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Why CDS investors need to lock in recovery rates now

Until discrepancies between index auction prices and single-name CDS recovery rates can be ironed out, investors should sell recovery basis risk.

Thirty-two issuers defaulted globally in 2005, having an impact on bonds worth a total of $29 billion. With huge volumes of credit default swaps now written against these bonds, how and when recovery rates are determined is crucial. There is an urgent need for the market to establish a settlement standard that can minimize any price and recovery rate manipulation in the most efficient manner. The Isda protocol in May amended existing index-related contracts from physical to cash settlement but most single-name CDS are still settled physically and the difference between the two processes creates recovery basis risk.

The scramble to find bonds to achieve physical settlement of CDS contracts often results in a short squeeze, which triggers an artificial price spike. In Delphi’s case this inflated the bond price by 24% just before auction as the firm had $27.1 billion of outstanding CDS against notional outstanding bonds of just $2 billion. And Dana Corp’s bankruptcy in March resulted in another squeeze as $20 billion of CDS chased $2 billion of bonds.

Cash settlement of single-name CDS will not overcome this manipulation, it will just make settlement more orderly. Alternative solutions fall into two broad camps: net physical settlement via an auction and net physical settlement using a central repository of trades.

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