European Credit Views: Crossing Barriers

Transcription

1 09 June 2010 Fixed Income Research European Credit Views: Crossing Barriers Contributors Christian Schwarz Tom Gibney Helen Haworth Chiraag Somaia Atif Ali Credit for externs and interns This note is primarily geared towards investors from other asset classes; it also serves as a reference for credit experts For an investor to cross the barrier from their asset class to another, they need to feel comfortable in doing so. Getting the basics right and understanding the products is absolutely crucial. In this publication we give investors from other asset classes the details of credit instruments, make applied first hand working examples and try to build a bridge to credit. We begin with a summary of credit products. The subsequent chapter explains how fundamental credit analysts evaluate corporate credit and related instruments. Credit lingo and important ratios are defined and their application explained. In the next chapter, we describe the various quoting conventions and show what a typical trader run would look like. We will guide you through real life Bloomberg screens in detail to help readers navigate the credit space. Performance and risk measurement are critical, especially in credit. The next section explains the relevant and most commonly used measures, how they are used, and the pros and cons of each. Finally, in the quantitative credit analysis section, we look at the mathematical analytics and tools that can be used to supplement fundamental analysis and form a strong view. ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO

2 Table of contents Executive summary 3 Introduction to credit products 4 Corporate bonds 4 Financial securities 9 Asset swaps 11 Credit Default Swaps 12 CDS Indices 18 Credit Linked Notes 23 Total Return Swaps 24 Corporate loans 26 Fundamental credit analysis 28 Determining a fair credit spread 28 Analysing the business profile 28 Analysing the financial profile 28 Corporate credit ratings 32 Pricing, performance and risk measurement 34 Prices and quotes 34 Performance measurement 40 Risk measurement 40 Quantitative credit analysis 41 Appendix 44 The present value of risky coupons 44 The present value of risk free coupons 44 CS01: bumping the curve 44 European Credit Views: Crossing Barriers 2

3 Executive summary A credit primer: building a bridge to credit This report is meant to serve as a primer to the credit space. As such, it should serve as an introduction for investors new to credit and can also be used as a reference for the more experienced credit investors. In the following sections, we will help investors navigate the credit world by beginning with the basic concepts behind credit investing and evolving to advanced analytics and tools that can be leveraged to better gauge credit investment decisions. Below we identify the structure and content of the report: We start with an introduction to the various credit products, beginning with plain vanilla corporate bonds, followed by well established and lightly structured credit derivates and concluding with tradeable corporate loans. The featured products are: 1. Corporate bonds 2. Financial securities 3. Asset swaps 4. Single name CDS 5. Index Credit Default Swaps, swaptions and tranches 6. Credit linked notes 7. Total return swaps 8. Corporate loans The subsequent chapter explains how fundamental credit analysts evaluate corporate credit and related instruments. Credit lingo and important ratios are defined and their application explained. In the next chapter, we describe the various quoting conventions and show what a typical trader run would look like. We will guide you through real life Bloomberg screens in detail to help you navigate the credit space like a professional. Performance and risk measurement are critical, especially in credit. The next section explains the relevant and most commonly used measures, how they are used, and the pros and cons of each. In the quantitative credit analysis section, we look at the mathematical analytics and tools that can be used to supplement fundamental analysis and form a strong view. Finally, in the Appendix, we define measures that are used throughout the publication and, although not being essential to understand credit as an asset class, are useful as a reference to the more experienced investor. European Credit Views: Crossing Barriers 3

4 Introduction to credit products Corporate bonds Bonds are issued to investors by companies in exchange for cash. They are similar to loans, but are represented by standardised contracts that enable them to be easily bought and sold on a secondary market. The investors who own a particular bond are called bondholders. Standard features The standard features of a corporate bond are: i) Notional amount this is the amount that has been borrowed. ii) Coupon this is a regular payment made by the issuer to bondholders. It represents the interest rate on the notional amount. The coupon payment equals the coupon rate multiplied by the notional amount. Coupons are typically paid annually or semi-annually. iii) Maturity this is the date on which the bond must have been repaid. In most cases it will be the date on which the full notional amount is paid back to investors, though in some cases (e.g. amortising bonds ) the notional will be paid back throughout the life of the bond and the maturity date will represent the date of the last payment. Bonds entitle their holders to receive a pre-determined stream of future cash flows. The chart below shows a simple example of what an investor s cash flows should be if he bought a 100, 5-year maturity, 10% annual coupon bond at issuance. Exhibit 1: Investor cash flows for a 100, 5-year maturity, 10% coupon bond Investor cash flows ( ) Period Source: Credit Suisse Reference and denomination A bond s Bloomberg ticker, which is similar to a company s Bloomberg equity ticker, signifies which company has issued that bond. While bonds can be issued by several different legal entities within a group, a single bond ticker is usually used for all bonds that are issued from a given corporate group. For example, Iberdrola SA issues bonds from several special purpose finance companies, including Iberdrola International SA and Iberdrola Finanzas SAU, but all of the bonds issued from the Iberdrola group share the same bond ticker, IBESM. When identifying a particular corporate bond, credit market participants often refer to it in the form: ticker, coupon, maturity e.g. the bonds issued by Iberdrola Finanzas SAU which have a 4.875% coupon and mature on 04/03/14 would be referred to as the IBESM 4.875% 04/03/14 bonds. European Credit Views: Crossing Barriers 4

5 The vast majority of corporate bonds pay regular interest payments (usually paid semiannually, starting six months after the date of issuance) in the form of coupons and all of the notional amount at maturity. While bonds can be easily traded, they usually have fairly high denominations e.g. a single one of the IBESM 4.875% 04/03/17 bonds has a denomination of 50,000 and cannot be traded in smaller amounts. Even bonds aimed at retail investors rarely have denominations lower than 1,000. Valuation The price of a bond is quoted and traded as a percentage of the notional amount of the bond, regardless of its denomination e.g. if the price of the IBESM 4.875% 04/03/14 was quoted at 105, a single bond would cost 50,000 x 1.05 = 52,500. A price of 100 is known as par. In a normally functioning market, the price of the bond represents the amount that investors are willing to pay to receive the pre-determined stream of cash flows to which ownership of the bond entitles them i.e. it is the net present value of the cash flows expected to be received from the bond. The discount rate that is applied to a bond s cash flows in order to value them and arrive at the bond price is called the yield. A generalised formula for the relationship between price and yield for any bond is as follows: P = c n k + k= 1 1 N k ( 1+ r) ( + r) n Taking the simple example from Exhibit 1, we show below what prices would be implied by different yields and the calculations required to get these prices (assuming these calculations are done immediately after issuance, so the maturity is still five years away). Yield at 7%: Pr ice = ( ) ( ) ( ) ( ) ( ) 5 2 = 112 Yield at 10%: Pr ice = ( ) ( ) ( ) ( ) ( ) 5 2 = 100 Yield at 13%: Pr ice = ( ) ( ) ( ) ( ) ( ) 5 2 = The examples above show two basic features about the relationship betweens price and yield: i) Price and yield are inversely related as the yield rises, the cash flows are discounted more heavily and so the price falls, and vice versa, ii) If the yield is the same as the coupon, then the price will be par (i.e. 100) and vice versa; whether or not a bond trades above (below) par is simply a function of whether the yield is below (above) the coupon rate. When a bond is trading above par it is said to be trading at a premium to par and when a bond is trading below par it is said to be trading at a discount to par. 89 European Credit Views: Crossing Barriers 5

6 Duration and convexity The full relationship between the price and yield of the bond in the example is shown below: Exhibit 2: Price versus yield for 5-year, 10% annual coupon bond % 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Price Yield Source: Credit Suisse As can be seen from the chart, the price-yield relationship is slightly curved. However, over small ranges of yield the relationship is very close to linear; this means the gradient at a given point in the curve is a good approximation of the sensitivity of the bond price to small changes in its yield. Since this gradient is the first derivative of the price-yield relationship, it can also be shown to be equivalent to the average maturity of the cash flows of the bond, weighted by the discounted cash flows. It is therefore known as a bond s duration and is expressed in years (duration is almost always negative, since it describes the sensitivity of the negative relationship between price and yield). Duration is used by credit investors to determine how much they will gain or lose, from changes in the bond price, if yields increase or decrease by a certain amount. For example, the duration of the 5-year, 10% annual coupon bond when the yield is 10% is 4.2 years. If the yield on the bond increases by 0.1% (or 10 basis points), then the change in price can be calculated as: Δ Pr ice Duration ΔYield Δ Pr ice = 0.42% This suggests a change in yield of 100 basis points (bps) will result in a negative change in the bond price of approximately -0.42%. The exact change in price, calculated in the same way as in the equations above, would be -0.38%, so the duration gives a pretty good indication of the sensitivity of the price to changes in the yield. In fact, as the relationship is curved, the duration changes as the yield and price change. Since the gradient (duration) decreases as the yield increases, this curved relationship is known as convex. The extent to which a bond s duration changes as its yield changes is therefore known as its convexity. By taking convexity into account, the above approximation can be improved: Δ Pr ice Duration ΔYield Γ ΔYield 2 European Credit Views: Crossing Barriers 6

7 Credit spreads While the set of cash flows to which bondholders are entitled are contractually predetermined, they are not risk-free. So when discounting these cash flows they need to use a discount rate that accounts for the riskiness of these cash flows. This discount rate will be above the risk-free rate. The additional discount rate or yield that is applied to the cash flows of the corporate bond is known as the credit spread i.e. the credit spread is, in its most basic form, calculated as the difference between the yield on the corporate bond and the risk-free rate for that maturity. Please refer to the later section, Price and quotes, for more details on bond pricing and the more information on different spread measures. Different types of corporate bond There are many different types of corporate bond, but all are variations of the basic formulation described above. The most common differences that investors should be aware of are: i) Fixed versus floating coupons fixed coupons are determined in reference to a coupon rate that is fixed when a bond is issued; floating coupons are determined in reference to a coupon rate that varies according to a reference rate (e.g. LIBOR + 3%). ii) Zero coupons zero coupon bonds have a fixed coupon rate of zero but are issued below par. At maturity the investor is paid par, so his return is the difference between par and the issue price this substitutes for the lack of a coupon. E.g. a 1 year zerocoupon bond is issued at 90; it will pay no coupons but will pay back par (100) in one year at maturity, implying a 10/90 = 11% return over one year. This return would equal the yield on the bond. iii) Seniority Senior bondholders have a stronger (senior) claim than subordinated bondholders on a company s cash flows and assets in the event of default. Please refer to the later section, Corporate credit analysis, Analysing the financial profile for more details on company capital structures. iv) Security certain bonds are secured, which means bondholders have the ability to enforce security over (or take possession of) particular assets in the event of default. These are comparable to mortgage loans. Bond covenants Each individual credit obligation of a company, be it a bond, bank loan or finance lease, is formalised by a contract. In the case of a bond, this contract will be summarised in what is known as a bond prospectus. This prospectus sets out the terms and conditions of the credit agreement, including the notional amount of the obligation, the interest rate, the schedule of payments and the maturity date. Failure to abide by the terms and conditions of the credit agreement will, following a grace period, typically result in the issuer being deemed in default of the obligation. The terms and conditions will also often state various things that the issuer (or the group of which the issuer is a part) must or must not do. These conditions are called covenants. As with conditions stating when a particular amount of interest must be paid, if the issuer fails to comply with these covenants it will typically be deemed in default of the obligation. Covenants that require the issuer to do something are called positive covenants and covenants that require the issuer to not do something are called negative covenants. Covenants can apply for as long as the obligation is outstanding or for a certain period of time, and may change throughout the life of an obligation. They may be renegotiated, but only with the permission of a certain proportion of the holders of the obligation. European Credit Views: Crossing Barriers 7

