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February 2021 | Issue 231
Opinion Credit derivatives
It is unfair to extrapolate from one lemon on the lot that the whole fleet of cars is defective
Duncan Sankey
Portfolio director and head of credit research Cheyne Capital
quotation mark
As a barometer of Europcar credit risk before the credit event the CDS contract did a credible job
Buyers of protection on Europcar may be understandably miffed. The company passed on €9 million interest payments due on 30 October and $12 million due on 16 November on its 2026 and 2024 senior notes, respectively — a straightforward failure-to-pay credit event confirmed by the Determinations Committee (DC) on 2 December 2020.
The DC also found that a credit deterioration requirement added to the 2014 definitions to prevent dodgy manufactured credit events (previously discussed in this column) had also been satisfied. CDS pricing was implying recovery in the mid-60s area heading into the auction and a payout to protection holders of about 35%. The first round of the auction set the value of the company’s bonds at around 73 cents on the euro, implying about a 27% payout to CDS. However, by the time the auction was sewn up, so were buyers of protection. Recovery: 100%. Payout: 0 (save a rebate on the final coupon paid by the protection buyer).
Laying bare the auction process
To understand how this could be, we must delve into the arcana of the auction process. The auction consists of two parts. First, dealers make a two-way submission for the bonds and loans in question, with a maximum spreads and quotation size plus a physical settlement request.
Bids and offers are assorted in descending and ascending order, respectively. Crossing bids/offers are discarded and an average of the highest half of remaining bids and lowest half of remaining offers is calculated. This provides an ‘initial market midpoint’ (IMM). The buy and sell physical settlement requests are then tallied, with the difference constituting the ‘open interest’ to buy or sell bonds. These go forward to the second part of the auction.
At this point, dealers can submit limit orders (distinguished from physical settlement orders by a firm price) on their own or their clients’ behalf. If there is open interest to buy, the lowest sell order is matched to it and vice-versa. This process continues with the next lowest and so on, until all open interest is matched or there are no further limit orders. When there are no further limit orders to fill a net open interest to buy, the final price is par, recovery on CDS is 100% and protection buyers get nothing. This is what transpired with Europcar.
This is an infrequent outcome and, in this case, somewhat hard to fathom. The notional of Europcar deliverable obligations far outweighed the net CDS notional outstanding (<€100 million), especially since deliverables also included a €50 million loan.
The press hinted at an insider cabal. While it was certainly the case that over half of the 2024 bondholders and about three quarters of the 2026 bondholders were subject to a lock-up agreement with the company, there should still have been a sufficient float of deliverables to cover the net interest in the auction.
Inevitably, the news met with the usual hand-wringing in the media about CDS failing to do its job, with the resultant blow to investor confidence in the product. However, while CDS is a hedging instrument, it is also a vehicle for trading credit risk in its purest form, disaggregated from the rate risk that dominates cash bonds. As a barometer of Europcar credit risk before the credit event, the CDS contract did a credible job.
But, yes, as a hedging instrument it did, in this event, fall short. The auction process has certainly not been immune from gaming and there may be an argument for looking again at aspects of the process. For one thing, the submission of a dealer’s orders for their own book as well as for clients’ books is a possible conflict of interest.
Short squeezes and busted bonds
However, CDS is an evolving instrument. The current auction format, facilitating cash settlement, developed from a situation in which physical-only settlement and the absence of DCs allowed for opportunistic declaration of credit events at times of constrained liquidity in deliverable obligations. This created short squeezes and left protection sellers with the residue of busted bonds.
There will be other anomalies that will require review and potential amendments to the CDS definitions and auction process. But it is unfair to extrapolate from one lemon on the lot that the whole fleet of cars is defective.
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Global credit funds & CLO's
February 2021
| Issue 231
Published in London & New York.
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