAPTER ONE THE BACKGROUND Synthetic CDO volumes Estimating the size of the structured credit market is complicated not only because credit derivatives are bilateral contracts, for which it is difficult to get accurate information on volumes, but because many credit derivatives are leveraged, referencing exposure greater than their own notional size. Nevertheless, the numbers available illustrate a large market that is growing fast. New volumes of what Creditflux defines as portfolio credit swaps (synthetic CDOs and other tranched portfolio credit derivatives) increased to nearly $300 billion in 2005 from $125 billion in 2004 and $196 billion in Meanwhile, investment banks (also known as securities houses) underwrite and distribute the bonds which governments, financial institutions and corporates (nonfinancial companies) issue to the broader investment community. According to figures compiled by the British Bankers Association for the global market in 2003, banks were the most important group of buyers of protection that is, counterparties using credit derivatives to offload credit risk. They were also the biggest group of protection sellers that is, counterparties using derivatives to invest in credit. (See chart on page 10.) Banks There is a common perception that banks use credit derivatives mainly to reduce their exposure to credits they do not like. While this may be true for many banks, it is by no means the whole story. All banks are regulated indirectly by the BIS (under regulations called the Basel Accord, and to be updated in the future to the Basel II Accord) to reserve a certain amount of capital against the assets they hold. This is called the bank s regulatory capital requirement and it depends on factors such as the credit risk and maturity of the assets it holds. Regulatory capital is a measure designed to preserve bank capital, since the riskier a bank s assets the more capital it has to reserve against those assets. The credit portfolio management function of a typical commercial bank looks at the profitability of the assets on its balance sheet, taking into account the regulatory cost of holding those assets. The credit portfolio manager may choose to sell an asset that does Credit derivative and structured credit essentials

11 CHAPTER ONE THE BACKGROUND Buyers of credit protection (2003) Sellers of credit protection (2003) hedge funds 16% securities houses 16% others 17% banks 51% hedge funds 15% securities houses 16% others 11% insurance companies 20% banks 38% Source: British Bankers Association not provide enough of a return over its regulatory capital charge or does not fit with its portfolio strategy. Alternatively, in many cases, the credit portfolio manager will hedge the risk using a credit derivative, which allows the bank to release regulatory capital. In addition, banks of all types make use of credit derivatives as an investment tool. Many banks have a proprietary trading desk which makes short or medium-term bets on credit in much the same way that a hedge fund does. In addition, many commercial banks invest in single name credit or in synthetic CDO tranches on a longer term basis. They may also be a dealer (see below). Many regional banks act as a dealer within a certain niche, for example, repackaging synthetic CDOs for smaller banks and investors in their own country. Dealers (market makers) Dealers or market makers provide a service allowing market participants such as banks, insurance companies, corporates and hedge funds to buy and sell credit derivatives, making money from 10 Credit derivative and structured credit essentials

12 CHAPTER ONE THE BACKGROUND the difference between the buying and selling price (known as the bid and the offer). They can be commercial banks such as Citigroup or investment banks such as Morgan Stanley. Large credit derivative dealers typically offer a wide range of credit derivative instruments and make a market on a broad choice of reference entities. In almost all cases they also trade credit derivatives for their own book, though sometimes this proprietary trading business is kept at arms length from the market-making function. Most credit derivative dealers have dealing desks in New York and London, and some also trade from Hong Kong, Singapore, Sydney or Tokyo. Liquidity is one of the biggest concerns of hedge funds. They want to know they can get out of a position when they need to. Until the launch of liquid credit derivative indices, the market was regarded as too illiquid for their purposes The biggest credit derivative dealers have historically been JP Morgan and Deutsche Bank, two large universal banks (offering both commercial banking and investment banking). In recent years, the business has become less concentrated and around a dozen firms can be thought of as full blown credit derivative dealers. The list of institutions signed up as dealers on the main credit derivative indices in Europe and in North America (see table on page 13) gives an indication of which banks are involved as credit derivative dealers in each region. Hedge funds Hedge funds, investment management vehicles designed to produce positive returns regardless of the direction of the market, are typically short-term investors. One of their biggest concerns is to ensure that they will be able to get out of or unwind a position when they need to. (This ability is known as liquidity.) Credit derivative and structured credit essentials 11