8 The aim of covenants is to protect creditors from actions which the issuer may take that will diminish the quality of their claims, making their investment more risky. Some common covenant types are listed below. i) Financial covenants the issuer must keep certain financial ratios within certain bounds (maintenance covenants) or cannot perform certain actions if financial ratios are not within certain bounds (incurrence covenants); e.g. net debt to EBITDA must be below 5.0x at all times. ii) Change of control covenants if the issuer is taken over, the bondholders are able to put their bonds back to the issuer (i.e. they can choose to force the issuer to redeem them), subject to certain conditions; e.g. if one party acquires more than 50% of the voting capital of the issuer, then bondholders may put their bonds back to the issuer at par or slightly above. iii) Negative pledge covenants the issuer is limited in the amount of secured or structurally senior debt that it can create; e.g. secured debt in the group must be below 20% of total debt at all times. iv) Disposal limitations the issuer is limited in what or how many assets it may sell; e.g. it may not sell assets representing more than 50% of total assets within any given financial year. v) Information covenants the issuer must provide certain information to creditors; e.g. it must report full audited results on a quarterly basis. Events of default and restructuring Unfortunately, not all corporate bonds pay interest on time or are repaid on maturity or earlier. Issuers may also breach covenants and be unable to cure these breaches or renegotiate these covenants to the satisfaction of creditors. A bond s terms and conditions set out explicitly what events will lead to default, following a grace period. Restructuring of debt obligations, involving a partial or complete elimination of a claim, is commonplace in stressed situations (i.e. those in which a company is approaching default). Companies do not wait to run out of money before restructuring. Faced with a likely future liquidity crisis or covenant breach where creditors are not expected to reset and instead seek debt reduction, companies will appoint advisors and seek to restructure their obligations either consensually or, more often than not, through a court-administered process. The ability and ease of the latter approach will depend on legal jurisdiction affecting the rights and votes of the various classes of stakeholders and the concentration and cross ownership of the various classes of debt (i.e. the interests and positions of the negotiating parties). A restructuring process will also typically put pressure on the operating performance and cash flow of a business for obvious reasons. Unsecured corporate bond recoveries, often ranking behind substantial bank debt leverage, rarely fare well in such situations. Default/restructuring risk is therefore the biggest risk to bondholders and is the primary factor that drives credit spreads. Please see the section Corporate credit analysis for more details on how credit investors appraise default/restructuring risk. European Credit Views: Crossing Barriers 8

9 Financial securities Bonds issued by financials share common features with their corporate non-financial counterparts, but the very high proportion of bank and insurance bonds and their specialty of structured capital securities warrant an extra chapter. Bank Capital is split up into tiers. Exhibit 3 shows the current bank capital structure under Basel II and the capital structure as per the Basel III proposals. In liquidation, Tier 1 securities rank senior to ordinary equity and junior to Upper Tier 2, which in turn ranks junior to Lower Tier 2 securities. Contingent Capital is a new form of capital whose role is to be considered further by regulators in the summer of Exhibit 3: Current and Proposed Bank Capital Structure Current Typical Capital Elements Proposed Basel Capital Elements Min 50% of Total Capital Not more than T1 Max 50% of T1 Max 15% of T1 Min 50% of T1 Tier 3 Capital (Market Risk only) Lower Tier 2 Capital Upper Tier 2 Capital Innovative Hybrid Tier 1 Capital Other Hybrid Tier 1 Capital Core Tier 1 Capital 8% of RWA Z% of RWA (net of deductions) Y% of RWA (net of deductions) X% of RWA (net of deductions). Must be predominant amount of Tier 1 Capital Tier 2 Capital Additional Going Concern Tier 1 Capital Core Tier 1 Capital Min 5-year subordinated debt Instruments that are subordinated have fully discretionary noncumulative dividends, no maturity or incentives to redeem and loss absorption on a goingconcern basis Common Equity common shares or the equivalent for non-joint stock companies plus retained earnings and comprehensive income net of deductions) Contingent Capital Role to be considered further at July 2010 meeting Source: Credit Suisse Key Features of Bank Capital Securities Exhibit 4 details the key features of Lower Tier 2, Upper Tier 2 and Tier 1 securities. It is important to note that coupons have to be paid on Lower Tier 2 (failure to do is an act of default) while coupon payments on Tier 1 securities are fully discretionary, albeit with ordinary dividend pushers/stoppers. Exhibit 4: Typical Features of Subordinated Debt (LT2, UT2 and T1) Tier Maturity Coupon Lower Tier 2 Dated securities, potentially with a call date Coupons have to be paid otherwise deemed a default by the bank Upper Tier 2 Usually perpetual but can be dated in cases Coupons can be deferred but cumulative Tier 1 Perpetual, callable at specific dates Full discretion on coupon payment and typically non-cumulative Source: Credit Suisse European Credit Views: Crossing Barriers 9

10 Tier 1 Securities Diligent research is required before investing in Tier 1 securities. There can be considerable differences in the terms and conditions of securities which in turn can significantly impact valuation. Exhibit 5 details the typical features of Tier 1 securities. Exhibit 5: Typical Features of Tier 1 Securities Liquidation Maturity Interest Coupon payment flexibility Status of non paid coupons Loss absorbency through principal write-down Economic substance Source: Credit Suisse Attributes Rank senior to ordinary share capital and junior to Upper Tier 2 capital instruments Perpetual security, callable at the option of the issuer at specific dates Coupon is typically fixed to the first call date; thereafter, a floating rate linked to L (if in ), with step-up above L: (1) Innovative/Step-up: capped at highest of 100bps or 50% of the initial credit spread, (2) Non-Innovative/Non Steps: no step- up (typically in : issuance credit spread to swaps+3 month L) Typically have ordinary dividend and pari passu ranking coupon stopper/pusher, which requires the bank to pay coupons if ordinary dividends/pari passu ranking coupons are paid. When ordinary dividends and pari passu ranking coupons are not paid, coupons are discretionary. Distributable reserves availability typically applies Typically cancelled (non-cumulative) Only applicable in some countries and in most cases where it applies, linked to meeting minimum regulatory capital ratios. In such cases, typically have principal write-up language before ordinary dividends can be paid Non-cumulative preference share Exhibit 6: Typical Features of Upper Tier 2 Securities Liquidation Maturity Interest Coupon payment flexibility Status of non paid coupons Loss absorbency through principal write-down Economic substance Source: Credit Suisse Attributes Rank senior to Tier 1 capital instruments and junior to Lower Tier 2 securities Usually perpetual security, callable at the option of the issuer at specific dates Coupon is typically fixed to the first call date; thereafter, a floating rate linked to L (if in ), with step-up above L capped at 100bps of the initial credit spread Typically have junior securities and pari passu ranking coupon stopper/pusher, which requires the bank to pay coupons if junior securities /pari passu ranking coupons are paid. When junior securities dividends and pari passu ranking coupons are not paid, coupons are discretionary. Coupon payments based on sufficient distributable reserves/balance sheet profit Coupon is deferred i.e. cumulative Only applicable in some countries and in most cases where it applies, linked to a balance sheet loss usually defined as retained earnings plus reserves at the discretion of the issuer for the latter Cumulative preference share Exhibit 7: Typical Features of Lower Tier 2 Securities Attributes Liquidation Rank senior to Upper Tier 2 capital instruments and junior to senior debt Maturity Dated or double-dated security, callable at the option of the issuer at specific dates Interest Coupon cannot be deferred Coupon payment flexibility None Status of non paid coupons If coupon is not paid after a certain period of time this triggers the default of the issuer Loss absorbency through principal write-down No loss absorption language Economic substance Dated subordinated debt Source: Credit Suisse European Credit Views: Crossing Barriers 10

11 Exhibit 8: Typical Features of Insurers Capital Securities Tier 1 Upper Tier 2 Lower Tier 2 Source: Credit Suisse Attributes Same features as banks Tier 1 securities except that usually deferred coupons are typically cumulative Layer of capital which does not really exist for insurers except in the UK Same features as banks Lower Tier 2 securities except that coupons are deferrable and cumulative Other strong features in the terms and conditions that can impact valuation include Alternative Coupon Settlement Mechanism (ACSM). ACSM usually entails the bank issuing ordinary shares to settle deferred coupon payments owed to investors. This condition is favourable as it has the effect of hardening the coupon payment. ACSM is applicable to some UK, Benelux and Irish Tier 1 bonds. Another strong feature is Equity Settlement language which involves the bank having to issue stock to redeem the security at the first call date. This language hardens the call date, a valuable feature in an environment where the banks may not call the securities at the first call date. Equity Settlement at the first call date is applicable to a small number of UK, Benelux and Australian bonds. As mentioned above, investing in Tier 1 securities requires a diligent investor as thorough research is required. For further information on Bank Capital and Tier 1 securities, please see European Banks & Insurers: Credit Valuations Remain Compelling (dated 21 August 2009) Asset swaps Asset swaps represent one of the longest standing structures by which any asset can be customised to match more exactly a desired investment profile, and at its most basic simply involves the asset investor entering a separate transaction to exchange some or all of the asset cash flows into a more desirable series of payments Mechanics As an example, imagine that an investor with a positive outlook on a company wishes to gain exposure to the credit by buying its bond, however without being exposed to the interest rate risk that a bond additionally represents. They could purchase an FRN, however if no FRNs are available, rather than not purchasing at all, the investor could instead buy a fixed rate bond, and then enter an interest rate swap whereby the investor pays the fixed coupon to a swap counterparty in return for receiving floating Libor based payments in return. An asset swap separates interest and credit risk and enables the investor to express their view on the pure credit component of a corporate bond. Exhibit 9: Asset Swap Package Bond purchase proceeds Fixed bond coupon Fixed coupon bond Investor Libor + Spread Swap Counterparty Source: Credit Suisse European Credit Views: Crossing Barriers 11

