Growth and liquidity in the credit derivatives market have created new investment opportunities, which this paper aims to explore. In particular, the traditional pursuit of credit exposure by holding corporate bonds or loans leads to an allocation that not only has a bearing on a diversified portfolio’s credit component but that also affects its pure interest rate component. Moreover, the fact that a cash investment is no longer required when selling a credit default swap makes it possible to increase credit exposure to levels that used to be impossible or too costly to attain. Therefore, given that the investment opportunity set has changed, it is worth looking at the new allocation that takes advantage of the newly available instruments. What, in fact, are these new investment vehicles?
There are two broad categories of instrument, the most liquid being the credit default swap, or CDS, and the most complex being structured bonds such as the collateralized debt obligation, or CDO. CDS growth has been impressive. Basically, a CDS offers the buyer protection in case of a standardized and pre-defined “credit event”, the most acute case being default.
In case of a credit event, the protection buyer receives the principal of the bond upon delivery of the defaulted bond. There are many variations to this basic contract: the underlying debt can be a loan or an Asset Backed Security. Settlement may be in cash. In practice, under normal market conditions, the premium is never far from the spread over the swap rate of the corresponding debt instrument; otherwise, an arbitrage opportunity would appear. Leveraging credit exposure with CDS stems directly from the ability to sell protection several times on a single name, or to sell protection on several names. The risk of these leveraged positions is twofold: a market risk reflects the premium variation (CDS prices) in the market influenced by either macro factors or issuer-related information; and the default risk is simply magnified when selling a single name several times, and somewhat diversified when several names are in the portfolio.
Structured bonds such as CDOs are more complex securities. A full description of these instruments is beyond the scope of this paper (interested readers may refer to Felsenheimer et al. (2006) or Credit Magazine’s Guide (2007)). At the risk of oversimplifying, the CDO is a security issued by a special purpose vehicle (SPV) whose assets consist of a portfolio of debt instruments. Cash CDOs are investments in cash bonds (or loans in case of collateralized loan obligations, CLOs) and synthetic CDOs invest in CDS or other credit derivatives (selling protection on several entities).
As with other forms of debt, the securities issued by an SPV have different levels of subordination: the equity tranche of a CDO will bear the first capital loss, while the mezzanine tranches and senior (or even super-senior) tranches are protected by their higher ranking in terms of subordination. Investors in these CDO tranches receive a higher return for the same rating given by rating agencies, mainly because they have a leveraged credit position. To demonstrate this, we will take the theoretical example of an asset portfolio consisting of 100 equally weighted names, with no recovery rate. There is no leverage in that portfolio: if ten names default, the portfolio maintains a value of nearly 90%. On the contrary, a tranche with a subordination level of less than 10% will be harmed, and possibly left with no value. Another way to measure leverage is to consider the mark-to-market change in the CDO tranche created by a parallel change in the combined credit spreads of the portfolio’s bonds. Many other structures, such as Constant Proportion Portfolio Insurance (CPPI) or Constant Proportion Debt Obligation (CPDO), exhibit similar leveraged positions that result from other mechanisms.
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Do Leveraged Credit Derivatives Modify Credit Allocation?
