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Saturday, 18 November 2017

Derivatives 2006 - LCDS edge into limelight

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This year is struggling to live up to its billing as the breakout year for loan–backed credit default swaps (LCDS). Volumes in the product have certainly grown in both Europe and the US, but documentation issues remain and efforts to launch LCDS indices have faced delays on both sides of the Atlantic. Jean Haggerty reports.

Progress towards launching the iTraxx LevX Senior and the iTraxx LevX Subordinated indices in Europe has outpaced similar efforts to launch the CDX Index Company’s LCDX index in the US.

Barclays Capital, Credit Suisse, Deutsche Bank, Dresdner Kleinwort, Lehman Brothers and Morgan Stanley - the dealers active in the single name loan CDS market in Europe - are expected to act as market makers in the new European leveraged loan credit default swap indices at launch later this month.

One of the two European LCDS indices will launch as a 35-name index that covers first-lien loans, and the other will include the same number of reference obligations and will cover second-lien and mezzanine loans.

The iTraxx LevX Senior and the iTraxx LevX Subordinated indices were originally expected to launch in mid-September. Delays to the effort to establish a standardised Reference Entity Database (RED) for the European leveraged loan CDS market caused the postponement in the LevX indices’ launches.

The contract underpinning the European indices will be cancellable in the event of a full refinancing of a loan. The market is divided between those that want a cancellable contract and those that do not, so a transition period in which both contracts would be quoted will probably exist, dealers say.

The next series of the LevX indices in March may be non-cancellable if the underlying single name non-cancellable contract is established by then, they add. An International Swaps and Derivatives Association (ISDA) working group is already exploring the next evolution of the contract, with a view to making it non-cancellable, like a bond CDS contract.

Not all dealers who are already active in the European LCDS market are convinced that a non-cancellable contract is needed in Europe, however. “I do not think that the rationale for spending the time and money to develop the non-cancellable contract is there,” said Tom Johannessen, head of loan sales and trading at Dresdner Kleinwort in London. “All of the growth that we have seen is in the cancellable contract.”

Economically, the new index documentation is not materially different from the documentation supporting the single name European LCDS market. The only noteworthy differences are on voting rights and on minor changes on the foreign exchange.

European banks hedging loan portfolio books prefer a cancellable contract, but some hedge funds and US dealers want a non-cancellable contract.

For hedge funds, a non-cancellable contract is seen as offering more volatility and convexity. A cancellable contract also lacks the transparency hedge funds require so that they can assign a present value to cash flows. Hedge funds need to mark to market the cash flows of instruments that they are invested in. With a cancellable contract, this is more challenging.

To mark to market contracts, hedge funds need both a start date and a finish date for a contract, or they need a market assumption for when a loan may refinance. Market standards that hedge funds can use when marking to market exist for other credit derivative instruments. In loan CDS, market-based assumptions on loan refinancing assumptions can be obtained from data firm Markit, the daily pricing service for credit derivatives, Johannessen noted.

For some dealers, a big attraction of a non-cancellable contract is that a contract would more closely match US LCDS documentation. US loan CDS differ from their European counterparts in several ways, most notably in that they trade as non-cancellable contracts and they trade without restructuring as a credit event.

In Europe, the expectation is that the cancellable and non-cancellable single name contracts would be almost exactly the same, and they would probably trade alongside each other under a single contract with an option on cancellability, said Rob Lepone, executive director and head of European high-yield and loan trading at Morgan Stanley in London.

For a time dealers would have to manage the basis risk caused by this optionality, but as the market changes and more institutional investors start using the instrument one type of contract will emerge as the preferred contract, Lepone said.

The arrival of the new index is expected to give the European leveraged loan CDS market a boost, as market participants look to arbitrage the indices versus the single name market.

Between August and September the number of trades in the European LCDS market doubled, due in part to hedge funds, banks and collateralised loan obligation (CLO) managers taking advantage of negative basis trade opportunities, Johannessen said.

The fact that the European high yield loan market is larger than the European high-yield bond market increases the likelihood that the European LCDS market will become a large market, Johannessen added.

The market is not without its challenges, however. Credit powerhouses JPMorgan and Citigroup are not active in the European LCDS market yet. Both houses are waiting for non-cancellable documentation to take root.

An additional hurdle that the market faces is credit cycle related: LCDS spreads are tight. “Some CLO managers think: ‘Why should I write CDS where the yield is 150bp when I can get on cash trading 250-260bps?’ [In LCDS] the yield is less attractive for the risk. It is a similar story in the unsecured market,” Johannessen said, noting that this situation may be preventing more CLO managers from becoming active participants in the European market.

Changes to US loan-backed credit derivatives market documentation are not expected in the near-term.

Dealers operating in the US LCDS market in August said that they did not view Moody’s critique of the documentation template for US LCDS released by the International Swaps and Derivatives Association (ISDA) in June as a showstopper, and price action in the market has supported dealer claims.

According to Moody’s, the aim of its report was twofold. On one hand, it wanted to show investors in synthetic CLOs that use the LCDS template the incremental risks that they may be incurring versus a cash position, and on the other, it was meant to point out to arrangers why they might not get a pass-through of the rating of the underlying obligation. Achieving a pass-through of the rating would mean that the corporate family rating could be used for default probability and recovery assumptions.

“We want everyone to understand where we are coming in on this,” Rudolph Bunja, senior vice president at Moody’s Investors Services in New York said when Moody’s released its critique. Most of the major dealers have contacted the rating agency about creating synthetic CLOs that rely on the LCDS template.

Although the US loan credit derivatives market’s evolution has tended to be ahead of that in Europe, some market participants say that the opportunities are greater in Europe. In the US, the leveraged loan cash market is relatively liquid; market participants can short a loan without too much repercussion in the loan market. Also, most loan deals in the US have a bond in their capital structure that already has a CDS on it that market participants can use to go short.

According to Lepone, the continuing significant role played by banks in the leveraged loan market and the expected impact of Basel II on return requirements for leveraged loans should help drive the leveraged loan CDS market in Europe.

Today, the only way - other than using LCDS - for banks to mitigate risk in their leveraged loan portfolio is to sell the loan. Using LCDS to mitigate risk and continue to control a loan is particularly useful for banks in the light of the

relationship pressures that they face from sponsors. Also, using CDS to hedge a leveraged loan position can still be profitable in a credit event by unwinding or selling protection when spreads widen, without triggering the CDS protection and delivering the loan.

The tight spreads in investment grade CDS that have helped attract new money to leveraged loans will help accelerate uptake. As most of the hedge funds that have piled into the asset class come from a credit derivatives background, many already operate with an infrastructure capable of supporting the instrument.

Real money accounts that trade CDS on bonds may be keen to use CDS to gain exposure to leveraged loans, because it would mean that they would not have to deal with the vagaries of the leveraged loan market itself. Unlike loans, which do not yet have uniform settlement periods, CDS offer T+1, or better, settlement. Compared with straight loans, the CDS market is also more tax efficient and allows for easier leveraging.

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