12 Often it is the case that the investor will be offered both the bond and the accompanying asset swap at the same time (an Asset Swap Package), with the spread over Libor paid to the investor dependent both on the bond cash flows as well as the purchase price of the bond. The exact nature of the swap may be slightly more complicated than just a fixed-floating exchange. For example, the investor may desire to change the currency of the investment which would entail entering a currency swap that in turn requires exchange of principal as well as coupon. Or indeed the bond flows may be swapped for a much more structured payout that may incorporate for example views on a non-credit asset Analysis and Considerations Clearly both parties to the asset swap have the customary counterparty credit exposure of any derivative transaction. However, the investor must also consider what might happen if the underlying bond defaults when contractually it will still be required to continue payments under the interest rate swap. It is likely at this point that the investor will seek to unwind the swap with consequent payment between the parties of the prevailing mark-tomarket, which if the payment is owing by the investor, clearly augments the loss already suffered on the bond. This has led to the development in recent years of Perfect Asset Swaps where the interest rate swap is automatically cancelled upon default of the asset and there is no requirement for any termination payment to be made between the parties Credit Default Swaps Introduction The credit default swap (CDS) market has existed for close to 20 years, however it was between 2001 and 2007 that the market experienced phenomenal growth, with total CDS outstandings moving from USD 0.9 trillion to USD 62.2 trillion. The over-the-counter (OTC) nature of the CDS product has led to many market reforms over the past 18 months, aimed at improving market liquidity and transparency as well as reducing counterparty risk. Mechanics A single-name CDS contract provides protection against a credit event occurring for a particular entity, termed the reference entity. Similar to any other type of swap, the CDS consists of two legs a premium leg and a default leg. The protection buyer pays the premium leg and receives the default leg, and vice versa for the protection seller. The premium leg consists of a regular stream of coupons, more typically referred to as the par spread. Recently, the payment of the par spread has been replaced by a system of standardised fixed periodic coupons and initial upfront payments (see Trading Conventions section). This stream of coupons ceases to be paid upon a credit event occurring for the reference entity. What constitutes a credit event is determined by the CDS contract (see Credit Event section). When a credit event occurs and the CDS contract is triggered, cash flows occur on the default leg of the swap. In the case of physical settlement, the protection buyer delivers an obligation specified by the CDS contract, termed a reference obligation, and receives par. The par amount is dependent upon the notional of the CDS contract. There are often several reference obligations specified by a CDS contract and in this situation the so-called cheapest-todeliver obligation is usually delivered. In the case of cash settlement, the protection buyer receives the difference between par and recovery. Note that both cash and physical settlement are now done via an auction settlement process. Note that the protection buyer is short credit risk and that the protection seller is long credit risk. European Credit Views: Crossing Barriers 12

13 Uses of CDS In essence, a CDS contract is a transfer of credit risk from one counterparty to another. This notion of transferring credit risk has a variety of uses and users. Banks are one such user. Banks with corporate loan portfolios may find themselves in a situation where their credit risk exposures to certain counterparties are too high. Although the option to assign loans to other banks exists, assignments can be costly and timeconsuming. In addition, the assignment could damage the relationship between the client and the bank. As an alternative, the bank could enter into a CDS contract (as a buyer of protection) with a third party and with the original client as the reference entity, thus help mitigating their credit risk. Conversely, banks may want to diversify their credit portfolios by taking long credit risk exposure in entities or sectors in which they currently have little exposure. One way to achieve this goal is to enter into a CDS contract as a seller of protection. Other institutions such as pension funds and insurance companies also have uses for CDS contracts. For example, if there is concern about default risk for some of the debt instruments they hold, then the pension fund or insurance company can enter into a CDS contract as a buyer of protection to mitigate their losses. The above uses of CDS would broadly be termed as hedging. In addition to hedging, CDS can be used more speculatively. For example, hedge funds and asset managers may look to benefit from mark-to-market changes in the value of CDS contracts by taking long and short credit risk exposures through CDS contracts. The addition of this type of user in the market serves to improve the liquidity and depth of the market. Exhibit 10: The Mechanics of a CDS Contract Source: Credit Suisse Trading Conventions Single name CDS are quoted either as a spread or an upfront price and trade as a fixed running coupon and an upfront payment (see Standardisation of CDS Contracts section, where fixed coupons for North American and European contracts are given). Single name CDS are usually most liquid at the 5 year maturity. Other relatively liquid points include 3, 7, and 10 year maturities (due to the maturity dates of credit indices see CDS Indices section). Payments are made quarterly, accruing on an Actual/360 basis. A full first coupon is payable on the first coupon date, and so accrued coupon payments must also be taken into account. European Credit Views: Crossing Barriers 13

14 Funding CDS Positions Similar to other types of swaps, CDS contracts are an example of an unfunded product in that the notional of the contract is not exchanged by either counterparty. Thus, when entering into a CDS contract one or both counterparties may be required to post collateral. The amount of collateral is dependent upon many factors, which include the specific reference entity of the CDS contract as well as the credit quality of the counterparty itself. As and when the mark-to-market value of the CDS contract changes, margin calls may also need to be made. Counterparty issues surrounding CDS contracts during the financial crisis have led the market towards a process of central clearing, in which counterparty risk is reduced. The Depository Trust & Clearing Corporation (DTCC), a comprehensive global repository for OTC credit derivatives, is one move towards that process. DTCC collects data on OTC credit derivatives and also provides important post-trade functions such as automated calculation, netting and central settlement of payments, and credit event settlement. Standardisation of CDS Contracts In 2009, the CDS market saw a number of significant changes to the way in which CDS contracts are traded. One motivation for the changes was to harmonise and standardise the CDS product. A detailed discussion of these changes can be found in our publication CDS Market Developments, dated 22 June We summarise some of the key changes below. The Standard North American Corporate Contract (SNAC) became the standard CDS contract traded in North America on 8 April As part of SNAC, the payment of a par spread on the premium leg of a CDS was replaced with fixed coupons of 100bp or 500bp in combination with the exchange of an upfront fee. Similarly, on 22 June 2009, the Standard European Contract (SEC) became the standard CDS contract traded for European corporates, financials, and Western European sovereigns. Similarly to SNAC, SEC contracts replace par spread payments with fixed coupons of 25bp, 100bp, 500bp and 1000bp in combination with the exchange of an upfront fee. SNAC and SEC were introduced to aid trade compression, to improve liquidity, to aid in the transition towards centralised clearing, and to address the concerns of financial regulators. Two other market developments that year included the CDS Big Bang and the CDS Small Bang (see Credit Events section). Separate to these changes in 2009, the CDS market has been evolving and standardising throughout its existence. For example, similar to products in other markets, the CDS market adopted the convention of standardised maturity dates. These dates are 20 March, 20 June, 20 September, and 20 December of each year. Due to their proximity to the International Monetary Market (IMM) dates, they are often referred to as IMM dates themselves. All standard CDS contracts mature on these dates for example, a current five year contract will mature on the first IMM date following the date five years from today; similarly for other maturities. Every three months, the maturity dates of the on-the-run contracts therefore roll (these dates are also known as roll dates ) to the next IMM date. Since the on-the-run maturity is the most liquid, it is common for investors to roll their existing CDS contracts from the old maturity to the new one. The standardisation of maturity dates and roll dates serve to improve comparability and transparency of CDS contracts, and thus provide better liquidity. European Credit Views: Crossing Barriers 14

15 Credit Events After the introduction of the SNAC, the credit events for corporate and financial CDS traded in North America were limited to bankruptcy and failure to pay. In Europe, following the establishment of the SEC, restructuring was kept as a credit event in addition to bankruptcy and failure to pay for corporate and financial institutions. Credit events for Western European sovereign CDS differ slightly (see Sovereign CDS section). CDS Big Bang was introduced by the International Swaps and Derivatives Association (ISDA) on 8 April It is an ISDA protocol that CDS market participants sign up to, amending current and specifying future CDS terms. One key outcome of the CDS Big Bang was the establishment of Determination Committees. The role of these committees includes determining the occurrence, type and date of a credit or succession event. It also covers deciding upon whether an auction is necessary as part of the settlement process and choosing which deliverable obligations are eligible as part of the settlement process. Credit event auctions were introduced much earlier than the CDS Big Bang, in an attempt to make the cash settlement process more transparent. As the number of CDS contracts can be significantly larger than the number of physical bonds, cash settlement became more common. One of the key ideas behind the auction was to set one price for all market participants opting for cash settlement. Both CDS Big Bang and CDS Small Bang protocols hard wire this auction settlement process of CDS contracts. The inclusion of restructuring as a credit event under SEC means the complexity of the CDS settlement process increases. One reason is the inherent optionality of a restructuring credit event, as both buyers and sellers can choose whether to trigger a CDS contract. In addition, there is also an asymmetry between eligible deliverable obligations of buyer-triggered and seller-triggered CDS contracts. The definition of a restructuring is itself relatively complex. To qualify as a restructuring credit event, the changes in the legal terms of an issuer s obligation must result in a reduction in the contractually promised benefits to obligation holders and must arise due to deterioration in the creditworthiness or financial condition of the issuer. A full definition can be found in the 2003 ISDA Credit Derivatives Definitions. CDS contracts can have different restructuring conventions restructuring (R), modified restructuring (Mod R), modified modified restructuring (Mod Mod R), and no restructuring (No R). Following the introduction of the SNAC and the SEC, CDS contracts in North America and Europe now trade with the No R and the Mod Mod R conventions respectively. Restructuring (R), also referred to as Old R or Full R, means that all deliverables up to 30 years in maturity are deliverable in a restructuring Mod R or Mod Mod R means there is a maturity limitation on deliverables, based on the maturity of the CDS contract No R means that a restructuring does not classify as a credit event While failure-to-pay and bankruptcy are hard credit events that automatically trigger all outstanding CDS contracts, restructuring is optional protection buyers and sellers can decide whether or not to trigger the CDS contract in the event of a restructuring. If neither does, the contract continues until maturity or a future credit event. CDS Small Bang, introduced on 27 July 2009, included a Restructuring Supplement to cover auction settlement of restructuring credit events. Again the idea behind this protocol was to increase transparency. Further details regarding CDS Big Bang, restructuring credit events, and CDS Small Bang can be found in our publication CDS Market Developments, dated 22 June European Credit Views: Crossing Barriers 15

