Published: April 01, 2010
Credit default swaps (CDS) are rapidly becoming a vital risk measurement tool in treasury management. Credit spreads, and their rise or fall, provide a real-time barometer to measure and assess counterparty risk. Screen-based credit pricing is increasingly important to businesses which have historically relied on traditional methods of measuring credit risk to suppliers, customers, debtors and bank counterparties.
Business is based on credit. In order to manufacture, trade or grow, a company needs access to working capital and companies are generally both borrowers and lenders. Finance directors are adept at understanding how financing costs and counterparty risk can impact the financial integrity of their company. After several years of a relatively benign economic environment and easy access to capital the importance of measuring counterparty risk accurately is now recognised as a top priority.
The well documented Great Credit Crackup of 2007 was indiscriminate and many experienced financiers, traders and companies were caught unprepared. Bankruptcies, credit lines pulled, bailouts and malfunctioning capital markets had a previously unimaginable ripple effect. A meteorologist can use digital satellite imaging to assess conditions far enough in advance to evacuate and save people from a natural disaster but no one predicted the catalyst that finally triggered the credit implosion and sent worldwide markets into freefall.
However, if you had looked carefully, in the right place, there were ominous signs that a perfect storm was brewing. That place was the credit derivative markets, where professional traders research, lend and trade the credit quality of companies. While equity investors were snoozing in the comfort of a long bull run and traditional debt investors number-crunched to ‘AAA’ using black-box ratings models, savvy credit traders had the eye of the storm in their sights and were boarding up windows and piling up sand bags in anticipation.
In early 2007, CDS spreads started to show unsettling signs. On 14 February, a sudden drop in price of Markit ABX-HE-AAA 06-2 (a credit derivative index representing 2006 vintage of securitised US mortgage loans) was aptly dubbed the ‘Valentine’s Day Massacre’ as credit traders suffered sudden mark-to-market losses as they instinctively pulled billions of dollars’ worth of transactions. It later developed that some insightful credit traders had started shorting this index in large volumes in anticipation of a deterioration of credit quality in the US housing market. While equity markets continued their run credit traders and risk managers stepped back to re-assess the implications that this event had on their forecasts for the US and other economies.
In late June the first shoe dropped. Two credit hedge funds at a fabled investment bank began to teeter on the edge as banks pulled their credit lines. Troubling rumours of banks having difficulty off-loading illiquid CDO and subprime positions were rife. As investors began to ask more questions, markets from trade finance to credit card securitisations slowly ground to a halt. Now both credit traders and investors were hedging en masse, sending CDS on mortgage backed securities and corporates even wider. (An increase in spread, or CDS premium, corresponds to a decrease in price.)[[[PAGE]]]
In less than a month, the spread on Markit iTraxx Europe (an index tracking 125 of the most liquid European corporate CDS) more than doubled. It increased from 25 bps per annum in July to near 70 bps in August, just as customers began to queue outside Northern Rock to withdraw their savings. Over the next few months, the index rose a further 100 bps before US Fed chairman Ben Bernanke indicated, in April 2008, that the US economy could be heading into a slowdown, and it would eventually reach a height of 215 bps when he admitted, with hindsight, that 2007-2008 were years of recession.
By late 2008, with capital markets frozen amid the dramatic events in the banking sector, companies began to consider new ways to attract investors. By now CDS was increasingly being used by companies as an accurate reference point and guide to find a way through the economic haze to access debt capital as it was the only liquid fixed income instrument in the traded markets. Nokia began testing CDS as a rate setting mechanism for its commercial paper backstop facility, and in November, the mobile phone operator was among a handful of European borrowers that linked the margin of back-stop credit facilities to their CDS, thus heralding a new period of market-based pricing.
An increasing number of companies were successful in attracting investor demand by linking the interest they paid on debt to the premium on credit default swaps referencing their outstanding bonds or loans, allowing interested investors to gauge risk when ratings were proving unreliable.
CDS as a measure of riskIn many ways CDS is similar to insurance. A credit default swap transfers credit risk from one party to another, where the swap spread or premium is based on a bilaterally negotiated, or market clearing, price to compensate a protection seller to assume risk of default of the reference entity. In the case of a credit event the protection seller reimburses the protection buyer for actual losses suffered. [[[PAGE]]]
CDS were established in the 1990s to assist banks in hedging loans they extended to clients. Loans are private and bilaterally negotiated facilities and when lenders wanted to increase regulatory capital they found limited liquidity for these loans. However with CDS, banks could use credit default swaps referencing individual loans to transfer credit risk to alternative risk investors such as insurance companies, pension funds and hedge funds. Acting primarily as market-makers, banks and dealers established liquidity in credit default swaps in the inter-dealer and institutional markets, working amongst each other through the International Swaps and Dealers Association (ISDA) to standardise contract terms and establish settlement protocols. From an investor’s perspective, aside from the attractive leverage and customisable features of a bond-like instrument in swap form, CDS provided an investment opportunity previously available exclusively to participants in the wholesale loan markets.