13 CHAPTER ONE THE BACKGROUND For a long time, few hedge funds traded credit derivatives, regarding the market as too illiquid for their purposes. That changed in around 2003, with the launch of the liquid credit derivative indices that later evolved into itraxx and CDX (see page 30). This meant that for the first time, hedge funds could trade in and out of credit in large sizes without losing large amounts of money on the difference between the buying and selling price (the bid-offer spread) on each trade. Since then, hedge funds have become key players in the credit derivatives market. Anecdotal evidence suggests their share of the market in terms of outstanding trades has grown substantially since 2003, when the BBA survey put this figure at 15%. In fact, because they are active buyers and sellers, hedge funds can often dominate daily trading volumes. TRANSFORMATION Some insurance companies write insurance policies which are converted into selling protection on credit derivatives Some of the biggest multi-strategy hedge funds such as Amaranth, Citadel Investment, Moore Capital and Tudor Investment are active in the credit market. Other big hedge fund players are credit specialists, typically set up by former credit derivative traders at investment banks. These include BlueMountain Capital, Cairn Capital, Cheyne Capital Management, Solent Capital and Tricadia Capital. Most credit hedge fund managers are based in London or in various locations in the United States. The funds themselves are usually domiciled offshore. Asset managers Asset managers that manage institutional money are fairly active in credit derivatives, especially those that manage CDOs. Traditional long-only funds such as mutual funds are much less involved. However, their involvement is thought to be increasing, and many funds have become members of the DTCC DerivServ settlement system for credit default swaps (see page 75) in 2005 and Insurance companies Insurance companies are involved in credit derivatives in two different ways. Life insurers and property and casualty insurers hold large investment portfolios to match their liabilities. Some have invested a small portion of these funds into credit derivatives, generally using credit-linked notes. 12 Credit derivative and structured credit essentials

14 CHAPTER ONE THE BACKGROUND Licensed index dealers itraxx Europe ABN Amro Bank of America Bank of Montreal Barclays Capital Bayerische Landesbank BBVA Bear Stearns BNP Paribas Calyon Citigroup Commerzbank Credit Suisse Deutsche Bank Dresdner Kleinwort Goldman Sachs HSBC Dow Jones CDX ABN Amro Bank of America Barclays Capital Bear Stearns BNP Paribas Citigroup Credit Suisse Deutsche Bank HypoVereinsbank ING Ixis Corporate & Investment Bank JP Morgan Lehman Brothers Merrill Lynch Morgan Stanley Natexis Banques Populaires Nomura Nordea Royal Bank of Scotland Santander Société Générale TD Securities UBS Source: International Index Company Goldman Sachs HSBC JP Morgan Lehman Brothers Merrill Lynch Morgan Stanley UBS Wachovia Source: Markit Credit derivative and structured credit essentials 13

15 CHAPTER ONE THE BACKGROUND The other way insurance companies use the credit derivatives market is by writing insurance policies. In economic terms, this is similar to selling protection on credit default swaps and these insurance policies are usually converted into credit derivative contracts through a special insurance vehicle known as a transformer. The insurance companies that are involved in this business include both specialist bond insurers known as monoline insurers and reinsurers. Pension funds Pension funds are not big players in the credit derivatives market, though some funds have invested in CDOs and their involvement is growing. Pension funds often face compliance issues in trading credit derivatives, since their investment management guidelines often prevent the use of derivatives. Retail investors Credit derivatives are wholesale financial products that can almost never be traded directly by individual investors. Not only are the minimum trade sizes too large for most investors, banks are usually prohibited from offering these products to retail customers. However funded credit derivative products such as CDOs and credit CPPI products, which more easily lend themselves to being highly rated or principal protected, are an exception. These products are commonly sold to high-net-worth individuals, and in certain countries (notably Australia, Canada and the Netherlands) have been sold to true retail customers. Corporates Despite the best efforts of many credit derivative salespeople, big corporates have not taken to using credit derivatives in the same way that they routinely hedge their currency or commodity price exposures. Interdealer brokers Interdealer brokers do not trade credit derivatives themselves. They act as agents when credit derivative dealers trade with each other. As in other derivative markets, almost all credit derivative trades between dealers are brokered by one of the small number of these specialist firms. The biggest include Creditex, Creditrade, Garban, GFI and Tullett Prebon. 14 Credit derivative and structured credit essentials