16 Succession Events Every CDS contract relates to a specified Reference Entity, be it a corporate or a sovereign issuer. Broadly speaking, a CDS Succession Event occurs if, when undertaking some form of corporate reorganization (like a merger or a spin-off), one entity becomes liable for the obligations of another, potentially requiring a change in the CDS contract s Reference Entity and allocation of Relevant Obligations. For example, if a Reference Entity splits into two, the associated CDS contract may also split to reflect this if sufficient debt is inherited by the newly separated entity. Following the CDS Big Bang, all Succession Events must be raised to an ISDA Determinations Committee within 90 calendar days. The DC will then determine whether or not a Succession Event occurred, and if so the legally effective date and the Successors. We outline in Exhibit 11 the means for determining the Successors. Key in this determination is the idea of Relevant Obligations further information regarding how these are determined and exactly what constitutes a Succession Event is contained in our publication, ISDA Succession Events: Highlighting issues raised by current cases, dated 26 May Exhibit 11: Determining a Successor Situation One entity has 75% or more of the Relevant Obligations Only one entity has more than 25% and less than 75% of Relevant Obligations; not more than 25% of Relevant Obligations remain with the original Reference Entity Several entities have more than 25% of Relevant Obligations; not more than 25% of Relevant Obligations remain with the original Reference Entity Several entities have more than 25% of Relevant Obligations, including the original Reference Entity No entities have more than 25% of Relevant Obligations and the original Reference Entity continues to exist No entities have more than 25% of Relevant Obligations and the original Reference Entity no longer exists Source: ISDA, Credit Suisse Successors This entity is the sole Successor This entity is the sole Successor All entities with more than 25% of Relevant Obligations are Successors; the original Reference Entity is not All entities with more than 25% of Relevant Obligations are Successors, including the original Reference Entity There is no Successor and therefore no change to the CDS The sole Successor is the entity with the greatest % of Relevant Obligations If a Succession Event occurs and more than one Successor arises, the relevant CDS Transaction will be divided into the same number of CDS Transactions as there are Successors, regardless of the amount of debt held by each Successor. Each Successor is the Reference Entity of a new CDS Transaction with the same general terms and conditions as the original CDS Transaction. The notional of the original CDS Transaction is divided equally across the new CDS Transactions. CDS versus Cash Bonds The difference in spread level between a CDS and a cash bond is termed the basis. Market participants often look to trade this basis as a relative value opportunity. For example, towards the end of 2008 the basis across the market became very negative. This can be interpreted as the bond appearing cheap relative to the CDS, and one way market participants could have attempted to take advantage of this phenomenon was to buy the bond and buy CDS protection this is an example of a negative basis trade. European Credit Views: Crossing Barriers 16

17 The basis is viewed by market participants for two reasons in general. One reason is to decide whether to enter into a basis package. The second rationale is to determine which of the two markets offer more value, the synthetic market (CDS) or the cash market (bonds). There are many approaches to measuring this basis and choosing the most appropriate measure is not always easy. In Understanding the Negative Basis, dated 6 March 2009, we discuss the various methods of measuring the basis and also explain why the basis should be non-zero. Sovereign CDS In addition to corporate and financial institutions, CDS contracts can be traded with sovereign institutions as the reference entity. Sovereign CDS trade on both Emerging Market and Western European sovereigns, as single names and as indices. Western European sovereigns cover the obvious Western European countries, but also the US and Canada. The single name market itself is large and liquid notionals outstanding for a given sovereign are typically higher than those for a given corporate. In the context of the government bond markets however, the sovereign CDS market is tiny. The itraxx 1 SovX indices have only very recently been introduced. Sovereign CDS is quoted and trades exactly like corporate CDS, with the primary rationale that of hedging sovereign exposure whether outright sovereign or corporate bond/loan positions in a given sovereign, or other country exposure. Contractually and economically, there are some important differences between sovereign CDS and its corporate and financial counterpart. One of the key points to note is that for Western European sovereign CDS, in comparison to corporate CDS, bankruptcy is replaced with moratorium/repudiation as a credit event, and the CDS trades with full restructuring rather than modified modified restructuring. A moratorium/repudiation credit event occurs when an authorized officer disclaims, repudiates, rejects, challenges or imposes a moratorium/standstill on one or more obligations for a minimum amount of USD 10 million, followed by which there is a failureto-pay or restructuring within 60 days or by the next bond payment date. Currency is a particularly important consideration for sovereign CDS due to the potential for currency devaluation or redenomination by the sovereign. Of note Sovereign CDS contracts usually trade in both USD and EUR, with USD contracts the most liquid for European countries. The currency of the CDS matters since a sovereign credit event is likely to coincide with a high degree of currency weakness and/or volatility Redenomination of interest or principal payments into a currency that is not a G7 or AAA-rated OECD currency can trigger a restructuring credit event. For a thorough overview of sovereign CDS, the reader is referred to our publication Sovereign CDS Primer: Devilish Details, dated 12 February itraxx is a trademark of International Index Company Limited. European Credit Views: Crossing Barriers 17

18 CDS Indices In addition to the single name CDS contracts discussed above, it is possible to trade CDS indices. Broadly speaking there are two families: the itraxx indices cover Europe and Asia; the CDX indices cover North America 2. We outline some of the main characteristics in Exhibit 12. Exhibit 12: CDS Indices Number of constituents Current series Maturities (Years) Current spread (bp) Fixed Coupon (bp) Index Currency Credit Events* Europe itraxx Main EUR 3,5,7, Bankruptcy, FTP, MMR itraxx HiVol EUR 3,5,7, Bankruptcy, FTP, MMR itraxx Financial Senior EUR 5, Bankruptcy, FTP, MMR itraxx Financial Sub EUR 5, Bankruptcy, FTP, MMR/R itraxx Crossover Approx EUR 3,5,7, Bankruptcy, FTP, MMR itraxx SovX Western Europe 15 3 USD 5, R/M, FTP, R North America CDX IG USD 1,2,3,5,7, Bankruptcy, FTP CDX HiVol USD 1,2,3,5,7, Bankruptcy, FTP CDX HY USD 3,5,7, Bankruptcy, FTP Other itraxx Japan JPY Bankruptcy, FTP, MMR itraxx Asia ex-japan IG USD Bankruptcy, FTP, MMR itraxx Australia USD Bankruptcy, FTP, MMR itraxx Asia ex-japan HY USD Bankruptcy, FTP, MMR itraxx SovX CEEMEA 15 3 USD 5, R/M, FTP, R,OA CDX EM USD 5, R/M, FTP, R,OA Source: Credit Suisse * FTP = failure-to-pay; MMR = modified, modified restructuring; R = full restructuring; R/M = repudiation/moratorium; OA = obligation acceleration Investors would typically trade an index either to take a more systematic/top down view (be it on corporates, sovereigns or financials) or to hedge other positions. As a fully standardized, transparent product, the indices are liquid and widely traded. Trading and Quotation Conventions Indices are quoted and trade in the same way as single name CDS 3 : each is quoted either as a spread or an upfront price, depending on the index, and trades as a defined fixed running coupon and an upfront payment. Fixed coupons and current spreads for the main series are given in Exhibit 12. Most indices trade with 3, 5, 7 and 10 year maturities, although for some just the 5 and 10 year trade. Payments are made quarterly, accruing on an Actual/360 basis. A full first coupon is payable on the first coupon date, and so accrued coupon payments must also be taken into account. 2 Markit is the owner of both series of indices, having bought them in Prior to that Markit was the administrator for the CDX and calculation agent for itraxx. 3 Indices traded in this way prior to the convention changes affecting single name CDS in However, prior to 2009 the fixed coupon, while defined at the outset of the index, was not standardized to 100bp or 500bp as is now the case. This can be seen for the various fixed coupons of off the run series. European Credit Views: Crossing Barriers 18

19 Index Details The majority of the indices are equally weighted and rules govern the construction of each, detailing the eligibility criteria for constituents. Broadly speaking, index composition is as follows: Europe: itraxx Main: Most liquid 125 European investment grade names. 25 are financials, 100 are corporates; the financials then form the financials senior and subordinated indices itraxx HiVol: 30 widest spread non-financial names in itraxx Main itraxx Financial Senior: 25 senior financials (those included in itraxx Main) itraxx Financial Sub: subordinated issues for the 25 entities in the senior index itraxx Crossover: European sub-investment grade issuers 4 itraxx SovX Western Europe: 15 Western European sovereigns itraxx LevX: 50 most liquid European first lien credit agreements traded in the European leveraged loan CDS market North America: CDX IG: Most liquid 125 investment grade issuers CDX HiVol: 30 widest spread names in CDX IG CDX HY: 100 high yield issuers, split into HY.B, HY.BB and HB sub-indices LCDX: 100 North American first lien single-name loan CDS (LCDS) Other: itraxx Japan: 50 Japanese entities itraxx Asia ex-japan IG: 50 non-japanese Asian entities itraxx Australia: 25 Australian entities itraxx Asia ex-japan HY: 20 non-japanese Asian high yield entities itraxx SovX CEEMEA: 15 Emerging Market sovereigns CDX EM: Approx. 15 Emerging market sovereigns The itraxx LevX and LCDX indices are loan CDS indices; the other indices are all CDS indices. A complete set of the eligibility criteria for each index is beyond the scope here, but selection depends in general on a combination of liquidity, ratings and spreads 5. Each index rolls to a new series every six months so that index constituents can be modified to best satisfy the eligibility requirements. Index rolls occur on March 20 and September 20 each year 6 and are actively traded. The latest series is the on-the-run index; older series are off-the-run. While the latter still trade, liquidity tends to decline the older the series. Index maturity is then the IMM date following the roll date. For example, itraxx Main S14 began trading 22 Mar 2010, and the maturity of the 5Y index is 20 Jun Plus names that are currently rated BBB- and are on negative outlook 5 For an outline of criteria for the European itraxx indices, please refer to our publication: What's in itraxx Series 13, 1 March CDX HY rolls a week later, while LCDX rolls 2 weeks later. European Credit Views: Crossing Barriers 19

