Leveraged loan credit-default swaps have attracted significant investor interest for a number of reasons. Buyers of protection, i.e. those taking a short credit risk position, are able to hedge risk on loans without the borrower knowing. This is particularly important for bank portfolio managers for whom managing client relationships is paramount. LCDS also provide portfolio managers with means to reduce their concentration risk, which allows them to free up economic capital and enable their banks to provide value-added lending.
Basel II gives an added incentive to banks to hedge their loan exposures. Under the new Bank of International Settlements framework, due to be implemented next year, capital requirements are linked to the credit rating of the borrower. This has the effect of penalising leveraged loans, where ratings are BB and below. If a bank, however, buys protection from a well-rated counterparty, the risk-weighting--and consequently capital requirements--will fall dramatically.
The new product also enables investors to hedge the right part of the capital structure. Previously, long loan positions were hedged using unsecured CDS, which introduced basis risk and was also more expensive than LCDS. This is because loans' seniority and higher recovery rates mean the cost of protection is much lower.
The European Twist
A more contentious benefit of LCDS for European investors is the cancelability feature in the contract. This is also the main difference between the European LCDS market and its U.S. counterpart. If the underlying loan--that is, the reference obligation--is fully repaid, as loans often are, then the LCDS contract will automatically terminate.
A U.S. LCDS contract, on the other hand, will only terminate if there are no loans outstanding of the same lien as the original reference obligation. Markit Group will conduct dealer polls to determine if a deliverable obligation meets the syndicated requirements. European portfolio managers are adamant about the importance of cancelability from a hedging perspective. Without cancelability, buyers of protection could be left paying a premium for a hedge they no longer need if the bond is called. The sellside appears to be aware of their clients needs. Dealers speaking at a recent conference acknowledged cancelability makes sense for European investors, most of which are banks. The U.S. has a more mixed investor base. Many dealers, however, expect the market will inevitably conform to a bullet product, as it makes second-generation products such as tranches and synthetic collateralized loan obligations easier to construct.
Sellers' Perspective
Sellers of LCDS protection, meanwhile, reap several benefits from the product. LCDS allows them to take long credit positions on loan credits that are difficult to access in the cash market. The unfunded nature of LCDS also means this is a much cheaper method of going long compared to buying a loan. This factor is particular germane for hedge funds, which suffer a funding disadvantage compared to banks.
Relative-value trading strategies, particularly on the capital structure, are an area where hedge funds are especially active. The LCDS product allows investors to take views on spread differentials between the different tiers of debt, whether bullish or bearish. If an investor feels senior unsecured credit is trading at wide levels compared to first-lien senior debt, taking into account historical default rates, then he can sell unsecured CDS and buy first lien LCDS. This trade is taking a bullish position on the company in question, as unsecured debt should improve markedly if the firm's credit profile strengthens, e.g. by deleveraging. In theory, LCDS should allow investors to trade on the secured term structure of a company, although the fact that most loans are called after two or three years makes this variant of relative value less relevant, at least in Europe.
Document Drivers
An advantage for both buyers and sellers is the development of standardized documentation. This is essential for the growth of the LCDS market on both sides of the Atlantic. TheInternational Swaps and Derivatives Association recently published a template for LCDS, and working groups in Europe and North America are currently fine-tuning the documentation.
A Numbers Game
Given the plethora of benefits to dealers and investors, the LCDS market should continue to develop rapidly. For this to happen, however, more buyers of protection need to get involved. It's generally accepted there is currently an imbalance in the market, as sellers--mainly hedge funds--outweigh buyers. This is partly a consequence of the tight spreads and low default rates predominating at the moment. There was a consensus, however, among both buy- and sell-side that there had been a reversal in this trend in recent weeks and buyers had entered the market in greater numbers. Evidence of this was shown in the decrease in negative basis typically seen in LCDS compared to cash.
But perhaps the most significant driver of increased volumes comes in the shape of LCDS indices. In Europe, the LevX index should attract a whole new class of investors, as has occurred with iTraxx and unsecured CDS. The index would provide a cheaper way of implementing relative value and capital structure strategies because indices trade with tighter bid/offer spreads than single names. Most of all, LevX will increase liquidity in LCDS. A U.S. index, LCDX, is expected to follow later this year.
Many commentators expect the credit cycle to turn in the near future, and the current benign market conditions could soon start to recede. As well as an efficient means of hedging credit exposure, LCDS will provide investors with tools to profit from differentials in capital structure valuations, which are likely to become more acute in a bear market.
This week's Learning Curve was written by Gavan Nolan, analyst at Markit Groupin London.
