CREDIT DEFAULT SWAPS The relationship between …

1 MAY 2005 THE TREASURER51package trade for many investors), and positivebasis does not generally represent a purearbitrage opportunity in the same in general is an important indicator ofrelative value between bond and CDS markets,and a key trade and profitability driver forinvestors. Implicitly, any investor whose remitallows investment in either bonds or CDS,isalways either long or short basis,depending onthe composition of their portfolio between bondsand a corporate perspective,understanding investors actions and creditappetite requires analysis of the relevantinvestment alternatives. As CDS moves centrestage,the drivers of the differential between it andmore traditional corporate CREDIT products becomea key component in this , as much as investors, will need tounderstand the drivers of basis starting with thosewhich are CREDIT ,bond or maturity specific,andmoving onto others which influence the tradingrelationships seen across the COVENANTS CDS and bonddocumentation are similar but not identical.

2 CDSis a commoditised instrument with littlecustomisation dependent on the referenced CREDIT ,whereas bond terms and conditions are a functionof issuance strategy, CREDIT strength, investordemand and market timing. An obvious exampleof this is significant differences in negative pledgelanguage for investment grade issuers, which canresult in varying levels of CREDIT risk betweendifferent bonds of the same issuer, despite eachbeing labelled senior investor who is long CREDIT risk through CDSwill gain comfort from outstanding bonds of theissuer which have strong negative pledgelanguage. However, should these bonds beredeemed early, the CDS, along with other bondscontaining less restrictive covenant language, willbe exposed to greater CREDIT risk. This uncertainty the risk of change to both corporate andfunding structures increases with , bonds can contain conditional investorputs or issuer calls.

3 The risks for holders of creditrisk through bonds and CDS in thesecircumstances can topical example isSainsbury s bonds which contain an investor putat par following a ratings downgrade in certaincircumstances,including a change of is no equivalent language in Sainsbury sCDS (as it is a standard contract), we wouldexpect,and do,observe that Sainsbury bondstrade expensively ( a lower spread) comparedto its CDS. Investors comparing Sainsbury s bondsand CDS as investment alternatives are givingvalue to the possibility that this put is characteristic of the bonds is an importantdriver of the basis. To make it more complicated,the value of the documentation differencesbetween Sainsbury s bonds and CDS will likelyvary over time, as it depends on a number offactors, including:nInterest rates: as interest rates rally, fixed rateSainsbury bonds will appreciate in value.

4 Thisdecreases the potential value of the put which isfixed at a cash price of par,rather than calculatedas a spread over Gilts or s CREDIT quality: as Sainsbury s creditimproves, the likelihood of investors gaining theopportunity to exercise the par put decreases,thus reducing the value of this potential , the relationship of step up/downbonds,whose coupon levels are dependent onratings, to CDS will depend on the market sexpectation of future coupon settings. Forexample, if investors expect a telecom CREDIT to beupgraded, its step up/down bonds will traderelatively cheap to CDS, reflecting the expectedreduction in While Bankruptcy and Failureto Pay are likely to have equal economic impacton bonds and CDS, the third CREDIT Event inEuropean CDS contracts,Modified ModifiedRestructuring does not have an equivalent instandard bond or loan documentation.

5 This givesCDS protection higher value as it can trigger apayout in circumstances where any one of theissuer s bonds and loans have been BUYBACKSIf a company repurchasesoutstanding bonds before maturity, for examplethrough a formal tender process, holders normallyreceive a premium to the current market level asan incentive for selling their holdings. While all ofthe company s bonds and CDS levels will benefitfrom this action reducing total debt, holders of thebond being repurchased stand to gain aCDS does not reference specific bonds, but rathera category of CREDIT obligation, CDS prices areunlikely to benefit to the same extent as thebuyback target, assuming that other debt of thecompany remains outstanding. This implies that ifthe market has a high expectation of specificbond buybacks,CDS should trade at a greaterpositive basis to these bonds, as bond holdersposition themselves for early redemption and aresulting windfall AND MARKET SEGMENTATIONA lthough a CREDIT investor can equally obtain longcredit exposure by buying a funded product suchas a corporate bond, or by selling CREDIT protectionon the same entity, they may have a preferencefor one of these options.

