Credit default swap desks in London are looking at offering protection on credit-linked notes backed by Russian loan repayments to the German government in what is thought to be the first CDS on credit-linked notes. Hedge funds are interested in playing the arbitrage between CDS on Russian sovereign debt and CDS on the credit-linked notes, according to traders. Russia's sovereign debt is rated Baa3 by Moody's Investors Service and the CLNs, issued by a special purpose vehicle named Aries, are rated Ba2. Standard & Poor's currently rates both sovereign and Aries debt at BB plus, but an analyst noted the sovereign debt rating is under review. Aries is designed to issue up to USD6 billion of notes linked to payments Russia will make on loans from Germany. Deutsche Bank, JPMorgan and Goldman Sachs are looking at offering such credit protection.
Although this would likely be the first CDS on a credit linked note, traders noted this is not because the structuring capabilities are newly minted, but because the demand for such a CDS is new.
Aries issued its first credit-linked notes last month. One trader commented, "It may seem illogical to offer a derivative on a credit-linked note, but there are definitely hedge funds asking for this."
The notes issued by Aries are unusual in that although they securitize Russian debt, Germany, rather than Russia, is the guarantor of the CLNs. In a ratings note, Moody's speculates that Germany might be unwilling to call a credit event on the CLNs because of its desire to avoid reputational risk. The notes also have a pre-determined recovery rate of 20%. One bond fund manager noted that because Paris Club debt amortizes and Aries debt does not, in around three years the German government could have recouped around 40-50% of the debt, and so it may pass on more than the pre-set 20% to note-holders. The price of a credit default swap would likely reflect this possibility.
"A CDS would be an interesting development," said Julian Jacobson, emerging markets bond fund manager at Fabien Pictet & Partners in London, who has already sold his position in Aries notes. "I would be very interested to see how it would trade," he added.
One potential problem could be defining a credit event in the CDS documentation, according to Christian Stracke, analyst at CreditSights in Augusta, Ga. "What constitutes a default is fairly clear in the bond documentation, but this would need to be extra clear for the CDS documentation," he noted.
