Over the past few years, the CDS market has seen an increase in activism and the evolution of creative refinancing and restructuring strategies intended to achieve particular outcomes in the CDS market. The authors have written extensively on the development of one such strategy — unconventional credit events — in the Codere, iHeart and, more recently, Hovnanian cases.
Amid the ongoing Hovnanian saga, and against the background of the prior unconventional credit event cases of iHeart and Codere, opportunistic CDS strategies may have appeared available only to protection buyers. This picture of vulnerable CDS protection sellers as sitting ducks for aggressive protection buyer-driven strategies that undercut the value proposition of CDS protection misses the reality. In fact, the CDS market has created a parallel source of financing for reference entities, where both CDS protection buyers and sellers can engage with reference entities, and offer economic incentives in exchange for cooperation that enhances their CDS positions. The restructuring option most readily available to CDS protection sellers is a migration of debt across a reference entity’s affiliated group of companies, resulting in the creation of a succession event or a so-called orphan CDS.
This article addresses the basic principles of a succession event and orphan CDS strategies. The companion article in this issue looks at two recent cases where those strategies may have played a role.
CDS Protection Seller Strategies
The succession event strategy involves transferring debt incurred by a reference entity to one or more (successor) reference entities, with a view to changing the entity referenced in all or a portion of the CDS contract.
In order to generate value for a CDS protection seller, all or some portion of the debt of the reference entity is assumed by one or more successor reference entities with a different credit profile. Under current rules, if the outstanding debt of a reference entity were assumed by an affiliate, a succession event would occur if at least 25% of the outstanding obligations at the existing reference entity are part of the succession. The CDS contract would then split, such that an equal portion of the notional amount will reference each entity (i.e., the initial reference entity and the affiliate) (See the infographic for a summary of post-succession event scenarios). For the strategy to be effective, the successor(s) would have to be more creditworthy, on a net basis, than the pre-succession reference entity. This would have the effect of narrowing the CDS spread in the aggregate for the CDS contract referencing the successor entities.
As a hypothetical example, consider a succession event where long-dated unsecured debt trading significantly below par is transferred to an affiliate of the reference entity, leaving only secured debt trading around par at the reference entity. Assuming all the succession event requirements were satisfied, and both the initial reference entity and its affiliate are deemed successor reference entities, 50% of the notional amount of CDS protection would now reference an entity with only secured debt trading around par. Compared to the pre-succession situation where 100% of the CDS protection referenced an entity with long-dated unsecured debt trading well below par, the spread on 50% of the CDS protection post-succession should significantly narrow. If the spread on the CDS referencing the entity holding the unsecured debt does not drastically widen, the succession event would result in a substantial net gain for the CDS protection seller.
Another strategy for enhancing the position of CDS protection sellers is the creation of an orphan CDS. In this scenario, there is no succession event, but the debt of the reference entity is nonetheless eliminated. For example, an affiliate of the reference entity could issue debt whose proceeds would be provided to the reference entity. The reference entity would then use the proceeds to repay or otherwise retire its existing indebtedness.
In such a scenario, the CDS protection seller would be left with a CDS contract referencing an entity that cannot default (if there were no debt that remained outstanding) or that is highly unlikely to default (if the amount of debt remaining at the reference entity were de minimis). As long as no additional debt is incurred by the reference entity, the CDS would remain an orphan. The protection seller would confidently collect its CDS premium from the protection buyers for the duration of the contract, with little or no risk of making a settlement payment. With the CDS spread substantially narrowing, the protection seller might also unwind its CDS position at a profit.
These strategies, of course, require the cooperation of the reference entity. Particularly where a CDS protection seller has sold protection on a reference entity that has come under financial distress, a protection seller may be strongly motivated to offer a reference entity economic incentives to cooperate in the creation of a favorable succession event or an orphan CDS. It may also be worthwhile for the protection seller to acquire a position in the debt of the reference entity, thereby affording it some input or influence over the restructuring process, where consent of the debtholders is required.
Cheapest to Deliver Obligations
One of the key components of the buy-side strategy in Hovnanian was the issuance of a low-coupon, long-dated note, potentially creating a cheapest to deliver debt security that would likely trade significantly below par. The result would be a CDS auction clearing well below par, and a corresponding gain for CDS protection buyers.
CDS protection sellers can implement the same strategy in reverse, with stratagems directed toward increasing the price of the cheapest to deliver obligations. By providing appropriate financial incentives, a CDS seller may be able to induce the reference entity to retire its cheapest to deliver debt. Even an issuer repurchase program, which did not wholly eliminate the cheapest to deliver debt, could boost the price of the debt and create substantial gains for a protection seller.
CDS protection buyers are not the only ones with options to impact the market for CDS contracts on distressed reference entities. CDS protection sellers may also employ strategies that take advantage of the existing procedures and contractual quirks in the CDS market to engineer gains. In the companion article, we examine two recently proposed refinancing situations — McClatchy and Sears — which may not necessarily be driven by CDS considerations, but in which the effects of protection sellers’ opportunistic CDS sell-side protection strategies may be observed.