20 Index Skew An index is an instrument that trades in its own right: it has its own value that is not directly computed from the spreads of the underlying constituents (contrary to the construction of equity indices). Since buying (or selling) an index is equivalent to buying (or selling) a portfolio of the underlyings, the value of an index must be related to the value of the constituents by no arbitrage arguments. The difference between the market index level, and the inherent fair-value index level based on constituent spreads is known as the index skew: Index skew = market index spread fair-value index spread To the extent that the single name and index CDS markets are influenced by different supply/demand or technical factors, the two can diverge for periods of time before skew players enter the market to arbitrage away the difference. Since the indices tend to be more liquid and easier to trade quickly, in periods of volatility, index moves tend to lead single name moves, generating a tradable skew. A history for itraxx Main skew is illustrated in Exhibit 13. Exhibit 13: itraxx Main skew history Spread (bp) Skew (RH axis) Fair Value Market Spread Skew (bp) 12/05/08 12/07/08 12/09/08 12/11/08 12/01/09 12/03/09 12/05/09 12/07/09 12/09/09 12/11/09 12/01/10 12/03/10 12/05/10 Source: Credit Suisse Credit Events Index investors are exposed to credit events, exactly as for single names. The relevant credit events depend on the index, as outlined in Exhibit 12. The main distinction is whether or not restructuring constitutes a credit event, and if so, whether the index trades with full restructuring or modified modified restructuring. If a credit event occurs for a constituent in the index, it is settled exactly as in the case of a stand-alone single name, and is split from the index. A new version of the index is issued with the entity is removed and a proportionately lower notional 7. In effect the original index (V1 here) becomes: If index V1 has n constituents and an aggregate notional N, each single name has notional N N ( n 1) and index V2 has a notional. n n 7 If there are n constituents in the index and 1 credit event occurs, the new version will have notional of (n- 1)/n times the original notional. European Credit Views: Crossing Barriers 20

21 If the event is a restructuring, the protection buyer and seller have the right to decide whether to trigger the single-name or not. If neither do, the single name CDS continues to trade, and the investor retains the single-name position. By splitting the index in this way, version 2 of the index becomes the standard, retaining liquidity, regardless of investor decisions regarding whether to trigger or not. For default, failure-to-pay or triggered restructuring credit events, the single name position is then auction-settled exactly as usual and the protection buyer receives Notional x (1-recovery) from the protection seller. Whether or not the new version starts trading and becomes the liquid index immediately or only once the auction has occurred (and the recovery rate determined) has not yet been standardized originally the new version used to become active immediately following the credit event; recently the old version has tended to trade until the auction. Swaptions Swaptions are options on CDS, providing the purchaser the right to buy or sell CDS protection on a specified reference entity at a fixed spread on a fixed future date. Swaptions trade on the main indices 8 : itraxx Main, Crossover, Financials, & SovX and CDX IG & HY. They and allow the investor to trade credit volatility, either in addition to or separately from taking a view on likely spread moves. When trading volatility, the investor is looking to monetize either changes in the implied volatility or the difference between implied and realized volatility. Exactly as for interest rate swaptions, there are two types: Payer swaption: the right to buy protection on the reference entity (and pay the premium) Receiver swaption: the right to sell protection on the reference entity (and receive the premium) Investors can then go outright long or short payer or receiver swaptions or enter into strategies combining positions in payers and receivers to express a variety of bullish and bearish views on spreads and volatility. The basic exposures for the most standard trades are outlined in Exhibit 14; these form the building blocks for more involved strategies. Exhibit 14: Standard swaption trades Trade Spread View Volatility Position Upside Downside Long Payer Bearish Long Unlimited Premium Short Payer Bullish Short Premium Unlimited Long Receiver Bullish Long Capped Premium Short Receiver Bearish Short Premium Capped Long Straddle Large moves Long Unlimited Premium Short Straddle Range-bound Short Premium Unlimited Long Strangle Large moves Long Unlimited Premium Short Strangle Range-bound Short Premium Unlimited Source: Credit Suisse Some popular strategies include: Bull spread: sell a low strike receiver, buy a high strike receiver. This strategy pays out if spreads tighten and loses if spreads widen, but both upside and downside are capped, providing protection against significantly wider spreads. It can also be done through selling a low strike payer and buying a high strike payer. A bear spread is the opposite position, benefiting if spreads widen and losing if spreads tighten, again with the upside and downside capped. 8 Some single name swaptions have traded, but the market never really took off and has no liquidity. Single name swaptions knock-out on occurrence of a credit event prior to option expiry. European Credit Views: Crossing Barriers 21

22 Calendar spread: a strategy to take a view on the evolution of volatility, usually by trading straddles of different expires. E.g. if volatility is thought likely to increase in the longer-term, sell short-dated straddles and buy long-dated straddles. Trading volatility skew: trade the difference in implied volatility for options with the same maturity but different strikes generated by supply/demand imbalances. Swaptions are European style options: they can only be exercised on the expiry date and settlement is physical at expiry the index is bought or sold. Index swaptions do not knock-out if there is a credit event on an index constituent prior to option expiry. The reference entity remains the old version of the index, including the defaulted entity, until option expiry at which point the protection buyer can trigger the contract and receive the recovery payment. Swaptions are usually quoted and trade with delta exchange a swaption position will be combined with an opposite index position, with the amount of index determined by the relevant swaption delta. Quotes for trading outright, without the index position, are likely to differ based on the cost required to exit the index position. Tranches The indices can also be traded in tranched format. As outlined in Exhibit 15, the index is split into standard tranches, each defined by an attachment and a detachment point, allowing investors to gain exposure to a specific part of the index loss distribution. Bespoke tranches also trade, with investor-specified attachment and detachment points, although these are considerably less liquid. Exhibit 15: itraxx Main and CDX IG Tranches The attachment point is the lower bound for the tranche, the detachment point is the upper bound for the tranche Source: Credit Suisse Tranches trade in a similar way to single name and index CDS, with a fixed coupon and upfront, and credit events impact the tranches in order, starting with the equity tranche. On occurrence of a credit event, the protection seller compensates the protection buyer for the loss and the remaining tranche notional, on which the premium is payable, is reduced. Once the equity tranche is exhausted, losses begin to impact the junior mezzanine tranche and so on up the capital structure. European Credit Views: Crossing Barriers 22

23 Exhibit 16: Credit Linked Note Trading a specific tranche of the index, rather than the index as a whole, allows investors to take a view on systematic vs. idiosyncratic risk. The greater the idiosyncratic risk, the more likely credit events are to impact the equity tranche, shifting a greater proportion of the loss distribution there. As risk becomes more systematic, as happened during the global financial crisis, risk moves up the capital structure, impacting the super senior tranche. Tranche quotes typically assume delta exchange: when trading the tranche, the investor simultaneously trades a delta-hedged amount of the index. So a long tranche position would be packaged with a short index position, with the amount of the index dependent on the tranche delta. Tranche deltas and reference index levels are set daily by the market; quotes for an outright position in a tranche would differ. Credit Linked Notes A Credit Linked Note ( CLN ) is effectively a synthetic corporate bond that provides similar, though not identical exposure, to a bond issued directly by the underlying reference entity. Mechanics A bank issues a structured note paying a coupon (fixed or floating). The CLN is referenced to the non-occurrence of a credit event in relation to a secondary reference credit. If a Credit Event occurs in relation to the reference credit, the issuer stops paying further coupons or any scheduled redemption. The CLN is then normally redeemed in cash at the post-default auction price of obligations of the reference entity as determined under the ISDA process with potential fallback to physical settlement via delivery of obligations of the reference entity in a similar way to a CDS. Purchase proceeds Issuer Investor Coupon + principal redemption (if no credit event occurs) Upon credit event... Issuer Source: Credit Suisse Cash payment equal to auction value of reference entity debt obligations (or physical delivery of such obligations as a fallback) Investor European Credit Views: Crossing Barriers 23

24 Analysis The investor is purchasing the CLN in exchange for payment of issuance proceeds, and is exposed, if a credit event happens, to loss of both coupon as well as a principal amount equal to the expected par redemption of the CLN minus recovery. So in many respects, the ultimate exposure profile is similar to a CDS, though with some differences. For the buyer of protection (the issuer of the CLN), the prefunding of the CLN removes counterparty credit risk. The reverse though is true for the investor (seller of protection) who, as well as exposure to the reference entity, also has credit exposure to the CLN issuer itself in that, even if the reference entity does not default, the investor may experience a loss if the Issuer defaults. This has come more sharply into focus for investors since the default of Lehman, and in some cases has led to greater consideration of CLNs issued on a secured basis by the bank, or even out of an independent special purpose vehicle collateralised with high grade assets Uses Like the unfunded CDS, a CLN can provide a number of immediate advantages, chief amongst which would be: Ability to invest in a bond-like product on credits where there may be no equivalent bond issued by the reference entity, or indeed no accessible debt at all. The CLN also can provide the ability to create a bond with a structured payout as an alternative to requesting the issuer to issue a structured bond. Potential for the CLN returns to be amplified by embedding a degree of leverage in the structure, or conversely to provide some investor protection via a guarantee on some coupon and/or principal repayment. Provide exposure to multiple reference credits in one CLN Total Return Swaps Under most of the basic synthetic credit structures, a loss only crystallizes if the underlying reference entity or bond defaults. In the interim, unless the parties seek an unwind of the structure, no loss is incurred by either party (notwithstanding that the interim mark-tomarket may fluctuate). In addition most products are based around repackaging the underlying exposure and altering the cash flow profile in one form or another. A Total Return Swap ( TRS ) though represents a product which mimics for the investor the exact payments and market risk of the underlying asset itself which includes sometimes the interim price appreciation or deterioration. Mechanics Under the most basic form of TRS, one party to the transaction will purchase the asset and enter a swap with the counterparty whereby it will pay on any cash flows that it receives on such an asset, including paying nothing if there is no payment as scheduled; as such, this party is generally referred to as the Total Return Payer. In return for such payments, the counterparty (the Total Return Receiver ) will pay a floating based payment equal to Libor + spread. Finally at the end of the trade, which doesn t necessary have to match the underlying asset maturity, a settlement payment may be made between the parties depending on whether the asset has risen or fallen in price. Over the life of the TRS, if it has risen, the Total Return Payer will pay the value increase, and vice versa if the asset value has fallen. European Credit Views: Crossing Barriers 24

