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Credit derivatives: Lehman hopes for index-inspired liquidity in preferred CDS

The experience of the high-yield sector shows synthetic risk can boost an illiquid product

Lehman Brothers believes it has developed a new tool for hedge funds. In February the US investment bank launched a product called preferred credit default swaps, and in August was planning to extend the product by launching a PCDS index.

As the name implies, PCDS are just like regular credit default swaps, but with preferred and trust preferred securities serving as the underlying. The regular Isda documentation for CDS suffices, with just a couple of tweaks: first, in the event of a default on preferred CDS, the buyer of protection can deliver a preferred or trust preferred security in addition to any more senior obligation. Second, the deferral of a preferred stock dividend or trust preferred coupon has been added to the documentation as a fourth credit event.

Hedge funds have found uncovering relative value in preferred securities difficult because most issuance is perpetual, though callable, and aimed at US investors that buy for tax advantages. Offshore hedge funds pay a 30% withholding tax, which makes relative value plays exceptionally difficult.

PCDS eliminate this, creating a synthetic, five-year bullet structure that bypasses such concerns. Hedge funds can more easily take exposure to preferred securities and shorting and hedging of preferred securities is much more efficient: roughly two-thirds of traditional preferred securities, according to Lehman research, are listed on the New York Stock Exchange and subject to the exchange's locate-to-borrow rule.

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