8. Credit derivatives
The synthetic credit market
The credit derivatives market has developed in parallel with the corporate bond market for the past 25 years. The big banks have long sought a way to manage their credit risk effectively. Credit derivatives are a cost-effective way for banks to diversify and hedge their credit portfolios.
In the 2000s, the credit derivatives market developed to manage credit relating to companies and sovereign risks in developing countries. Banks and hedge funds have been active in the market since then. Mispricing sometimes occurs between bonds and their credit derivatives.
CDS – CREDIT DEFAULT SWAP
The most common credit derivative is a credit default swap (CDS). Buying a CDS can be viewed as buying insurance against default. One party sells the credit risk by purchasing a CDS (see diagram below). The buyer of the CDS makes continuous premium payments to the seller. If a default occurs, the seller has to compensate the buyer for the credit loss.
ITRAXX AND CDX
The 2000s saw the creation of liquid credit derivative indexes: iTraxx in Europe and Asia and CDX in North America and developing countries. Liquidity has improved continuously, and today these indexes are a good indicator of where the corporate bond market is heading. There are indexes for different sectors and with different maturities. The most liquid maturity for all sectors is the five-year index, but there are also maturities of three, seven and ten years.
Many banks and securities companies that issue structured products issue credit-linked notes based on companies and baskets of companies and indexes.
One of the most popular companies to structure credit-linked notes on in Sweden is Stena AB.
A credit-linked note is not a corporate bond. It is a structured product based on the issuer’s credit derivatives (CDS). This means that the buyer of a credit-linked note is not only taking a risk on the company the credit derivative is based on (which the buyer wants to take a risk on) but also taking an unwanted risk on the bank that has structured the credit-linked note. Credit-linked notes usually have a worse recovery value than corporate bonds because the recovery value of the note can be set to zero in the structure. The advantage of credit-linked notes is that they can be bought in smaller blocks than is usually possible for corporate bonds.
DO NOT ALWAYS WORK AS INTENDED
There are several examples of investors buying CDS (insurance against default) in which the CDS was not triggered as it should have been; i.e. the purchaser of the CDS could not realize a profit on the derivative. One of the more recent examples is Greece, where the credit derivatives were never triggered even though the country was undergoing a restructuring and bondholders had to take losses on their bonds. Investors who had bought Greek government bonds and CDS (purchased insurance) took losses in both positions, even though they thought that they had a hedged position.
Structured credit – tailored product
Issuing securities on a basket of corporate bonds or credit derivatives has long been popular. What’s newer is the creation of a capital structure for a basket and making securities from the tranches in the structure. Just as with a company, the financing can be divided up into different tranches with different priorities: an equity tranche, a subordinate tranche and a senior tranche.
The first default in one of the example basket’s bonds affects only those who invested in “equity”, while the other investors in the structure remain unaffected. If a further default occurs, the subordinate tranche is also affected, while the more senior tranches are unaffected, and so on. There are two types of basket: default baskets and index baskets (standardized collateralized debt obligations).
Default baskets comprise a small number of corporate bonds or credit derivatives (see previous example). Investing in the equity tranche of a default basket may be of interest to an investor who is comfortable taking risks on all of the companies in the basket, but who does not have the capital to invest in them all. The return is higher, but the investor takes a loss if one of the companies in the basket defaults.
A more cautious investor may choose to buy only the senior tranche of the basket. That way the investor will not take a loss unless there are several defaults in the basket. A default basket can be expected to be held to maturity. Default baskets are illiquid because they often have a unique composition of corporate bonds.
Index baskets, or standardized collateralized debt obligations (Standardized CDOs), are a capital structure of the liquid iTraxx and CDX indexes (see page 41). The advantage of the index baskets is that they are more liquid than the default baskets. The indexes they are based on are traded daily in large volumes.
The different tranches of the capital structure vary in size depending on which index is used (see table below). For the high-yield index in North America, equity takes the first 15% of the defaults in the index. For the investment-grade index in North America (CDX Main), equity takes the first 3% of the defaults in the index. The risk is high for equity and the coupon for this tranche has to compensate for this risk. The risk for the super senior tranche is very low, and consequently the coupon for this tranche is low.
Index baskets are most liquid in the five-year segment, but they are also traded, like the indexes, for maturities of three, seven and ten years.