25 Exhibit 17: Total Return Swap At Inception Asset purchase proceeds Libor + spread Asset Total Return Payer Returns paid on underlying asset Total Return Receiver At Maturity Sale of Asset Downside in value of asset Sale proceeds Total Return Payer Upside in value of asset Total Return Receiver Source: Credit Suisse Analysis The Total Return Receiver has clearly mirrored an investment in the underlying asset without the need to fund the position upfront and hence the transaction is very similarly economically to a repo. As such, the spread over Libor payable by the Total Return Receiver will be a function of a number of factors, including: The cost of funding the position for the Total Return Payer Any correlation perceived by the Total Return Payer between the underlying asset and the Total Return Receiver. Such correlation arises as the Total Return Payer has much greater counterparty credit exposure if there is a simultaneous deterioration on credit quality of both the underlying asset and the Total Return Payer Uses Total return receiver Full economic exposure to the asset with minimum upfront expenditure When linked to a portfolio, provides an ability to avoid operational requirements of monitoring the cash flows of multiple assets If the Total Return Receiver holds the assets initially & sells to the Payer, the transaction may provide a means to raise financing from instruments where traditional methods (e.g. repo, securitization) might not be viable Total Return Payer Utilise excess liquidity Ability to create outright short position in the underlying asset, or undertake securities lending European Credit Views: Crossing Barriers 25

26 Corporate loans A loan is provided by a lender (a bank or an institutional investor) to a borrower (typically a corporate) to support certain financing needs. A corporate loan can be used by a company to finance an M&A transaction, capital expenditure or working capital needs whereas a leveraged-buyout (LBO) loan is often used by a financial sponsor to fund the acquisition of an LBO target. For larger financing needs, one or several commercial or investment banks (the arrangers ) structure and arrange the loan and often distribute it subsequently to a wider group of lenders (the syndicate ). Such a syndicated loan is then administered by the agent who acts as intermediary between the borrower and the lenders and is responsible for the communication flow and information exchange between the borrower and the lenders, as well as maintaining a register of the lenders and their respective shares in the loan (the commitments ). In an underwritten deal, the entire commitment is guaranteed by the arrangers upfront and only distributed, or syndicated, to other banks and/or investors subsequently. In a bestefforts syndication, the arrangers guarantee less than the entire amount of the loan sought by the borrower and look for additional commitments, or subscriptions, in the syndication. This results in the risk that some of the key terms of the loan need to be changed or improved if the deal is not fully subscribed. Loans are normally the most senior and therefore safest part of a company s capital structure. These loans are often with a first lien (or first priority) on the security (i.e. collateral pledged in favour of the loan). This security can comprise of assets such as bank accounts, fixed assets, inventory, trade receivables, shares in the holding company or major subsidiaries of the company. In a leveraged capital structure, the Company s financing needs may be greater than the size of the senior loan and subordinated (or junior) forms of capital like second lien loans, mezzanine loans or high yield bonds may be required. Some of the key features of a loan are similar to a bond: i) Principal amount this is the amount that has been borrowed. ii) Interest rate this is the rate at which the loan will bear interest. Loans are typically floating rate instruments whereas bonds tend to be fixed rate. The interest rate is often expressed as a margin (e.g. 3.5%) over a base rate (e.g. EURIBOR or LIBOR). If a facility is not drawn then only an undrawn fee or commitment fee is paid on the undrawn amount. On more junior (or subordinated) facilities, an element of the interest may be deferred and paid-in-kind ( PIK ) 9. This is common for a portion of the margin of a mezzanine loan. Generally the longer the maturity and the more junior or subordinated a loan, the higher the margin. iii) Maturity this is the date by which the loan must have been repaid. For so called bullet term loans, it will be the date on which the full principal amount is paid back to the lenders. Amortising term loans in contrast, pay back the principal amount in several installments throughout the life of the loan, typically on a progressive repayment schedule, and the maturity date will represent the date of the last repayment. iv) Covenants these are certain rules and financial measurements stipulated by the credit agreement to which the borrower needs to adhere. Maintenance covenants set certain ratios of net debt to EBITDA (i.e. leverage test) and/ or net interest expense to EBITDA (i.e. interest cover test) with which the borrower must comply on a quarterly basis. HY bonds contain incurrence based tests rather than maintenance based tests. 9 PIK ("Payment in kind") - payment of the agreed rate of interest is deferred until the maturity of the loan with the interest accruing and capitalising during the loan's life rather than being paid in cash at the end of each interest period. European Credit Views: Crossing Barriers 26

27 A syndicated loan is often comprised of various parts of tranches. For example a 1,000m deal might consist of the following tranches: 100m senior revolving credit facility (or RCF) (7 years) 200m amortising senior term loan A (7 years) 200m bullet senior term loan B (8 years) 200m bullet senior term loan C (9 years) 100m second lien tranche; (9.5 years); and 200m mezzanine tranche (10 years). In an insolvency scenario, if the agent were to try to sell, and monetize, the security (i.e. often the entire company or the key valuable assets of a company), proceeds would first be applied against the exposure of the senior lenders. If there are surplus proceeds, once the senior lenders have fully recovered their monies, then additional proceeds would be applied against the second lien; once those holders had fully recovered their monies then any surplus proceeds would be applied against the next level of debt. The relationship between a borrower and the lenders is typically a closer one than the relationship between a bond issuer and the bondholders. The information provided to lenders is mostly considered non-public (or private), at least in Europe. Reporting requirements for borrowers are typically more frequent (e.g. on a monthly basis) and more comprehensive than to bondholders. Borrowers typically meet with the lenders at least once a year in person and provide regular updates. In contrast to bonds, loans are not represented by securities, but are simply based on contractual arrangements between the borrower and the lender, e.g. the credit agreement. Consequently, trading of loans in the secondary market is less straightforward than trading bonds, as the buyer of a loan needs to assume the previous contractual position of the seller. Loans are not traded on exchanges, but over-the-counter (OTC), typically through dealers such as trading desks of investment banks or brokerage firms. Loan trades can take two forms, assignment or participation. In an assignment, the assignee becomes a direct signatory to the loan, appears as a lender of record on the agent s registry and receives interest and principal payments directly from the agent. A participation (or subparticipation) is an agreement between an existing lender and a participant whereby the buyer is taking a participating interest in the existing lender s commitment. The seller remains the official holder of the loan (i.e. lender of record) and the buyer would receive interest and principal repayments from the seller. Apart from banks, institutional investors also participate in the loan market and they often view loans as a separate asset class within the credit spectrum. Among the non-bank investors in loans include the following: collateralized loan obligations (CLOs), credit funds, mezzanine funds, hedge funds, but also pension funds, insurance companies and other proprietary investors on an opportunistic basis. European Credit Views: Crossing Barriers 27

28 Fundamental credit analysis In this section, we discuss the main ways in which credit investors assess corporate fundamentals to inform relative value comparisons between different credit securities. Determining a fair credit spread Corporate credit analysis aims to inform judgements about what credit spread is necessary to compensate creditors for default/restructuring risk (we use the terms default and restructuring interchangeably going forward, even though it should be recognised that these are legally separate concepts). Since the required credit spread reflects compensation for the expected loss to creditors from default, it is a function of: a) the probability of default and b) the loss to creditors in the event of default ( loss given default or 100% minus the expected recovery rate ) 10. Credit analysis focuses on the characteristics of companies that affect these two factors. In assessing these factors, credit investors are likely to start with a base case outlook, much as do equity investors when arriving at a valuation for a company. Also similar to equity investors, they will then try to identify and evaluate the main risks to this outlook and to the company itself. These may include earnings risk, acquisition risks, strategic risks and other more purely financial risks. But rather than using this risk analysis to determine an appropriate discount rate for cash flows, this risk analysis itself, together with the existing credit profile, forms the primary basis for relative value judgements between different corporate credit securities. Analysing the business profile A credit analysis of a company s business profile centres on earnings stability and cash flow generation. The more predictable a company s earnings, the greater confidence credit investors can have in the company s ability to continue to meet interest payments. The stronger a company s cash flow generation, the sooner it is likely to be able to repay its debt and the less likely it is to need to turn to its liquid resources to avoid a default. Operational risks will clearly be the most important factor in assessing predictability of earnings, but the appraisal of cash flow generation will look at other contributions to and uses of cash flows such as expected changes to working capital and flexibility of planned capex. In respect of strategy, credit investors focus on what the likely impact of a given strategy will be on business risk, cash flow generation and leverage. Analysing the financial profile There are four main features of a company s financial profile that need to be assessed by creditors: leverage, liquidity, capitalisation structure and covenants. These give an indication of a company s robustness to shocks as well as the likely recovery for different creditors if it defaults. Leverage The leverage of a company can be assessed using a range of financial ratios known as credit metrics, which express the level of a company s debt or interest payments relative to its valuation and/or cash flow. If a company s level of interest payments is very high relative to its earnings or cash flow, it is more likely to find itself unable to meet its interest payments due to a decline in earnings or an increase in interest payments. If a company s level of debt is very high relative to its valuation, it is less likely that its debt will covered by its valuation in the event of default. Furthermore, the more leveraged a company is, the fewer financing options it is likely to have, so the more likely it is to run out of liquidity. 10 Expected loss from default = Probability of default x Loss given default European Credit Views: Crossing Barriers 28

29 Commonly used credit metrics include: i) Net debt to EBITDA (x) Credit investors are concerned about whether the value of a company is sufficient to cover the value of its debt. Since valuations are typically discussed in terms of earnings multiples e.g. EV/EBITDA the comparison of debt and valuation is made easier by also translating the level of debt into an earnings multiple. The multiple used is net debt to EBITDA. This metric is so commonly used in discussion about the credit quality of firms that it is often used interchangeably with the term leverage. ii) FFO to net debt (%) Funds from operations (FFO) measures the cash flow of the group before any changes in working capital, dividends to shareholders, investing cash flows and financing cash flows. It is typically defined as: FFO = EBITDA - non-cash items in EBITDA + dividends received from associates - cash net interest - cash tax FFO to net debt, expressed as a percentage, indicates how long it would take to pay down net debt if a company had stable working capital and suspended all dividends and investments. The higher the number, the quicker a company should be able to pay down its debt burden, all else equal. iii) FFO minus capex to net debt (%) This is similar to the ratio in (ii), but addresses two issues: a) a company is unlikely to be able to sustain its FFO at the current level if it suspends investments entirely, b) a company may simply not be able to suspend investments. In some industries it may be more appropriate to subtract only maintenance capex from FFO for this ratio; but in others, such as those heavily dependent upon R&D in order to maintain market position, it may be more appropriate to use the total level of capex. This ratio represent a more accurate measure than (ii) of a company s actual ability to reduce debt over time. iv) Interest coverage ratios (x) Interest coverage can be assessed using two ratios: a) EBITDA to interest or b) FFO to interest. Both indicate resilience to shocks of a company s ability to pay interest, or the extent to which either EBITDA and/or FFO can fall before failing to cover interest payments. Adjustments In order to aid comparability between firms and reflect the full risks to creditors in the event of default, credit investors may make a number of adjustments to the ratios above. Adjustments primarily relate to liabilities that are not considered debt under IFRS but which, for the purposes of credit analysis, it makes sense to treat as debt. Since the assessment of whether or not a particular liability should be treated as debt is highly subjective, different analysts, investors and ratings agencies will make different adjustments and the same investor will often consider several versions (e.g. unadjusted versus pension-adjusted) of the same credit metric. The standard method behind such adjustments is to take a liability and amend the financials to reflect what credit metrics would look like if this liability was replaced with actual IFRS debt e.g. adjusting net debt for the amount of the liability, adjusting interest expense for the additional interest that would be incurred if this liability were replaced with debt, and adjusting FFO for this additional interest expense. European Credit Views: Crossing Barriers 29

