For all its increased transparency, standardization, and liquidity, investors should treat the credit derivatives market with caution in 2005.
In a November report that focused on the high-yield credit default swap market in the US, Fitch Ratings looked at some of the issues surrounding restructuring as a credit event. Restructuring through a distressed debt exchange could be particularly problematic.
Using a sample of 16 high-yield bonds, Fitch found that investors who bought at or close to par could lose between 40% and 60% of their investment by the time a distressed exchange has occurred. But buying protection in the CDS market might not fully make up for the shortfall because most high-yield CDS don't cover the protection buyer specifically in the event of a loan restructuring or distressed bond exchange.
Beware lack of protection
?The fact that most high-yield loan restructurings and distressed exchanges effectively are not credit events triggering payment is something the market should remember,? says James Batterman, analyst at Fitch Ratings in New York. ?Were language in place to protect the CDS buyer, the cost to the seller would increase, which would make sellers less likely to offer protection, or sell it at higher cost. But that doesn't mean that the lack of protection in such cases should be ignored, especially as they are typically the culmination of some sort of credit impairment suffered by the company. In a continuing low-default environment, the market risks losing sight of that.?
A distressed bond exchange leaves investors with several different outcomes. ?If you choose not to tender bonds in a distressed exchange but a sufficient number of other bondholders do, you will be left holding a very illiquid instrument, you could be stripped of covenant protection, and any credit protection would not have been triggered,? says Batterman. Unwinding positions can be costly, but investors in this situation might have to close out a cash market position prior to a debt exchange.
?Ordinarily, all other things being equal, under a restructuring situation, it may be preferable to be a high-yield CDS protection seller than to hold a long cash bond position in the same reference entity,? says the report. ?This should be considered in relative pricing.?
According to Fitch, over the past three years 5% of all high-yield bond downgrades on a par-weighted basis to D (default) were caused by a distressed exchange. In 2003 the figure was 10%. ?As a proportion of all downgrades to default, that's certainly less significant than failure to pay or bankruptcy,? says Batterman. ?But if you're one of the affected parties it matters ? 10% is certainly a meaningful proportion. It's complicated, because if you're hedged, for example, you are still protected against bankruptcy and failure to pay, but there is a question of whether you face heightened basis risk in the meantime.?
Fitch's report uses measured language and stresses that it isn't attacking the hedging value or investment value of CDS. Others are more strident. Anne Wrobel is director, European structured finance at monoline Financial Security Assurance (FSA). FSA has about $60 billion of exposure to credit derivatives, mostly written on investment-grade names. As a final portfolio investor that does not trade on single names, it has to be cautious.
At the end of November, Wrobel told Euromoney's second annual credit derivatives conference in London that the implications of restructuring as a credit event were one of a number of unresolved problems that the CDS market had to face.
?We have not solved anything since the 2003 trade definitions were published,? Wrobel said. ?We still don't know what an event is. For an investor like us, standardization is not a good thing. I agree with all the positive statements about the market, but for a buy-and-hold investor, there is huge systemic risk on the indices and you need to diversify outside that. Once that risk is on our balance sheet, we don't hedge it other than in the reinsurance market.?
?Volumes have increased and risk is down,? Richard Stuart-Reckling, vice-president, Morgan Stanley, said at the same event. ?But fudging the 2003 definitions into synthetic CDOs is a problem.?
Wrobel said that it was hard to anticipate the impact of a default by an emerging market corporate. She also said that it was risky to build structured credit products on assets that don't have a liquid single-name market, like MBS. ?Unlike the US, Europe has no standard mortgage contract,? she said. ?You can't have CDOs of ABS without a single-name market. Collateral managers at banks have to hedge themselves through single names. What will happen in the next credit cycle??