Learning Curve: Defining Restructuring Under ISDA & Associated Issues
Loan Market Week is launching a new feature designed to highlight key issues in the market. This week James Batterman, senior director in the credit policy group at Fitch Ratings, highlights what defines a credit event triggered by a restructuring under current ISDA language.
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As we have entered a low default environment, it is easy to overlook restructuring as a meaningful factor. Lower defaults ordinarily imply less corporate restructurings. However, such things are cyclical, and especially for the longer-term investor, low corporate default rates at this time should not necessarily give one complete comfort. While failure to pay and bankruptcy are the most common corporate CDS credit events called, restructuring events do occur, and not that infrequently, especially with regard to high-yield entities. This tutorial highlights what defines a credit event triggered by a restructuring under current ISDA language, how that can differ from the rating agency interpretation of default, and some of the potential implications of the mismatch between the two.
Currently, CDS participants can choose four different forms of restructuring, including:
* Full Restructuring, which is the original form, currently used in the Japanese market;
* Modified Restructuring, used principally in the North American investment-grade market, and which imposes a tenor limitation of 30 months post the Scheduled Termination Date, for any obligation to be delivered by the protection buyer to the seller as settlement in the event of a credit event due to restructuring; this is in addition to the requirement that any obligation delivered be "fully" transferable;
* Modified Restructuring, used principally in the European market, and which imposes a tenor limitation of 60 months post the Restructuring Date for any restructured bond or loan to be delivered to the seller, as well as the requirement that any obligation delivered be "conditionally" transferable;
* No Restructuring, used for high yield CDS and otherwise, and which provides no protection against any restructuring event.
ISDA Definition of Restructuring
ISDA defines a restructuring constituting a credit event as having taken place when all of the below apply:
* Restructuring in some form is indicated as a potential credit event in the CDS confirmation;
* Any one or more of the following events occur in a form that binds all holders of an "Obligation", which is typically specified (in most markets) as any form of "borrowed money" in the CDS confirmation: 1) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals; 2) a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates; 3) a postponement or other deferral of a date or dates for either the payment or accrual of interest, or the payment of principal or premium; 4) a change in the ranking in priority of payment of any obligation, causing the subordination of such obligation to any other obligation; 5) any change in the currency or composition of any payment of interest or principal to any currency which is not a "permitted" currency;
* Any such event noted above is not 1) expressly provided for under the terms of such Obligation in effect as of the latter of the trade date and the issuance date, and is not 2) the result of "administrative" or other adjustment, but is instead the result of a deterioration in the underlying creditworthiness or financial condition of the Reference Entity;
* Some minimum dollar amount of instrument(s) restructured has been met (the "Default Requirement," which is $10 million, if not specifically stated otherwise); and
* The instrument triggering a restructuring credit event, unless otherwise specified, must be a "Multiple Holder Obligation", defined as one which is held by more than three nonaffiliated parties, with at least 2/3 of holders required to approve any restructuring that is to be construed as a credit event.
Much of the preceding was excerpted from ISDA documentation; please refer to the latest ISDA definitions and other material for more details and exceptions to the above.
While very frequently there is significant overlap between the agencies' definition of a restructuring that results in a security being classified as having defaulted and that which constitutes a "Credit Event" under current CDS restructuring language, there is the potential to have a mismatch between the two definitions.
Overly Broad Definition?
The problem has been that ISDA desires, understandably, a set of objective rules to determine what exactly constitutes a restructuring to avoid having a called credit event contested, which can occur even with the current language which has been tightened up somewhat over the past few years. However, as currently structured, certain so called "soft" events, that in an economic sense do not disadvantage the creditor, can result in a credit event being triggered. This is despite the fact that creditors may be better off in one form or another as a result of the restructuring (such as through a greater collateral interest, for example), and the fact that the company had effectively not defaulted on its obligations (i.e., loans and bonds) according to rating agency definitions. A key difference is that the agencies look at the overall economics of the restructuring, unlike the ISDA definition, which can be tripped simply by meeting the basic requirements previously specified. To the extent that the economics of the deal indicate that the creditor has suffered a diminished financial obligation, these securities would typically be downgraded to "D" (for default), given the impairment. The occurrence of soft credit events is not insignificant, particularly as far as high yield entities are concerned; this is one of the principal reasons that restructuring generally has not been included as a potential credit event in most high yield CDS.
Overly Narrow Definition?
A curious result of current ISDA language is that effectively, distressed exchanges of bond issues would typically not be construed as credit events, given that bondholders generally are not technically required to tender into an exchange offer. Consequently, such offers do not generally represent an instance that "binds all holders" to participate as is stipulated under current ISDA language, and therefore, such exchange offers are not credit events. (Fitch views this situation differently. Bondholders typically will not accept a significant reduction in principal and/or coupon, a cash tender significantly below par, a swap into equity, etc., with no positive offset, in a truly voluntarily manner. Such distressed exchanges are effected to avert the possibility of bankruptcy, an even worse outcome, and represent credit impairment sustained by the company.) Therefore, even if a form of restructuring is specified in a CDS contract, it is unlikely that a distressed bond exchange, alone, would be a covered event. However, if restructuring is specified, and the company also amends its loans, then the protection buyer may very well be covered given that current ISDA language is more suitable to that type of event ocurring. That said, high yield CDS, unlike investment grade CDS, typically excludes restructuring altogether, so effectively protection buyers will not be covered for any restructuring, though protection against failure to pay and bankruptcy should remain in place post any restructuring action.
For a bondholder, restructuring is almost always preferable to bankruptcy from a recovery standpoint. However, to the hedged investor long CDS protection, bankruptcy may be the better outcome given all the aforementioned. This may create perverse incentives on the part of hedged investors when considering whether to go along with a restructuring plan, by consenting to amend a loan or tender bonds, or not. If a company's fundamental situation following a restructuring significantly improves (worsens), tighter (wider) spread levels for both CDS and all outstanding bond issues will likely result. However, hedged investors should be aware that unwinding positions may entail certain costs, given that the CDS on the reference entity may not offer a perfect hedge and the possibility that bid/asked spreads may already be quite wide given the company's distressed situation.
Protection Buyer vs. Protection Seller and Pricing
Ceteris paribus, the protection buyer ordinarily would want to be protected against the possibility of restructuring, while the protection seller would ordinarily prefer to exclude restructuring as a possible credit event from a CDS contract altogether. In certain instances, sellers may not be willing to offer protection with any form of restructuring, especially in regard to high-yield entities, or they may be willing to offer it at a significantly higher price. Theoretically, the probability of a restructuring occurring for a specific name, which is itself largely a function of the underlying credit quality, macro/market environment, and other factors, should distinguish pricing between CDS with and without restructuring as a specified credit event and the cash (bond) market.
While we cannot predict how the incidence of restructurings as a percentage of all defaults or all credit events will evolve, it is clear that the overall default rate will eventually rise from current levels, so this issue may become more relevant going forward.
Loan Market Week is now accepting submissions from industry professionals for its "Learning Curve" section. This feature is intended to highlight significant issues that affect the asset class and act as a forum to educate the market. For details and guidelines on writing a Learning Curve, please call Pierre Paulden at 212- 224-3639 or Michelle Sierra Laffitte at 212-224-3277.