30 The following is a list of items which may be adjusted for (the list is by no means exhaustive): i) Pensions in many jurisdictions, unfunded pension liabilities will effectively crystallise as a claim on the assets of the company in event of a default. ii) Operating leases these are used by companies as a substitute for investment in their own operating assets. iii) Asset retirement obligations these are liabilities that will be outstanding when certain assets stop generating cash flow (e.g. nuclear decommissioning liabilities). iv) Fair value hedges against borrowings these may reduce or increase the amount of actual liabilities in the event of default. v) Restricted cash some cash may be tied up in margin accounts, for example, so would not available to creditors in the event of default. Liquidity A company s liquid reserves consist of its unrestricted cash and any amounts that it is contractually entitled to draw down from credit lines. It may need to use these liquid reserves to meet its ongoing obligations if, for example, its operational cash flow turns negative or it is unable to refinance its borrowings with new debt. If it is unable to pay its obligations as they become due it will suffer an event of default. Its liquid reserves therefore provide a buffer between financial deterioration and an event of default, potentially buying a company time to resolve its financial situation and begin to either generate sufficient cash to meet its obligations or to refinance its maturing debt. An analysis of a company s liquidity position aims to assess the adequacy of liquid reserves to meet its obligations. Liquid reserves typically consist of cash and credit lines, but other sources of liquidity such as short-term investments and equity investments may also be relevant. The most significant obligations are likely to be debt maturities, though other committed expenditures, for example on capex, could also be substantial. Capital structure A firm s capital structure is essential for determining the priority of claims on it in the event of default or restructuring. In combination with a distressed valuation, this can be used to estimate likely recoveries for different classes of creditor. The starting point in a recovery analysis is often the assumption that a company will be restructured with claims being recognised for each class of creditor in strict accordance with their legal priority. The priority of claims on a company s assets and cash flow are likely to be determined by a number of different factors including which entities in the corporate structure are directly responsible for which liabilities (e.g. subsidiary versus parent company), guarantees, laws within the governing jurisdiction, liability specific contractual terms (such as specific security) and agreements between creditors. The basic classes of creditor to consider are as follows: i) Secured In the event of default, secured creditors can exercise their security either over a particular asset (a fixed charge) or over all the assets of a group (a floating charge). ii) Senior unsecured Most bonds and bank loans are issued from the parent company of a group on a senior unsecured basis. This means they have a claim on the assets and cash flows of the group which remain after the claims of preferred and secured creditors have been satisfied. iii) Subordinated debt Subordinated debt only have a claim on the assets of the group that are left after the claims of preferred, secured and senior have been satisfied. European Credit Views: Crossing Barriers 30

31 Capital structure example The following tables show how different capital structures, with different amounts of each type of debt, can result in wildly different recovery rates for each class of creditor as well as much higher or lower sensitivity to changes in the distressed valuation of a company (i.e. the valuation in the event of default or restructuring). Exhibit 18: Capital structure scenarios - a worked example, unless otherwise stated Scenario A B C Starting nominal claims of each class of creditor Secured debt Senior unsecured Subordinated Total debt Enterprise valuation Of which each class of creditor benefits in strict priority Secured debt n.a. Senior unsecured Subordinated Recovery rate to each class of creditor (%) Secured debt n.a. Senior unsecured Subordinated Source: Credit Suisse All three scenarios have the same amount of nominal debt of 100. In Scenario A, there is 40 of secured debt, 50 of senior unsecured debt and 10 of subordinated debt. In this scenario the enterprise valuation is 100, so if the value of the company were to be monetised there would be enough funds to cover all the creditors claims and the recovery rate for all creditors would be 100%. In Scenario B, there is the same capital structure, but the valuation is instead 60. Assuming strict priority and monetisation of the value of the company, this would first be applied to meeting the claims of the secured creditors, who receive the full 40 of their claim. The remaining 20 of value is distributed to the senior unsecured creditors, but since their claim is more than the value available to them, this only covers 40% of their claim their recovery rate is 40%. As there is no value left after this, the subordinated creditors receive nothing in this scenario. In Scenario C, there is the same valuation as in Scenario B, but the capital structure is different. There is no secured debt, 50 senior unsecured debt and 50 subordinated debt. With a valuation of 60, there is 50 of value available to the senior unsecured creditors, who have a recovery of 100%, and 10 available to the subordinated creditors, who have a recovery of 20%. What these examples show is that, assuming strict priority of claims, the further down the capital structure (i.e. more subordinated or less senior), the more sensitive the recovery rate on a given claim will be to changes in the valuation of the company. The implication for valuation of a credit security is plain if it is more subordinated, the loss given default is higher (the recovery rate is lower) and the expected loss due to default is higher; investors in more subordinated securities will therefore demand a higher credit spread to compensate for this higher expected loss. European Credit Views: Crossing Barriers 31

32 Structural subordination Most companies are structured as a holding company, which is usually the company that would be listed in the equity markets, and one or many operating subsidiaries. Often the only substantial assets on the balance sheet of the holding company are the equity holdings in its operating subsidiaries. As an equity holder, the principal way in which a holding company can receive funds from these operating subsidiaries is through dividends from them 11. So assuming a company needs to monetise its assets in a default, the operating subsidiaries would have to sell their assets and then upstream the proceeds to the holding company. However, if the operating company itself has external debt, it will have to apply the sale proceeds to pay off this debt first, reducing the amount that will be left to upstream to the holding company. Since the operating company creditors must be paid first, they are considered structurally (as opposed to contractually) senior to holding company creditors. This has similar implications to the presence of contractually senior (or secured) debt as shown in Scenarios A and B above. The position of creditors within a group s corporate structure therefore matters in respect of which cash flows and assets of the group they would have access to in the event of default. The less debt that is structurally senior to a given claim, the less sensitive the recovery rate of that claim will be to the distressed valuation of the company. Covenants Covenants are favourable for creditors as they aim to prevent companies from taking actions that reduce credit quality and/or allow creditors to intervene at a relatively early stage (while there is still value) if a company is heading towards financial difficulty. In general, the more restrictive the covenants in the documentation for a given bond, the less risky that bond is and the tighter the spread it will trade at. However, if covenants held by other creditors are more restrictive than those held by bondholders, this may enable these other creditors to position their claims relatively more favourably as a company s financial position deteriorates e.g. these creditors could demand security in exchange for covenant renegotiation. The quality of covenants also needs careful consideration, given that they are often open to legal interpretation or challenge and sometimes can be circumvented. A full assessment of the quality, nature and interrelation of covenants in the various debt instruments of a company therefore forms an essential part of corporate credit analysis. Corporate credit ratings Ratings agencies assign credit ratings to issuers and/or individual credit securities. These ratings provide an independent assessment of the credit quality of an issuer and/or its securities. Rating are assigned by each agency according to a set scale that is used to indicate varying degrees of credit quality. The three major rating agencies are Moody s Investors Service (Moody s), Standard & Poor s (S&P) and Fitch Ratings (Fitch). While their methodologies often differ in important respects, their credit rating scales are closely aligned. Ratings are divided into two categories: i) Investment grade, which indicate strong credit quality, and ii) Noninvestment grade, which indicate more risky investments and are also known as Highyield, Speculative grade and, more colloquially, Junk. Basic corporate credit ratings are assigned from the scale of ratings shown below (each agency also has different ratings to determine different levels and types of default and a plethora of other ratings besides to describe different aspects of an issuer such as its short-term liquidity position). 11 For simplicity, we are ignoring the possibility of intercompany loans extended from operating companies to the holding company. European Credit Views: Crossing Barriers 32

33 Exhibit 19: Rating scales and their equivalents across agencies Moody's S&P Fitch Investment grade Aaa AAA AAA Aa1 AA+ AA+ Aa2 AA AA Aa3 AA- AA- A1 A+ A+ A2 A A A3 A- A- Baa1 BBB+ BBB+ Baa2 BBB BBB Baa3 BBB- BBB- Non-investment grade Ba1 BB+ BB+ Ba2 BB BB Ba3 BB- BB- B1 B+ B+ B2 B B B3 B- B- Caa1 CCC+ CCC+ Caa2 CCC CCC Caa3 CCC- CCC- Ca CC CC C C C Source: Credit Suisse In addition to assigning a rating, each agency will assign a rating outlook. The main outlook categories are: i) positive indicating either that the credit quality of an issuer or a given security is improving and if this continues then its rating is likely to be upgraded, or that the credit quality has improved and if this is sustained then its rating is likely to be upgraded. ii) stable indicating that the rating agency does not expect the rating to change in the foreseeable future, given how the company s credit profile is developing. iii) negative indicating either that the credit quality of an issuer or a given security is deteriorating and if this continues then its rating is likely to be downgraded, or that the credit quality has deteriorated and if this is sustained it is likely to be downgraded. Exhibit 20: Historical default rates for Moody's ratings categories 5-year cumulative default rates for European and North American issuers, % 50% 40% 30% 20% Europe North America 10% 0% Aaa Aa A Baa Ba B Caa-C Investment-grade Speculative-grade All Source: Moody's Investors Service European Credit Views: Crossing Barriers 33