16 CHAPTER ONE THE BACKGROUND Highlights in evolution of the credit derivative market Late 1980s First cashflow CDOs issued First credit derivatives begin to be traded, often swaps on specific bonds created for tax or regulatory purposes Mid to late 1990s Issuance of large balance sheet synthetic CDOs for the purpose of achieving regulatory capital relief 1996 Isda publishes the first credit derivative definitions July September Isda publishes the second credit derivative definitions, which bring much greater standardisation and acceptance to the market Bank of America extends the maturity of a loan to Conseco, triggering a controversy which eventually leads the market to change its definition of restructuring as a credit event 2001 December December 2002 April April Default of Enron, the biggest corporate default in history by volume of debt outstanding Default of Argentina, the biggest sovereign default in history by volume of debt outstanding, triggering a controversy on the definition of repudiation/moratorium, the main credit event for sovereigns Morgan Stanley launches Synthetic Tracers, which becomes the market standard index for North American investment grade credit Dealers launch the reference entity database (Red) in response to high profile cases in which counterparties had disagreed over which was the intended reference entity in a credit default swap. The project is later taken over by data company Markit. continued Credit derivative and structured credit essentials 15

17 CHAPTER ONE THE BACKGROUND Highlights in evolution of the credit derivative market December 2003 March April October 2004 April 2005 April/May May June September October North American dealers begin trading credit derivatives with standard maturity and payment dates in an effort to increase liquidity. European dealers later also adopt this practice Isda publishes 2003 credit derivative definitions, which significantly revise the 1999 short-form documentation in areas such as restructuring, successor events and guarantees JP Morgan and Morgan Stanley kick-start credit index trading in Europe by merging their proprietary indices to form Trac-x North American dealers launch CDX NA IG, which takes over as the standard credit index for North American investment grade Credit derivative dealers agree to merge various indices to form a single index in each market A dramatic repricing of credit index tranches causes losses to banks and hedge funds Default of Collins & Aikman, the first credit event to be settled using an auction Isda launches standard documentation for credit default swaps on asset-backed securities The New York Fed hosts a meeting between top credit derivative dealers and regulators from around the world, who are concerned about the operational weaknesses of the credit derivatives market. Dealers agree to take steps to cut the time it takes to settle trades. Default of Delphi, thought to be the biggest default to date in terms of credit derivatives outstanding 16 Credit derivative and structured credit essentials

18 CHAPTER TWO The products BUILDING BLOCKS Almost all credit derivatives take the form of a credit default swap. The simplest type is a single-name credit default swap Single name credit default swaps Credit default swaps, also known as default swaps, credit swaps and CDS, are the basic building block of the credit derivatives market. Almost all credit derivatives take the form of a credit default swap, and most of these swaps are based on a standard legal contract known as a confirm. The simplest and most common type of credit default swap is one where there is just one reference entity. This is called a single-name credit default swap. The reference entity can be any borrower, but is most often one of a few hundred widely traded companies (corporates or financials) or a handful of governments (sovereigns). Credit default swaps can be used to transfer types of credit risk other than borrowings (such as trade debt), but these contracts are not standard and are rarely seen in practice. A single name credit default swap acts rather like an insurance contract against the default of a reference entity. The buyer of protection (known in the contract as the fixed rate payer ) makes periodic premium payments to the seller of protection (the floating rate payer ). Structured Credit and Credit Derivatives: Essentials 17

