Last week's auction setting the recovery rate for index-traded credit default swaps on Delphi Corp. has likely affected the way the market will price recoveries of highly referenced names and CDOs containing them in the future, according to Derivatives Week, a CIN sister publication. The lesson, credit trading officials said, is that bonds heavily referenced in CDS index contracts will be squeezed if they default, and the market will price a higher premium than fair value for recovery. This could affect valuations and ratings of popular names and CDOs.
The Delphi auction, in which 574 institutions participated, priced fixed recovery for index and tranche trades at 63.375%--midway below where the bonds traded pre-auction and above analysts' fair-value estimates. While analysts priced Delphi's real value at about 55, traders ran recovery rates as high as 72 before the auction. This squeeze was driven by a huge discrepancy between the number of contracts--$27.5 billion--and the number of bonds available--$2.2 billion.
"The take-away from Delphi is its impact on how to value recovery rates," said Robert McAdie, global head of credit strategy at Barclays Capital in London, noting the recovery value was profoundly impacted by technical factors, notably the shortage of paper relative to contracts on this popular name. "Going forward, this will have an implication for similar names." Less popular names should still recover at or below real value, and traders said they continue to price 40% recovery into models for these defaults.
Delphi's trading value dropped to 62 last Monday, but hovered in that range all week, suggesting that artificially high recovery values are acceptable to investors in some instances and may become the norm for settling defaults by highly referenced names. "The prices reflect some sort of short squeeze," one trader said. "But it's reasonable. It should trade higher than fair value if everyone's short. It could have been a lot worse and, in fact, it's not so bad."
