Bond Buyer Conference Municipal Credit Default Swaps

Transcription

1 Bond Buyer Conference Municipal Credit Default Swaps 20, 2008 This material has been prepared by Municipal Structured Products and is not a product of Lehman Brothers Research Department. It is for information purposes only. All levels and prices are indications only and do not represent firm market levels. Changes in market conditions since the issuance of this document may affect some or all of the levels and prices listed. For firm levels and prices please call the desk

2 Uses of Muni Credit Default Swaps Buy credit protection for a municipal asset / portfolio Buying protection through CDS can eliminate or reduce credit risk without having to sell an asset The term of the CDS may be shorter than that of the asset if the investor is concerned about default risk only over the short- or intermediate-term Source of synthetic municipal credit exposure Seller of protection is paid to assume municipal default risk The CDS market makes it possible to short a municipal credit If an investor believes spreads will widen out, buying credit protection will lead to mark-tomarket gains on the purchased protection if CDS spreads widen Manage credit capacity Buy protection on credits in which an investor is full but wishes to buy more assets CDS are unfunded so leverage is possible Investor does not have to buy an asset to assume credit exposure 1

3 Muni CDS Quotes The most commonly-quoted maturity is 10 years Some sample muni CDS quotes from Lehman Brothers (1) 10 Year Muni CDS Quotes Reference Entity California G.O. Delaware G.O. Florida G.O. Illinois G.O. Maryland G.O /11 2/5 4/8 3/6 2/ /64 16/22 33/38 23/27 16/22 Reference Entity Massachusetts G.O. New Jersey G.O. New York City G.O. New York State G.O. Texas G.O /9 6/10 7/11 6/10 2/ /27 32/37 42/48 32/37 19/24 1. Indicative quotes. These quotes are for informational purposes only and should not be relied upon as an offer to buy or sell securities or as a solicitation of an offer to buy any product, as an official confirmation or statement of Lehman Brothers or its affiliates. With respect to indicative values, no representation is made that any transaction can be effected at the values provided and the values provided are not necessarily the values carried on Lehman Brothers books and records. Lehman Brothers shall not be liable for the provision of this information, its completeness or accuracy. 2

4 Pricing Considerations Since a credit default swap is an instrument which allows the transfer of default risk, the compensation that an investor should demand for assuming a credit risk and the premium that a hedger should be willing to pay to remove a credit risk should be linked to the magnitude of that credit risk The magnitude of a credit risk can be defined in terms of The likelihood of default The size of the payoff or loss following default The greater the probability of default and the greater the loss following a default, the higher are credit default swap spreads, all other things equal Factors that tend to increase or decrease credit default swap spreads relative to cash bond spreads Delivery option: buyer is long a delivery option, which tends to increase CDS spreads relative to bond credit spreads Funding / leverage: Default swaps are unfunded transactions which can be used to provide leverage, a fact which will generally decrease CDS spreads relative to cash bond credit spreads Taxability of income: Premium payments on a credit default swap are taxable, a fact that generally tends to increase the level of CDS spreads demanded by sellers relative to tax-exempt cash bond credit spreads Supply and demand: Dislocations between supply and demand in the credit default swap market can put upward or downward pressure on CDS spreads relative to cash bond spreads 3

5 CDS Mark-to-Market Value Just like a cash bond position, a CDS has a mark-to-market value that may fluctuate The mark-to-market value of a credit default swap depends on several key variables, including the remaining term of the swap, the spread on the existing swap, the current market spread for an identical swap through the scheduled maturity date, and the risky PV01 of the swap Example: An investor sells credit protection on an issuer through a 5-year credit default swap with a spread of 20bps and after 1 year has passed would like to determine the mark-to-market value of this swap After 1 year, there are 4 years remaining on the swap and the current market spread for a 4-year swap is 15bps The investor has a gain of 5bps because they are receiving 20bps per year under the existing swap, compared to the 15bps that is available in the current market Question: What is this 5 basis point gain worth? The answer is not simply the present value of 5bps per year for the remaining 4 years This is because the CDS premium payments stop upon the occurrence of a credit event Thus, each scheduled premium payment must be adjusted by the probability that a credit event will occur prior to each payment (in which case the payment would not be received) each payment is a risky cash flow, hence it is necessary to use a risky PV01 A pricing model is necessary to determine the risky PV01 MTM for a seller of protection = (Existing Spread - Current Market Spread) x Risky PV01 MTM for a buyer of protection = (Current Market Spread - Existing Spread) x Risky PV01 A market-to-market gain or loss may be realized or locked-in by terminating the existing swap or by entering in to a new, offsetting default swap 4

6 Disclaimer This material has been prepared by Lehman Brothers Municipal Structured Products and is not a product of Lehman Brothers Research Department. It is for informational purposes only. Lehman Brothers makes no representation that the information contained in this document is accurate or complete. Opinions expressed herein are subject to change without notice. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the issuance of this document. Under no circumstances should this document be used or considered as an offer to sell or a solicitation of an offer to buy any financial instrument mentioned in it. The products mentioned in this document may not be eligible for sale in some states or countries, or suitable for all types of investors; their value and the income they produce may fluctuate and / or be adversely affected by exchange rates, interest rates or other factors. Clients are advised to make an independent review regarding the economic benefits and risks of purchasing or selling the financial instruments mentioned in this document and reach their own conclusions regarding the legal, tax, accounting and other aspects of any transaction in the financial instrument in relation to their particular circumstances. Lehman Brothers enters into transactions on an arm s length basis and does not act as advisor or fiduciary to its counter parties except where a law, rule or written agreement expressly provides otherwise. Lehman Brothers and / or its affiliated companies may make a market or deal as principal in the financial instruments mentioned in this document or in related securities, options or other derivative instruments based on them. In addition, Lehman Brothers, its affiliated companies, shareholders, directors, officers and / or employees, may from time to time have long or short positions in the financial instruments, including loans, securities or in options, futures or other derivative instruments based on them. One or more directors, officers and / or employees of Lehman Brothers or its affiliated companies may be a director of the borrower or issuer mentioned in this document. Lehman Brothers or its predecessors and / or its affiliated companies may have acted as agent or arranger with respect to the loans of the borrowers mentioned in this report, and may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking, lending or other services for, or solicit investment banking or other business from any company mentioned in this document. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Lehman Brothers, Inc. All rights reserved. Member of SIPC. 5