19 Example of a single name credit default swap An investor who wants to take a view on France Telecom might sell credit default swap protection. In May 2006, dealers quoted five-year credit default swap spreads on France Telecom at 37/39 basis points (bp, hundredths of a percentage point). This means the dealer quotes 37bp for a trade where the investor sells five-year protection and the dealer buys protection, and 39bp for a trade where the investor buys protection. (The difference between the two quotes is known as the bid-offer spread.) On a typical trade size of 10 million, the protection seller would receive 37,000 a year, usually in four quarterly payments. Conversely, the investor could buy protection for 39bp, paying 39,000 a year. If France Telecom defaults during the life of the trade and, following the default, the value of the company s debt falls to 40% of face value (the recovery rate ), the protection seller will compensate the protection buyer for the 6 million loss. If the reference entity defaults (that is, it undergoes one of the credit events defined in the contract) the protection buyer stops paying premiums and receives a one-off payment from the protection seller which compensates the protection buyer for the loss experienced as a result of the default. (Note, however, that a credit default swap is not an insurance contract. There are several important legal and economic differences between the two products. For example, the buyer of an insurance policy can normally only insure itself against an event that would cause it a loss that is, it must have an insurable interest in the risk whereas a buyer of credit protection does not need to own debt issued by the reference entity.) In the event of a default, the credit default swap terminates and settlement takes place with the protection seller making a payment to the protection buyer. Depending on the terms agreed up front by the counterparties, settlement can be either physical (current market standard) or cash. In either case, the settlement amount is intended to compensate the protection buyer for the loss that it would have incurred had it owned the notional amount of the reference entity s debt. 18 Credit derivative and structured credit essentials

20 Physically settled credit default swap $30,000 annual premium paid quarterly for IBM protection protection buyer (fixed rate payer) $10mm protection seller (floating rate payer) deliverable obligation (worth $4mm) Source: B&B Structured Finance Ltd Physical settlement The standard form of settlement for credit derivatives at the time of publication is physical settlement. After the protection buyer has triggered a credit event, with the delivery of a notice of physical settlement, the protection buyer delivers to the protection seller bonds or loans ( deliverable obligations ) with a notional amount identical to the notional amount of the credit default swap. The protection seller then pays the protection buyer the notional amount of the credit default swap. For example, for a standard $10 million contract on IBM, when IBM defaults, the protection buyer delivers defaulted bonds with a $10 million face value and receives $10 million from the protection seller. If the defaulted bonds are worth $4 million (40% of their face value, where 40% is called the recovery rate), the protection buyer has effectively made $6 million as a result of buying protection. The seller of protection could choose to sell the defaulted bonds, so achieving their recovery value. Credit default swap contracts define the deliverable obligations that is, which of the issuer s bonds or loans can be delivered by the protection buyer following a credit event. This pool of deliverables is usually defined as bonds or loans issued by the reference entity that are not subordinated to the reference obligation. However, certain types of debt instruments such as those denominated in Credit derivative and structured credit essentials 19

21 minor currencies, those that are not fully transferable, and those whose payment is contingent on particular circumstances are usually excluded from this pool and may not be delivered. In a standard credit default swap, the pool of deliverables includes all the entity s conventional senior debt (bonds and loans, secured and unsecured), but it excludes subordinated (junior) debt, preference shares, trade debts and obligations with certain nonstandard features. DELIVERABLES In a standard credit default swap, the pool of deliverable obligations includes all the reference entity s senior bonds and loans, but excludes subordinated debt, preference shares, trade debts and obligations with non-standard features The reference obligation is simply a specific bond or loan issued by the reference entity which is agreed to at the start of the trade in order to characterise the deliverable obligations. If the protection buyer can access more than one deliverable obligation, it has the option of delivering the cheapest one available. Thus the protection buyer owns a cheapest-to-deliver option, which is one of the main reasons that credit default swap spreads are usually wider than bond spreads for the same reference entity. Physical settlement has the advantage that it is not subject to manipulation by either party. But it has some severe drawbacks (see page 75). As a result, many credit derivatives are cash-settled. Cash settlement In a cash-settled credit default swap, no bonds or loans are delivered. Instead, the protection seller simply pays the protection buyer an amount of money calculated as the notional value of the contract minus the recovery rate. While most single name credit default swaps are physically settled, counterparties may agree to cash settle them instead. The recovery rate is based on a dealer poll, where the calculation agent obtains quotes from several firms that are active market makers in the reference obligation to determine its market value. For example, if the $10 million IBM contract were to be cash settled, the protection seller would pay the protection buyer $6 million, based on the 40% market value (recovery rate) of IBM s reference obligation. 20 Credit derivative and structured credit essentials

