of 20
In anticipation of an announcement of leveraged buyout of a publicly traded company,
which of the following actions would be most appropriate?
A) Sell protection of the company’s bond and buy put options on the company’s stock.
B) Buy both the stock and the bonds of the company.
C) Buy the stock of the company and buy CDS protection on company’s debt.
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.