Question #14

In the case of a leveraged buyout (LBO), the firm will issue a great amount of debt in order to repurchase all of the company's publicly traded equity. This additional debt will increase the CDS spread because default is now more likely. An investor who anticipates an LBO might purchase both the stock and CDS protection, both of which will increase in value when the LBO happens. (Module 29.3, LOS 29.e) Idrissa Sylla and Joel Lynch both work for Kazenga Asset Management. The fund made losses on fixed income securities during the 2008 credit crunch and is keen to minimize the risk of losses due to credit events going forward. Sylla and Lynch have been tasked with writing a report on the hedging of credit risk for the firm's investment committee. Extracts of their report are included below. Introduction: Credit Default Swaps (CDS) have the advantage of allowing the investor to separate credit risk and interest rate risk. Purchasing a CDS allows us to go long only the bond's credit risk. A single-name CDS allows us to purchase credit protection for a single reference entity. Typically, the reference obligation for a single-name CDS is a senior unsecured bond. Interestingly there is a payoff not only when the reference obligation defaults but when any bond of the issuer that ranks pari passu with the reference obligation defaults. The payoff received on a default will be the par value (notional principal) of the reference obligation less the value of the reference obligation after the credit event. Settlement after a credit event will either be physical delivery of the cheapest to deliver bond or alternatively a cash settlement. Illustration CTD: A credit event occurs for a single-name CDS with a three-year, senior bond as the reference obligation. The notional principal is $15m. Exhibit 1 shows bonds currently outstanding for the reference entity. Exhibit 1: Current Market Price of Reference Entity Bonds Bond type Price Bond Q: Subordinated unsecured 5-year maturity 30% of par Bond P: Senior unsecured 2-year maturity 45% of par Bond R: Senior unsecured 3-year maturity 50% of par Value after Inception of CDS: At initiation of a CDS, the CDS spread depends on the credit quality of the reference obligation at that point. Subsequent changes in credit quality of the reference obligation result in a gain or loss for the CDS holder. Entering an offsetting contract can monetize this gain (or loss). Exhibit 2 shows an illustration. Exhibit 2: Illustration Notional principal covered £36,000,000 Coupon rate Duration Upfront Premium At initiation 1% 5 5% 1 year later 1% 4 8% The Credit Curve: The credit curve is the relationship between credit spreads and bond maturities for the same reference entity. Longer maturity bonds typically have a higher credit spread than shorter maturity bonds. An investor purchases a 'naked' CDS when the investor does not hold the reference obligation. Essentially, it is a pure bet on the credit prospects of the bond issuer. If we believe the credit quality of the issuer will deteriorate and hence the credit curve steepens, we should take a short position in the CDS. A curve trade is a type of long/short trade where the investor buys and sells protection on the same reference entity but with a different maturity. For example, if we were concerned about the credit risk in the short term but felt the entity's long term prospects were stronger, we would sell protection in a short maturity CDS and buy protection in a long maturity CDS. The improvement in the credit quality over time should cause the credit curve to flatten, resulting in a profit on the strategy.