22 Cash settled credit default swap $30,000 annual premium paid quarterly for IBM protection protection buyer (fixed rate payer) $6mm (=$10mm - $4mm) protection seller (floating rate payer) effectively netting the following cashflows: $10mm par amount $4mm recovery Source: B&B Structured Finance Ltd Binary or digital settlement In binary or digital credit default swaps, the recovery rate is fixed. For example, if two counterparties trade a $10 million credit default swap on IBM with a 40% fixed recovery rate, the protection seller will simply pay the protection buyer $6 million in the event of a default by IBM. This approach has the advantage of simplicity, but the disadvantage that the protection buyer does know if it has bought enough protection to cover its losses. For this reason, binary credit derivatives are relatively rare. Credit default swaps compared to bonds As credit default swaps isolate and transfer credit risk, users can buy and sell protection depending on whether they want to hedge (or in some cases speculate) or take on credit risk. Since sellers of protection take on credit risk and earn a premium for this risk, they are equivalent to the buyers of bonds. And since buyers of protection hedge credit risk paying a premium for getting rid of risk this is equivalent to shorting a bond. In both cases, the party taking on credit risk loses money if the credit defaults. Credit derivative and structured credit essentials 21

23 The main difference between bond and credit default swap cashflows is timing of principal payments. The bond buyer pays the principal to buy the bond on the trade date, whereas the protection seller pays the principal (or rather, principal less the recovery rate) only when the credit defaults. Credit default swaps are therefore leveraged instruments because the protection seller does not need to put any money down to earn a premium for the risk it takes. Credit default swaps are also referred to as unfunded instruments, since the protection seller unlike the bond investor does not need to raise money (or get funding) to buy credit risk. CDS versus bond cashflows bond $100 principal bond issuer bond coupon x $100 principal recovery/deliverable obligations bond investor CDS protection buyer (fixed rate payer) premium/credit spread contingent payment protection seller (floating rate payer) effectively netting the following: par amount recovery/deliverable obligations Source: B&B Structured Finance Ltd 22 Credit derivative and structured credit essentials

24 Credit default swaps are leveraged instruments. The protection seller does not need to put down money to earn a premium for the risk it takes. By contrast, a bond investor needs to raise money to take on credit risk Credit default swap cashflows mean that the protection buyer is exposed to the credit risk of the protection seller. This counterparty risk is the risk that the protection seller cannot or will not pay the par amount, at the time when the protection buyer needs it most. By contrast, the protection seller s only counterparty risk is that the protection buyer will stop making premium payments. Single name trading strategies Single name credit default swaps can be used as part of a large range of relative value trading strategies. Among the simplest are basis trades. This strategy is designed to take advantage of the difference (the basis) between credit default swap spreads and cash bond or loan spreads for the same credit. A trader puts on a negative-basis trade when the credit default swap spread is lower than the spread over Libor on a cash asset, allowing the trader to buy the bond, buy protection on the issuer of the bond and earn a positive net spread (this surplus is referred to as positive carry). The trader either buys a floating rate asset or a fixed rate bond that has been asset-swapped into a floating rate instrument paying a spread over Libor. This trade carries no credit risk and the trader is able to earn a positive spread for taking advantage of the CDSbond basis. Because of the bid-offer spread, negative basis trades tend to be worth putting on only when the basis exceeds around 10bp. These opportunities have become increasingly rare as the trade has become well known. Other single name trading strategies include convergence trades where a trader believes that the difference between the spreads of two names will decrease. Credit derivative and structured credit essentials 23

