Decoding Derivatives – Q2 2020

Kramer Levin Naftalis & Frankel LLP

Hertz CDS Auction Attracts Unusual DC Action 

The Determinations Committee (DC) dealing with the Hertz bankruptcy credit event received a challenge from a market participant to the inclusion of certain letter of credit (LC) disbursements in the final list of Deliverable Obligations. The challenge centered on a requirement in the credit derivatives definitions that a Deliverable Obligation may not require a CDS protection seller taking delivery of such obligation to assume a commitment to lend further funds. In a somewhat unusual move, the DC engaged with the administrative agent to agree on a form of assignment agreement that ensured a CDS protection seller would not be liable to a CDS protection buyer for any funding obligations in the event it took delivery of the LC disbursements in settlement of the trades formed in the CDS auction. Although an unusually active step by the DC, facilitating the inclusion of the LC disbursements provided additional liquidity to fill the 111.525 net open interest to sell in the Hertz auction. The Hertz auction cleared at 25.375.


CDS Bets Win Big In Pandemic

The recent uptick in bankruptcies, coupled with expectations of lower recoveries in the credit markets, means traders going short by buying CDS protection have seen windfalls in their portfolios. Some hedge funds were able to lock in significant gains on index-based short positions, while others simply shorted reference entities in heavily impacted industries such as retail and oil and gas. CDS auctions for retailers Neiman Marcus and J. C. Penney cleared at 3.0 and 0.125, respectively, and auctions for oil and gas companies Diamond Offshore Drilling and Whiting Petroleum cleared at 7.375 and 7.0, respectively, resulting in near-100% recovery for CDS protection buyers. In spite of recent worries that the CDS market was in decline, the COVID-19 pandemic has shown the product still has significant value when deployed effectively. 


CDS Volume Spikes 

With COVID-19 ripping through markets, its effects were certainly felt in the CDS market. March volumes of cleared U.S. CDS hit $2.6 trillion, up 89% compared to March 2019 (the previous month high), with $367 billion of cleared trading being single-name. Similarly, in Europe, cleared CDS trading hit $1.67 trillion, up 92% from its previous month high. This strong Q1 has been followed by an equally robust Q2. Mid-June notionals in cleared CDS were up 45% ($4.92 trillion) compared to the same point in 2019.


Conventional Credit Events and Depressed Recovery Rates 

While the global pandemic has undoubtedly triggered some credit events earlier than expected, those events have typically resulted in a smooth auction process and very little market bluster. The absence of negative headlines or other adverse market reaction is a welcome sign that the CDS market is resilient and has trended back to convention following a raft of unconventional events over the past couple of years. That said, of the eight corporate credit events in 2020, in five (McClatchy, Whiting, Diamond Offshore, Neiman, J. C. Penney) the auction cleared below 10. These auctions therefore represented a significant windfall for CDS protection buyers, with the low recovery rates presumably reflecting some uncertainty related to post-pandemic business prospects for those companies. The Frontier and Hertz auctions cleared at 28.750 and 25.375, respectively, also representing a significant payout for CDS protection buyers. Indeed, the average recovery of 2020 credit events, 22.9, is almost half of the average recovery, 43.2, since 2005 and also significantly below CDS market pricing modeled by sources such as IHS Markit and Bloomberg. The only outlier, Intelsat, was an anomaly, given there were no Deliverable Obligations and therefore a default final price of 100.

  • Subcode: Sovereign Defaults Tick Up 

In addition to the fast start to 2020 for corporate defaults, sovereign defaults are on pace for a record year. In the first half of the year, three sovereign credit events have already occurred in Argentina, Ecuador and Lebanon. With a significant increase in sovereign downgrades in the same period, sovereign CDS may well see more events before the year is up.


CDS Indices Hit Hard 

IHS Markit models a recovery of 40 in its CDS Indices (CDX, iTRAXX, etc.). For the U.S. high-yield index, CDX HY, a spate of credit events in the first half of 2020 has resulted in significant economic implications for investors in CDX HY. As noted above, several CDX HY constituent names cleared their respective auctions significantly below the 40 assumed recovery. This concentration of low recoveries has generated both risk and opportunity in what has, for the past couple of years, been a relatively flat product.

  • Subcode: Structured Credit Also Facing Outsized Losses 

Limited defaults over recent years have led to more esoteric trading in the structured credit space. Some bullish market participants have entered into so-called first loss trades, where they effectively take exposure to the riskiest tranches of bundled credit (loans, bonds, CDS). While returns in these products can be significant, the recent rapid-fire bankruptcies and below-model recoveries have resulted in significant losses on the riskier tranches of these highly structured deals. That said, many of these losses are based on widening credit spreads, expectations of default and assumed recoveries and are therefore unrealized and may never materialize. Thus, given the variety of underlying credit in these products, a rally in the underlying loans and bonds and narrowing of CDS spreads could mitigate some of the losses resulting from the COVID-19 pandemic. 


RBC Gets a Seat at the CDS Table 

In 2020, for the first time, Royal Bank of Canada was permitted as a participating bidder in three credit event auctions (Frontier, Ecuador and Diamond Offshore). Presumably in line with growing its distressed credit business, this is RBC’s first foray into CDS. The introduction of a new dealer to provide auction liquidity should be a good sign for a CDS market primed to capitalize on a turning credit cycle.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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