Credit derivative
A credit derivative is a contract (derivative) to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. This is usually achieved by transferring risk on a credit reference asset. Early forms of credit derivative were financial guarantees. Some common forms of credit derivatives are total return swap, credit default swap and credit linked note.
What are Credit Derivatives?
Credit derivatives are designed to allow the independent trading/hedging of credit risk. It is also possible to transfer and/or transform credit risk through securitisation.
The securitisation process has become increasingly popular over the last decade, with structures ranging from the simple passing on of cash flows from underlying assets, to complex structures utilising credit derivatives. It is these latter structures that are important for this course, but we need to revisit the principles of securitisation in general to be able to understand the more complex products.
The Market
Types of Credit Derivative
Trading Applications of Credit Default Swaps
Complex Structures
Securitisation Concepts
Securitisation is a group of techniques used for transforming illiquid sources of cash flow into tradable securities. Illiquid Sources of Cash Flow may include Home Loans (Mortgages), Credit Card Accounts, Car Loans, Consumer Loans, Corporate Bank Loans, Illiquid Bonds, Aircraft Leases, and many more asset and receivable types.
Securitisation in Principle
The aim of securitisation in general is to take an illiquid asset and transform it into cash. For instance, a leasing company may have provided £10m nominal value of leases, and it will receive a cash flow over the next five years from these. However, it cannot demand early repayment on the leases and so cannot get its money back early if required. If, however, it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today. In effect, receive today the present value of a cash flow). Where the company originating the debts (the leasing company in our example) is a bank or other organisation that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts.
In vanilla structures, the credit derivative is used to change the credit quality of the underlying portfolio of leases so that it will be acceptable to the final investors. The diagram below describes a typical transaction with this separate company (usually referred to as a Special Purpose Vehicle [SPV] or in the USA as a Special Purpose Entity [SPE]).
Explenations:
- Originator: Assets such as loans are created by a company, and appear on that company's balance sheet - eg., Abbey International makes a number of residential mortgages and these appear in their account.
- SPV: Once a suitable large portfolio of assets have been build up, they are packaged as a portfolio, and then sold to a third party which is normally a Special Purpose Vehicle company (an "SPV") formed for the specific purpose of funding the assets. The SPV must not be owned by Abbey National (the originator) or the mortgages will still remain in the balance sheet. The company must be structured in such that if Abbey National went into bankruptcy, the assets of the SPV would not be distributed to Abbey National's creditors.
- Investors: The SPV has no money of its own. To be able to buy the loans from the originator (Abbey National), it issues tradable "securities" to fuind the purchase. The performance of these "securities" is directly linked to the performance of the assets and there is normally no recourse back to the originator.
Why Securitise?
Why should Abbey National do this and give up the income stream from the mortgages? The rationale for securitisation varies widely, but some of the more frequently cited reasons are:
- Increased Profitability: The securitised assests attract a reduced (or possible 0) regulatory capital requirement , which frees up Abbey National to be able to take more new loans. This means that the originator can release capital that would otherwise have to be held against the risk of default. For non-regulatod originators, there is a corresponding boost to return on capital resulting from a reduced equity requirement.
- Balance Sheet Management: Securitisation can be used to 'monitise' assets on the balance sheet of the originator, with out being forced to sell them outright.
- Off-Balance-Sheet Funding: The finance raised will not appear as an additional item on the balance sheet of the originator and the assets removed. This is fresh additional finance, or it can be used to reduce debt, and hence gearing.
- Transfer of Risk: The transfer of the recievables may also have the effect of tranfering the risk of losses due to default, etc. to be the investor.
Off Balance Sheet Derivatives of many types have in the past been referred to as off balance sheet. This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognised in the income statement on a similar basis as the underlying assets and liabilities. Certain Credit Derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documenta
Sequential Payments/Cash Flow Waterfalls
The structure we have looked at so far has just one type of investment. However, it is more usual that the SPV issues several tranches of investment, each of which has a different claim on the cash flows that come into the SPV. Usually there is a hierarchy where some classes have access to the cash before others.
The 'Senior Classes' have first claim on the cash that the SPV receives, the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascade effect, these arrangements are often referred to as a cash flow waterfall.