25 For example, if Renault spreads are wider than Peugeot spreads, and a trader believes their credit risk is very similar, the trader could sell protection on Renault and buy protection on Peugeot, expressing the view that their spreads will converge and making a gain on the overall trade. Another strategy is to sell protection on one name whose spreads the trader believes will tighten, and to use the income to buy protection on another name whose spread the trader believes will widen. For names where there is a liquid market in both senior and subordinated credit default swaps (chiefly financials), traders can use single name credit default swaps to bet that the reference entity s subordinated debt will outperform its senior debt or vice versa without taking an outright view on the creditworthiness of the borrower or the direction of its spreads. The emergence of a liquid market in seven and 10-year credit derivatives, starting around 2005, has made it possible for traders to express views on spreads at different points on the credit curve (called curve trades) using single name credit default swaps. These strategies express a view not just on the likelihood of default, but on the timing of any possible default. Basis trades Basis trades involve buying a bond and buying protection or vice versa asset swap par (100) investor coupon (L+X) CDS CDS premium = Y bp dealer basis = Y - X bp Source: B&B Structured Finance Ltd 24 Credit derivative and structured credit essentials

26 Curve steepener 10Y CDS widens relative to 5Y CDS initial CDS curve company X CDS spreads 5Y CDS tightens relative to 10Y CDS or some combination of these two effects 5Y 10Y time Source: B&B Structured Finance Ltd A popular curve trade in 2005 and 2006 has been a curve steepener. A trader who believes that an issuer s long-term credit spreads are likely to widen relative to shorter-term spreads, causing the credit curve to steepen, might sell five-year protection and buy 10-year protection on the name, making money when five-year spreads tighten, ten-year spreads widen or some combination of the two effects. A curve flattener is the opposite bet that spreads at different maturities will converge. Credit default swap conventions The credit default swap creates no legal relationship between the reference entity and either of the counterparties, only between the two counterparties. Confirms are used to document the trade and confirm the terms and conditions agreed by both parties. The confirms contain a list of definitions that determine, among other things, the credit events that will trigger settlement, the obligations observed to determine whether a particular type of credit event such as failure to pay has occurred, the form of Credit derivative and structured credit essentials 25

27 settlement, and the bonds and loans that may be delivered if the contract is physically settled. The definitions and the confirm template are drawn up periodically by Isda. The most recent are the 2003 credit derivative definitions (see page 69). By convention, there is a standard set of choices from the menu for each type of credit (for example North American high yield corporate, Asian sovereign, European investment grade corporate or Japanese corporate). Prices are quoted assuming that this market standard documentation will be used. However, counterparties sometimes agree to trade on non-standard terms. STANDARDS Prices are quoted assuming that market standard documentation will be used. Counterparties somethimes agree to trade on nonstandard terms Credit events (or defaults) are precisely defined in a credit default swap. The definition of credit events can make a big difference to the value of the credit default swap. Different types of credit events are used as the market standard for different types of credits (see page 71). For example, North American high yield corporates trade with only two credit events: bankruptcy and failure to pay, while investment grade credits in North America can also be triggered by some types of debt restructuring. The notional size of a credit default swap on an investment grade credit is typically $10 million or 10 million, although US investment grade names often trade in sizes of $20 million. For high-yield names, typical trade sizes are smaller, usually $5 million or less. The quoted price of a credit default swap is the annual premium or coupon expressed as a proportion of the trade size (or notional) in basis points. This figure is commonly referred to as the spread of the credit default swap, by analogy with a bond s spread over Libor. In most credit default swaps, the premium is fixed for the life of the trade. (The main exceptions are constant maturity credit default swaps see page 60). Single-name credit default swaps can be for any term agreed at the outset by the counterparties. However, the majority of trades are for one of a few standard maturities. Originally, most credit default swaps were five-year trades. However, by early 2006, three, seven and 10-year trades had also become popular. 26 Credit derivative and structured credit essentials

