Investors looking for new ways to apply loan-only credit default swaps are currently looking at loan portfolio synthetic tranche trades. The trade is a way for banks to efficiently lay off loan risk and offer investors a variety of investment choices dependent on their risk tolerance. Several banks are working on the trade and at least one is in the marketing stage. One banker, however, said his firm felt the trade was too risky to get involved in. Some buyside firms have completed a similar trade.
While the play may bear similarity to a synthetic collateralized loan obligation, these trades are on specific tranches rather than on the entire portfolio. The trade has been done on CDS, but not on LCDS.
"I do think it's important," one trader said. "Bank loan hedgers are coming up with new ways [to use the product]; they are basically buying portfolio protection."
For example, a dealer will source $100 million of single-name credit risk from a bank and go to a customer to sell the first 0-10% of losses as the first loss piece, and then to another customer and sell the 10-20% of losses, all the way up to 100% of the aggregate. By segmenting the risk into tranches, the sum of the parts is many times greater than the whole. Banks and Dealers may retain certain risk pieces of a portfolio depending on market demand and/or trading views.What banks are currently trying to do is have an entire pool, 0-100% of LCDS. Investors in the tranches, primarily hedge funds, are selling protection. The trade is expected to offer more flexibility and will demonstrate a more liquid secondary market.
It has yet to be done, however, because "Making the economics work is tough," another dealer said. Because LCDS is trading at levels well inside of cash loan yields, it can make more sense for investors in the equity and debt to just put together a regular CLO rather than invest in LCDS tranches. At this point, investing in the tranches offers less yield, he said.
Since the International Swaps and Derivatives Association published an LCDS confirm in June, single-name trading has increased immensely (CIN, 6/12). One bank estimated that the LCDS market is about $5 billion since June 8. Hedge funds account for about 70% of the number of trades. The most common trade had initially been hedge funds going long secured risk and short unsecured risk, but recently have been looking at other trades (10/23). Traders are currently working on an index, LCDX, expected next quarter. It is expected to include around 100 names (10/23).