6 A possible reason is thattechnical update extra CREDIT DEFAULT SWAPS50 THE TREASURERMAY 2005 Growth in the CREDIT derivative market means thatthe CDS has become crucial to corporates as theyseek to understand the bond markets and monitorinvestor appetite for funding opportunities orbuybacks. This review discusses the pricingmethodology of the basic CREDIT DEFAULT swap, theequivalent spread measure for corporate bonds,considers how CDS and bond spreads relate toone another,and how CDS may on occasion drivebond CDS AND BOND SPREADS Creditspreads reflect the market s perception of any efficient market the return for taking arisk must equal the loss expected as a result ofthat risk. If this not the case, for instance, werethe expected loss under a CDS contract to belower than the spread paid for the protection,there would be a pure arbitrage opportunity.

7 Giventhis efficiency axiom,we can calculate theexpected loss under a contract directly from itsmarket a practical example, if Sainsbury 5 yearcredit protection is trading at 100 bps mid-market,the loss expected under a 5 year CDScontract equals approximately the sum of thepremia received over the contract s life, Adjusting for positive interest rates andthe time value of money, a more accurate presentvalue calculation of these periodic payments givesus a expected loss by going long onSainsbury CREDIT risk through a 5 year is in fact no different to the informationcontained in bond prices. However, as a typicalfixed rate corporate Eurobond bundles interestrate together with CREDIT risk, it takes a littlefurther work to reach the same , before using bond prices to deriveexpected loss,we must decide which bond spreadmetric by which to measure the portion of abond s return due to CREDIT risk.

8 While traditionallyUS Dollar and Sterling corporate bond marketshave relied upon the spread of a corporate bondover the reference government bond, increasinglyinvestors use the swap curve as their risk freereference, and therefore measure a bond s creditspread as its spread over SWAPS . Still there aremore choices between the asset swap, z- andi-spread of a bond ( the zero coupon orinterest bearing yield curves). Each uses a slightlydifferent methodology to compute the CREDIT riskpremium over the risk-free the asset swap spread is the mostcommon measure of a bond s CREDIT risk, it suffersdistortion when the bond price is significantlyabove or below par. In the current low interest rateenvironment, many corporate bonds currentlytrade significantly in excess of par. As a result, weuse z-spread as it takes the bond s cash price intoaccount.

9 Although there are further technicaldifferences between z- and CDS spreads,themarket is comfortable using these measures as abasis for BASIS between BONDS AND CDS Whilez- and CDS spreads measure very similar creditrisks, we frequently see them trade at differentlevels in the market for the same issuer andmaturity. This differential is called basis , and iscalculated by subtracting the z-spread from theCDS spread. To the extent the CREDIT risksreflected in each spread are very similar, theyshould represent a relative value tradingopportunity. As we discuss below, we don tconsider these as being pure arbitrageopportunities as there are real differencesbetween bond and CDS instruments as means fortaking or hedging CREDIT convention is that we describe the basisas negative when CDS trades inside (tighter) thanthe bond spread for the same maturity.

10 Whenthere is a negative basis an investor who is ableto trade both CDS and bonds can earn a near-riskless return by buying a bond and creditprotection of the same maturity in equal is a negative basis package .Conversely if the CDS spread is higher than thebond spread for the same maturity, an investorshould prefer to sell CREDIT protection rather thanown the bond. We don t really consider the latter atradable package as the inefficiencies of the repomarket for corporate bonds can make it difficultand expensive to borrow bonds in order to be ableto sell them negative basis opportunities aregenerally short-term (as they are an attractiveThe relationship betweenCDS and bond spreadsExecutive summaryn A CREDIT DEFAULT swap (CDS) is analogousto an insurance contract, with the buyerof CREDIT protection paying a periodic feein return for receiving compensationshould the specified reference entityexperience a CREDIT event during thecontract s life.)