28 Even though single-name credit default swaps are unfunded, most counterparties generally collateralise their contacts with each other through a credit support annex (CSA) - effectively a margining arrangement Credit derivatives can be funded or unfunded. In an unfunded trade, as described above, the protection seller makes no payments until there is a default. Alternatively, single-name credit default swaps can be funded by repackaging them as credit-linked notes. Even though single-name credit default swaps are unfunded, most counterparties generally collateralise their contracts with each other through a credit support annex (CSA), which is effectively a margining arrangement. As a protection buyer s credit exposure to its counterparty increases beyond a certain threshold, the counterparty has to post collateral to offset the protection buyer s counterparty credit risk. Most trades with hedge funds are transacted under a CSA. For example, a hedge fund might trade a $10 million single name default swap with a dealer and put up $1 million to collateralise the trade. If the market value of the trade moves against the hedge fund beyond a certain threshold, say $2.5 million, the dealer will ask it to post additional collateral to cover the increased risk. Credit-linked notes Credit-linked notes (CLNs) are typically issued by dealers or by special-purpose companies (or special-purpose vehicles, SPVs) domiciled in an offshore location. Some dealers have a medium term note (MTN) issuance programme under which they can issue notes in their name, which are linked to reference entities to which investors want to take risk. For example, an investor might want to take $10 million of exposure to Hilton Hotels in a maturity or currency for which there are no outstanding Hilton bonds. A dealer with an MTN programme could issue a $10 million note in its own name, with Hilton being the primary credit risk of the instrument. The investor would pay Credit derivative and structured credit essentials 27

29 Credit-linked deposit dealer (protection buyer) deposit issued by dealer paying L + CDS premium 100 investor (note holder) 100 L deposit Source: B&B Structured Finance Ltd the dealer $10 million on the trade date to buy the note, whose proceeds the dealer puts into its own deposit. The dealer issues a note which embeds a credit default swap in which the dealer buys $10 million of Hilton protection from the investor. The note coupon would consist of the interest earned from the deposit (typically Libor) plus the spread of the credit default swap, and would be paid to the investor quarterly. If there is no default, the credit default swap and deposit terminate on the maturity of the note, and the proceeds from the redemption of the deposit are paid back to the investor. If Hilton experiences a credit event, the deposit is unwound and its proceeds used to pay the dealer the par amount. The dealer then pays the investor the recovery amount in the case of a cash settled CLN or delivers deliverable obligations in the case of a physically settled CLN. 28 Credit derivative and structured credit essentials

30 CLN issued by an SPV dealer (protection buyer) CDS premium SPV CLN issued by SPV paying L+ CDS premium $100 investor (note holder) 100 L collateral Source: B&B Structured Finance Ltd Credit-linked notes are also often issued by SPVs. SPVs are set up by dealers to issue numerous different credit-linked notes. However, the notes are documented so that each investor s risk exposure is completely segregated. Applying the example above to an SPV-issued CLN, the dealer arranges for its Cayman Island s vehicle XYZ Finance Limited, to issue $10 million of notes. The investor buys the note from the SPV and the proceeds are invested in low-risk collateral such as triple A rated Rabobank bonds. (Sometimes, the collateral takes the form of a repo agreement with the investment bank.) XYZ Finance Limited then sells protection on a $10 million Hilton Hotels credit default swap to the dealer. The premium from the credit default swap along with the coupons from the collateral are paid to the investor quarterly. Credit derivative and structured credit essentials 29

