Loan CDS (LCDS)

When a bank or investor hedges the credit risk of a syndicated loan, it has to settle what happens to the contract if the loan is repaid before maturity. Designing the hedge means deciding whether the contract survives repayment or refinancing of the loan.

The reference obligation is a syndicated secured loan

A loan CDS (LCDS) is a type of credit default swap. Unlike a CDS on bonds or unsecured loans, it limits the reference obligation to syndicated secured loans¹. Its structure is almost the same as that of a standard CDS². The credit events for LCDS generally include the borrower's bankruptcy and failure to pay¹. The basics of the CDS are covered on the Credit Default Swaps (CDS) page.

Consider a hypothetical example in which Bank V holds 10 billion yen of a syndicated secured loan to Company Z and buys protection from Fund W. The notional amount is 10 billion yen, the term is five years, and the spread is 300bp (3% a year). Premiums are paid every three months. Each premium is 10 billion yen × 3% ÷ 4 = 75 million yen, which comes to 20 payments and 1.5 billion yen over five years.

Figure description

Bank V lends to Company Z, and Company Z pays interest to Bank V. Bank V pays the premium to Fund W, and Fund W pays Bank V only when a credit event occurs. Company Z is not a party to the LCDS: Bank V, the lender, transfers the credit risk through the LCDS.

The types of credit events and how the loss is determined are covered on the Credit Events and Settlement page.

How a cancellable contract ends

A cancellable LCDS ends either on a default by the borrower or on cancellation. Forms without cancellation also exist³. Cancellation occurs when the loan is repaid early, for example through refinancing¹⁴. An LCDS trade can be cancelled when repayment leaves no suitable loan to deliver². A payment arises only on default³.

The table compares three cases in the example. In the second and third cases, eight premium payments covering two years have been made before Company Z repays the loan through refinancing or a credit event occurs. In the credit event case, the recovery rate is set at 60%, and the loan itself returns 6 billion yen. The seller pays the recovery-adjusted notional amount⁴, which the example takes as the unrecovered 40%: 10 billion yen × 40% = 4 billion yen. Interest on the loan is excluded.

If nothing happens, Bank V collects the 10 billion yen loan at maturity and has paid 1.5 billion yen of premiums on the LCDS. If the loan is repaid and the LCDS cancelled, Bank V collects 10 billion yen and pays no further premiums. After a credit event, the 6 billion yen recovered from the loan plus the 4 billion yen LCDS payment, less 0.6 billion yen of premiums, leaves 9.4 billion yen.

Fund W's gain or loss on the LCDS has the opposite sign to Bank V's. Fund W keeps receiving premiums if no credit event occurs and makes a large payment if one does.

In a November 2006 announcement, the International Association of Credit Portfolio Managers (IACPM) said that when a hedged loan is repaid or refinanced, a swap that cannot be cancelled no longer matches the hedged loan and can raise hedging costs. The same announcement said the US standard documentation lacked a cancellation option and asked ISDA to add one⁵.

Differences from a standard CDS

LCDX was launched in April 2007¹. Like a CDS index, it lets you trade several reference entities as one bundle, and it is the benchmark index for loan CDS in North America. It is made up of 100 equally weighted LCDS, and when an LCDS trade is cancelled, the corresponding LCDX trade is reduced in notional amount².

Reading the spread

For the same borrower, if the probability of default is the same and the effect of cancellation is ignored, the spread divided by (1 − recovery rate) should be the same for an LCDS and a standard CDS. This relation is from Ong et al. (2012)³.

$$\frac{s_{\mathrm{LCDS}}}{1 - R_{\mathrm{LCDS}}} = \frac{s_{\mathrm{CDS}}}{1 - R_{\mathrm{CDS}}}$$

Here $s$ is the spread and $R$ is the recovery rate. The subscripts show which contract each belongs to.

Consider a hypothetical example in which the standard CDS spread is 400bp, its recovery rate is 40%, and the LCDS recovery rate is 70%. The LCDS spread is 400bp × (1 − 70%) ÷ (1 − 40%) = 200bp. Under this relation, if the standard CDS spread is unchanged and only the expected LCDS recovery rate falls, the LCDS spread rises and the value to an existing protection buyer rises.

Actual prices need not follow this relation. Kryzanowski et al. (2014) compared non-cancellable LCDS and standard CDS using daily data on 120 names from April 2008 to March 2012, and concluded that the two markets are segmented. They found that prices deviate from the parity relation that should hold without arbitrage, and that exploiting the deviation could produce profits. However, insufficient liquidity is said to make it difficult to arbitrage away the gap³. For cancellable contracts, the probability of early repayment also affects the price. Default and early repayment are negatively correlated, and the stronger the correlation, the higher the LCDS spread².

What LCDS are used for

LCDS are used to hedge the credit risk of loans. Risk managers use LCDS to hedge specific obligations, usually syndicated secured loans⁵. As in the example of Bank V, the lender keeps the loan and transfers only the credit risk. In the example, if nothing happens the hedge costs 1.5 billion yen; if a credit event occurs after two years, Bank V receives 4 billion yen in exchange for 0.6 billion yen of premiums.

In the same announcement, IACPM said that where syndicated secured loans are in short supply, hedging with LCDS could add to the supply of senior secured risk and raise market liquidity⁵.

Standard documentation

According to the 2006 IACPM announcement, ISDA had developed standard documentation for US LCDS at the time and was expected to do the same for Europe⁵. In 2014, the Loan Syndications and Trading Association (LSTA) published a form of physical settlement rider to be used with ISDA's Syndicated Secured Loan Credit Default Swap Standard Terms Supplement⁶.

Notes

1. Augustin et al., "Credit Default Swaps - A Survey" (external site) (2014 public draft), Section 3.6, "The loan-only credit default swap (LCDS)" (p. 48). The credit event description cites ISDA (2010), and the tendency of names traded is from Benzschawel et al. (2008) in footnote 22. ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶ ↩⁷

2. Liang and Zhou, "Valuation of a Tranched Loan Credit Default Swap Index" (external site) (2011), Introduction (p. 240). ↩ ↩² ↩³ ↩⁴ ↩⁵

3. Augustin et al., "Credit Default Swaps - A Survey" (external site), continuation of Section 3.6 (pp. 48–49). ↩ ↩² ↩³ ↩⁴

4. Liang and Zhou, "Valuation of a Tranched Loan Credit Default Swap Index" (external site), "2. Modeling LCDX" (p. 241). The paper describes the seller's payment on default as "the recovery adjusted notional amount". ↩ ↩²

5. IACPM, "IACPM Releases Letter Calling for Standard Cancellability in LCDS Contracts" (external site) (November 21, 2006). ↩ ↩² ↩³ ↩⁴

6. LSTA, "LSTA Form of Loan Credit Default Swap Physical Settlement Rider (Nov 11 2014)" (external site) (posted November 24, 2014), introductory text. The form itself is members-only. ↩