With CDS gaining popularity, dealers began to reference CDS to a variety of fixed and floating rate debt instruments, including unsecured bonds, asset-backed securities, mortgage-backed securities and other forms of borrowed money. CDS contracts accelerated in trading volume at annual rates exceeding fifty percent, reaching over $60tr in outstanding contracts by 2008. Today there are over 2,500 single name CDS and over 20 index instruments trading actively in the credit markets with screen-based pricing available from multiple vendors. (In some cases this data is available publicly such as on the website of ISDA.) Dealers are staffed with dedicated research and trading teams actively tracking, reporting and trading the most liquid CDS tickers. During the credit crisis buy-side players, salivating at the best buying opportunities in decades, quickly built out their credit infrastructure, purchasing advanced trading technology and picking up sell-side traders to enhance investment analysis and accelerate trade execution.
Most risk management modules and trading systems are now adapted to take CDS trade parameters into account alongside equities, foreign exchange and futures volatility. Over 1,000 firms globally actively trade CDS across a wide range of investment strategies from public to private credit, investment grade to distressed credit, absolute return to relative value credit and capital arbitrage. Companies are applying CDS to facilitate trade, foreign exchange and commodity transactions.
As of December 2009 CDS is cleared through at least three major exchanges including the Intercontinental Exchange, Chicago Mercantile Exchange and Eurex. Real money investors are attracted by enhanced transparency and are actively tracking CDS markets to identify basis opportunities across asset classes as well as to hedge long risk positions. Sophisticated traditional equity and currency investors are also assessing how CDS affects trading patterns in their markets.
Over the last couple of years there has been an overdue wake-up call from shareholders and regulators to company boards to examine sources of risk and to fortify their businesses accordingly. This alarm heightened as trade insurers exited the market in the wake of the bankruptcy of General Motors last year.
Finance directors can use CDS as an accurate measure of the risk profile of their counterparties on a daily basis. With CDS liquidity growing across maturities ranging from six months through to 30 years, CDS pricing can assist in determining the type of payment terms to extend to a customer, assess the value of traditional trade insurance and also to weigh the benefits of factoring.
Here is an example: imagine if in September 2008 you had a supply contract in place with Cementos Mexicanos (one of the world’s best known building materials companies) worth £200m which you part paid up front, with the balance due over the next 18 months. Also assume that your company bonds matured later in the year and you are planning to refinance.
Given the size of this supply contract and the resulting potential loss of corporate revenue in case of a Cemex default, this was a significant risk and one that a potential bond investor might highlight on your bond road show. CDS on Cemex traded at 390 basis points per annum on 12 September 2008, almost six times the low reached in June 2007. The market was saying that the risk of a default of Cemex had been increasing for the last twelve months. News stories such as the announcement in August 2007 that Cemex had reached an agreement to refinance $15bn of bank debt that barely kept the company from defaulting on loans further heightened your concerns about Cemex’s ability to meet its obligations.
In this situation how could you have used CDS to protect your company?
You purchase credit protection from a dealer, or investment firm, on a notional amount of £30m to match the duration of the contract of two years.
You pay a total of £2.3m spread over eight quarters and by hedging this exposure to Cemex you protect your business from the cost of finding a replacement supplier and lost instalment payments. [[[PAGE]]]
With this hedge in place, you are in a stronger position to sell your story to investors.
By March 2009 Cemex’s financial condition deteriorated further and its CDS spread spiked at 1,521 bps or 15.21%, which means you would have been in the money on your CDS contract for £11.6m. In return for extending debt maturities, lenders forced Cemex to pay higher interest, pledge shares of subsidiaries as collateral, limit capital expenditures and agree to use cash profits to pay debt. In December, a restructuring credit event was called by ISDA which is a standard trigger event in credit derivatives. On 18 February 2010 an auction to settle Cemex contracts resulted in a recovery of 97% (and loss of 3%). If you had not terminated your contract in February to monetise the (large) mark-to-market profit and held the contract, you were entitled to receive a 3% recovery payment upon cash settlement of the contract, which was £0.9m, which means the total cost of hedging to you was £1.4m or 2.3% per annum, a relatively small amount compared to the notional risk you had hedged.
This example can similarly be applied to illiquid risks where the CDS of your supplier is not actively traded by establishing proxy credit prices. In addition, your hedge can be executed on notional amounts as small as £5m and a maturity as short as six months.
CDS spreads can be used to develop customised pricing algorithms and indices that allow finance directors to monitor their risk daily. In addition to CDS on individual companies there are industry specific indices (e.g., Markit tracks sub-indices in many sectors including auto, transport, industrial and TMT). Proxy CDS spreads for less well known companies can be established using CDS of comparable companies and adding a liquidity premium.
Whilst escaping the impact of the recession may not have been totally avoidable, studying CDS data in 2007 and 2008 could have helped many companies prepare and better position themselves against the impending disaster across the financial markets. One must learn lessons from the past and add this new CDS data stream to the arsenal of treasury management tools. Used wisely this can enable companies to manage risk more effectively and react more quickly to events that concern and potentially impact their stakeholders. CDS should be embraced by finance directors and their treasury management departments as shareholder pressure grows for ever more effective and far-reaching risk management.
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