31 If there is no default, the credit default swap terminates and the collateral redeems on maturity, and the collateral redemption proceeds are paid back to the investor. If there is a credit event, the collateral is sold and its proceeds used to pay the dealer the par amount. The dealer either pays the investor the recovery amount or delivers deliverable obligations to the investor. From a protection seller s point of view, investing in a credit-linked note is like buying a bond issued by the reference entity. The investor pays the notional amount of the trade upfront, receives a regular coupon payment and receives principal back when the bond matures. In the event of default, the investor receives the recovery rate of the reference entity s debt. Investors buy credit-linked notes for a variety of reasons. Creditlinked notes are investments customised to their maturity, currency and coupon requirements, and could match their liabilities far more closely than bonds available in the market. Some investors are not allowed to trade derivatives, so may not be able to sell protection on credit default swaps, but can buy credit-linked notes which are securities. Other investors may be able to sell protection, but prefer to buy credit-linked notes since they have cash to invest. BENCHMARKS Credit derivative indices allow investors to buy and sell a crosssection of the credit market much more efficiently than they could buy and sell individual credits Credit indices A credit derivative index is a basket of single name credit default swaps with standardised terms. Unlike other multi-name credit default swaps, such as first-to-default baskets, index swaps provide unleveraged exposure to the names in the basket. The indices act as a global set of benchmarks, allowing investors to buy and sell a cross-section of the credit market much more efficiently than they could if they were buying and selling individual credits. There are credit default swap indices in Europe, North America, Japan, Australia, non-japan Asia and emerging markets. Unlike in most equity and cash bond indices, constituents are not selected on the basis of their market size, but by specific rules set out for each index. For the main indices, constituents are chosen by liquidity, for example. They are also (for most indices) equally weighted. 30 Credit derivative and structured credit essentials

32 Credit derivative index cashflows index ref. entity 125 receives index spread on $125mm ref. entity 70 pays $1mm (par for ref. entity 70) receives recovery or deliverable obligations with $1mm face value index investor ref. entity 3 after credit event: receives index spread on $124mm ref. entity 2 ref. entity 1 Source: B&B Structured Finance Ltd A new credit derivative index is launched every six months, usually in March and September, to reflect the names in the credit derivative market that fit the rules for each index at that time. On these roll dates, a new basket of credits is created, with constituents selected by an independent index administrator based on input from dealers. Usually, only a handful of names change from one series to the next. The current series of the index is known as the on-the-run index and is usually much more liquid than the off-the-run versions. However, some off-the-run indices continue to trade actively after they have ceased to be the current version. Index trades are intended to be highly standardised to ensure liquidity. Not only do all counterparties trade the same list of names for each six month period, they also trade using a fixed spread for Credit derivative and structured credit essentials 31

33 Credit derivative index prices (bp), 20 June 2006 North America DJ CDX NA IG 45.6 DJ CDX NA HVOL 89.2 DJ CDX NA XO DJ CDX NA HY Europe itraxx Europe 34.0 itraxx Europe HiVol 61.5 itraxx Crossover Japan itraxx CJ Japan 28.9 the life of the series. If, as is usually the case, the market spread is different from the coupon, the counterparties exchange money upfront to account for this difference. Maturities are also standardised, with three, five, seven and 10-year maturities traded for the biggest indices. However, few index trades are held to maturity. In order to ensure that their positions are as liquid as possible, most counterparties roll into the new version of the index every six months. For example, a firm that bought protection on series 5 of the CDX NA IG index in January 2006, and wanted to keep a position in the on-the-run index, would have unwound this trade at the 20 March 2006 roll date and put on a new trade referencing series 6 of the index. Sources: Markit, International Index Company Indices are among the most actively traded credit derivatives because they provide a way to buy or sell diversified credit risk quickly and with low dealing costs. The main indices trade with bid-offer spreads of one-half of a basis point. These patterns of trading give credit indices their own trading dynamics. Although there is little fundamental reason why the spread of the index should not be the same as the average spread of its constituents (its theoretical value ) in practice indices often trade wider or tighter than their theoretical value. When the market price of the index is higher than its theoretical value, it is said to trade with a positive basis to theoretical. When 32 Credit derivative and structured credit essentials