34 Pricing, performance and risk measurement Prices and quotes Like all investors in financial products, credit investors are exposed to a range of risks for which they require compensation in the form of a credit risk premium: Default risk: the risk of experiencing a loss due to a credit event, e.g. a default. This is the original meaning of the word credit risk and is still used interchangeably with it. Spread risk or Mark-to-Market (MTM) risk: the risk of experiencing a MTM loss due to a change in price or the spread of the product. Liquidity risk: Liquidity across products, underlyings, maturities and other contract specifications can vary quite substantially. The MTM loss in a position therefore can even be exaggerated by a lack off liquidity, i.e. the impossibility to (fully) close the position. Recovery risk: The risk of the size of the loss following a credit event, due to the uncertainty in the value that can be recovered. A risk that mainly affects funded products is interest rate risk. Credit instruments share this kind of risk with funded pure interest rate products, e.g. fixed coupon Treasury bonds. We will examine how to measure these risks in a later section. As explained above, the credit investor will demand an excess return over the risk free rate to compensate for the risks that they are bearing. In the credit world this will almost always be measured by a spread. The spread can be measured in many ways and is very much product dependent, as we explain in the following section. Bonds There are two main price conventions for bonds: The dirty Price of a bond represents the value of a bond. The dirty price is also called the "full price." The clean price is the price of a bond excluding any interest that has accrued since issue or the most recent coupon payment. This is to be compared with the dirty price, which is the price of a bond including the accrued interest. Accrued interest is the interest that has accumulated since the principal investment, or since the previous interest payment if there has been one already. For a financial instrument such as a bond, interest is calculated and paid in set intervals. Accrued income is an income which has been accumulated or accrued irrespective to actual receipt, which means the event has occurred but cash not yet received Bonds are quoted using clean prices, whether on trader runs, Bloomberg or Reuters etc. Clean prices are more stable over time than dirty prices when clean prices change, it is for an economic reason, for instance a change in interest rates or in the bond issuer's credit quality. Dirty prices, on the other hand, change day to day depending on where the current date is in relation to the coupon dates, in addition to any economic reasons. When comparing bonds, prices actually are not the preferred measure. Take for example two bonds of different issuers, both trading at par, with the same maturity, bond A with a coupon of 3%, bond B with a coupon of 6%. If both bonds don t default, the former will return an annual yield of 3%, the latter will yield 6%. However, they both trade at 100, meaning that investors are willing to pay as much for the former as for the latter. Why is that? The answer is, that bond B does not only have a higher return, it also has a higher risk; otherwise investors would clearly favour it over bond A, resulting in a higher price of bond B. A preferred way to compare different bonds therefore is to look at the (extra) yield they generate. European Credit Views: Crossing Barriers 34

35 The Yield to maturity (YTM) or redemption yield of a bond is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. Assuming annual payments for simplicity, the yield is defined in the following way P = c n k + k= 1 1 N k ( 1+ r) ( + r) n Where: P is the price of the bond, c is the coupon, r is the yield or discount rate, n is the number of payment dates and N is the nominal value of the bond. Therefore, given a price, the yield can be found via trial and error or a root search algorithm. There are bonds that have optionalities and there are measures that account for these: Yield to call: when a bond is callable (can be repurchased by the issuer before the maturity), the market also looks at the Yield to call, which is the same calculation as the YTM, but assumes that the bond will be called, so the cash-flow is shortened. Yield to put: same as yield to call, but when the bond holder has the option to sell the bond back to the issuer at a fixed price on a specified date. Yield to worst: when a bond is callable, puttable, exchangeable, or has other features, the yield to worst is the lowest of yield to maturity, yield to call, yield to put, and others. A natural way to measure the spread of a bond is to compare its yield to the yield a risk free investment would generate. There are a couple of measures that fall into this category: Spread over benchmark: The credit spread of a particular security is often quoted in relation to the yield on a risk-free benchmark security, for example a AAA rated government bond with a similar maturity denominated in the same currency. This measure can be imprecise since there is not always a government bond with the same maturity. Example: The EDF 5.625% 23 January 2013 has a YTM of 1.61% and its benchmark government bond (OBL 3.5% 2013) yields 0.83%. Its spread over benchmark hence is 0.78%. The Interpolated Spread or I-spread is the difference between the yield to maturity of the bond and the interpolated swap rate Example cont d: The bond matures in 2.7 years. The 2-year and 3-year euro swap rates are 1.25% and 1.55%, respectively. The (linearly) interpolated 2.7 year swap rate hence is 1.47%. The spread to the interpolated swap curve therefore is 0.14%. I spread = 1.61% (1.25% + ( 2.7 2) * ( 1.55% 1.25% ) ) 3 2 European Credit Views: Crossing Barriers 35

36 The Z-spread of a bond is the number of basis points that need to be added to the zero swap rate curve, so that the present value of the bond cash flows (using the adjusted yield curve) equals the market price of the bond. Example cont d: To simplify things, lets assume the bond has a maturity of 3 years and the coupons are paid annually. The 1- year swap rate is 1.06% and the 2- and 3 year rates are as above. The bond currently trades at 111. The equation that needs to be solved for the z-spread therefore is: = 2 3 ( z) ( z) ( z) Using for example a root search algorithm we find that z =28bp. As for the yield itself, spreads need to be adjusted for eventual optionalities: The option adjusted spread (OAS) is the flat spread which has to be added to the yield curve in a pricing model (that accounts for embedded options) to discount a security payment to match its market price. The OAS is hence model dependent. As discussed in the Asset swap section, the asset swap spread (ASW) depends on the underlying bond cash flows and on the bond price. Both of these are affected by the credit quality of the reference entity (the company issuing the bond) making the ASW a measure of credit risk. The formula for the ASW is: ASW Priskfree P = PV 01(0, T ) 111 where P is the price of the bond, P riskfree is the price of the bond, if the discount rate used were the risk free rate and PV 01(0, T ) is the risk free present value of a basis point paid until maturity T. 12 This illustrates that entering into an asset swap is equivalent to being long the credit-risky bond and short a risk free bond with the same maturity and coupons. The asset swap spread thus is the price difference between these bonds paid in a running spread format until maturity. For example, if the credit quality of the risky bond was to deteriorate the bond price would fall resulting in a rising ASW. Exhibit 21 shows the yield analysis screen on Bloomberg (YAS <GO>), which illustrates the concepts introduced above Spreads for Floating Rate Notes Instruments that pay a floating coupon such as Floating Rate Notes (FRNs) have their own spread measure, which accounts for the fact that these products are quite commonly funded via a swap, e.g. LIBOR or EURIBOR. The quoted margin is the amount that needs to be added to the rate in order to determine the coupon. The discount margin estimates the expected return earned in addition to the index underlying the FRN. Exhibit 22 illustrates a typical dealer run, including bids and offers expressed in benchmark spreads, prices and asset swap spreads. 12 The formula for the risk free PV01 is defined in the appendix. European Credit Views: Crossing Barriers 36

37 Exhibit 21: Yield analysis screen for the EDF 5.625% 23 January 2013 bond The measures discussed in the text are highlighted in the red rectangle. The numbers vary slightly due to approximations Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service Exhibit 22: Corporate bond dealer run The columns display from left to right: Corporate ticker, coupon in %, year of maturity, Bid and ask benchmark spreads, prices and asset swap spreads, S&P ratings, ISINs and the respective benchmark securities Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service European Credit Views: Crossing Barriers 37

38 Credit Default Swaps (CDS) CDS are non-funded credit derivatives and therefore have very little sensitivity to changes in interest rates. They are mainly exposed to the various forms of credit and liquidity risk and their spread stands in direct relation to these. CDS used to be quoted by their CDS par spread. The definition of the par spread is the running CDS spread that makes the CDS be fair, i.e. have zero present value at initiation. This is equivalent to the default and the coupon leg of the CDS having the same present value at the start of the trade. The par spread therefore reflects, and is a function of, the market implied default probabilities and interest rate term structure, as well as the expected recovery, coupon and maturity of the contract. The worse the market-perceived creditworthiness of an issuer, the higher the market implied default probabilities and therefore the higher the par spread. As explained in the section about CDS, the standardized contracts, SNAC for the US and SEC for Europe, trade with a fixed coupon and an upfront fee that is exchanged at the beginning of the trade. The running coupon can be chosen by the counterparties but are standardized to be either of 25bp, 100bp, 500bp and 1000bp in Europe (SEC) or 100bp and 500bp in the US (SNAC). Depending on whether the par spread is lower or higher than the coupon, the protection buyer will receive or pay the protection seller an upfront premium that will reflect the difference in present values of the coupon and default leg. ( c s) U RPV 01 = Where RPV01 is the present value of a risky basis point. The notion risky here means that there is a chance that the payments of coupons cease to take place. The calculation of the present value of a running basis point is explained in the appendix. U is the upfront paid by the protection seller to the protection buyer, c is the coupon and s is the par spread. The quoted spread, i.e. the spread that CDS traders send in their runs 13 is a number that directly reflects this upfront payment. It can be inferred through the same relationship as the par CDS spread, however with a different RPV01 convention. Knowing what the upfront and the coupon are, one can back out the quoted spread. RPV 01 * ( c s) = U = RPV 01 ( c q) Where RPV01* still is the present value of a risky basis point, however different 14 to RPV01. q is the quoted spread. In addition to the upfront, the actual payment between the two counterparts at inception will include the interest accrued, which is due to the fact that the protection buyer will pay a full coupon at the first coupon date, no matter when they enter the contract. Example: On 14 May 2010 the investor buys $10mn protection on Marks & Spencer PLC, which trades at 138bp quoted mid spread. The standard coupon traded is 100bp and the maturity of the contract is 5 years, currently falling on the 20 June The protection buyer therefore will be paying 38bp running too little over the life of the contract, resulting in them paying the present value of these 38bp to the protection seller as an upfront at inception. In this example the upfront (Bloomberg call this Principal) and the Accrued are $177,249 and -$15,000, respectively, the minus sign indicating that the protection buyer receives money. We illustrate these in Exhibit 23, highlighting the various measures. 13 A run is a electronic, written communication of prices sent from market makers, usually via Bloomberg s 14 Broadly speaking, the RPV01 function for par spreads uses a term structure of interest rates and default probabilities that is calibrated to the market, whereas the RPV01* function for quoted spreads assumes a flat default term structure and different discount factors. A more detailed explanation can be found in the appendix. European Credit Views: Crossing Barriers 38

39 Exhibit 23: Credit default swap (CDSW) screen on Bloomberg The measures discussed in the text are highlighted in the red rectangle. Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service The most liquidly traded maturity for virtually all CDS contracts is the 5-year maturity. Other maturities are quite often quoted via the difference to the 5-year point. As discussed in the section about CDS, single name and index CDS roll to the next maturity in a pre-specified way. After these roll dates, traders therefore send runs with the quotes for the on-the-run (OTR) CDS and rolls indicating their bids and offers for the difference between the off-the-run and the OTR CDS. Exhibit 24: CDS dealer run The columns display bid and offers of, from left to right: Rolls between CDX IG series 12 to pervious series, curve steepness between the 5-and 7-year and the 5- and 10-year CDS curves for different series of the CDX IG indices. Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service European Credit Views: Crossing Barriers 39