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Capital Markets

CDS on leveraged loans

Access to collateral is the number one topic of conversation in the CLO market. But if a viable leveraged loan CDS market develops, Christmas will have come early for many players.

How CLO managers muscled in on the LBO market

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However, as the ABS CDS market has shown, these products can be tough to get off the ground.

In order to be traded in any size a CDS market needs liquidity and volatility in the underlying. Indeed, the ABS CDS market has only really taken off in the triple-B home equity space, with hedge funds using it as a speculative play to go short US consumer and housing risk. And while leveraged loans may be more volatile than ABS (see chart), are they volatile enough?

“LCDS are an attractive product for both trading and investment books,” says Marcus Schüler, managing director, integrated credit marketing at Deutsche Bank in London, which together with Morgan Stanley and DrKW has been most active in the nascent market. He adds that this is probably the CDS on a new underlying that has created the most intial interest from clients: “The creation of LCDS has brought more than 30 new high spread exposures to the market, something many market participants have been waiting for.”

A leveraged loan CDS market could be created from capital structure arbitrage; playing the relative value of the senior loan versus the high yield bond or mezzanine loan or second lien.

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