There are usually three different waterfalls in these types of transaction, with different groups of investors having different rights:
Revenue distribution during the normal life of the securities, i.e. when there has been no default in the underlying asset *portfolio
- Scheduled principal repayment
- Distribution of funds after a default
This means that each class of investor has a different 'payment risk' and will therefore receive a different return.
- The most junior class (often called the 'equity class') is the most exposed to payment risk.
In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In the extreme version, the equity class receives no coupon (either fixed or floating), just the residual cash flow (if any) after all the other classes have been paid. There may also be one other special class which will absorb early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.
Revenue Waterfall
Revenue usually consists of all income receipts and would be distributed according to the hierarchy of the different tranches.
If all goes well, there is sufficient cash to pay everyone. However, if there has been a default, reducing the income, the priority access to revenue would come into play.
Principal Waterfall
Principal would generally consist of all principal receipts from the redemption or sale of the underlying assets, together with receipts credited from the revenue waterfall if there are any.
Not only may there be a sequential pay structure for the whole of the principal, deals may also use a pro rata structure (i.e. different tranches of notes are amortised pro rata).
Merged Waterfall
If the underlying assets are mortgages or loans, there are usually two separate waterfalls because the principal and interest receipts can be easily allocated and matched.
But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.
So the distribution could be shown as: 1. Fees 2. Class A interest 3. Class B interest 4. Class A principal 5. Class B principal 6. Release cash to the originator
But in the event of default the priority could change and there could be a structure such as: 1. Fees 2. Class A interest 3. Class A principal 4. Class B interest 5. Class B principal 6. Release cash to originator (equity tranche receives any residual cash)
| Tranche | Amounts due | Payment made | Balance | |
| A | Interest due | 5 | 5 | 16 |
| Principal due | 8 | 8 | 8 | |
| B | Interest due | 3 | 3 | 5 |
| Principal due | 6 | 5 | 0 | |
| C | Interest due | 1 | ||
| Principal due | 4 |
Credit Linked Notes and Obligations Collateralised Loans
There are several different types of securitised product, which have a credit dimension. Before looking at some of them in detail, let us look at some definitions to get the differences clear in our minds first. The market place often uses terminology interchangeably, but we might say that CLN is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
- Credit Linked Notes CLN: Credit Linked Note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
- Collateralised Debt Obligation CDO: Generic term for a bond issued against a mixed pool of loan assets
- Collateralised Bond Obligations CBO: Bond issued against a pool of bond assets or other securities. It is refered to in a generic sense as a CDO
- Collateralised Loan Obligations CLO: Bond issued against a pool of bank loan. It is refered to in a generic sense as a CDO
- Collateralised Debt Obligation CDO: Generic term for a bond issued against a mixed pool of loan assets
CDO refers either to the pool of assets used to support the CLNs or, confusingly, to the CLNs themselves!
Credit Linked Notes CLN
Numerous different types of CLNs have been structured and placed in the past few years. Here we are going to provide an overview rather than a detailed account of these instruments.
The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk.
Example: A bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank runs into difficulty, their investments will suffer even if the country is still performing well.
The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.
askets
Simple baskets of instruments give investors exposure to a portfolio of risks and usually reduce risk through added diversification. A simple basket can comprise a portfolio of well diversified, high-yield or emerging-market instruments.
In contrast, first-to-default baskets are intended to increase risk and thereby increase returns for investors, who can lose their principal if any of the names in the basket defaults.
These more complex credit-linked structures have been available for some years, but they remain difficult to value and their risk is difficult to manage.
Nevertheless, they have proved to be attractive to specific investors looking for high returns.
Leverage
Leverage can be used as traditional financial leverage in order to increase the return on a given amount of funds invested. The increased return reflects the additional risk taken.
Leverage can also be used as duration leverage, where a CLN concentrates the risk of a longer-dated (e.g., 10 years) instrument in a shorter-dated (e.g., three years) instrument.
The principal amount of the note loses or gains value according to the mark-to-market of the long instrument when the note matures.
Credit Enhancements
By setting a subordinated tranche or subordinating one risk-taker's position to another, an issuer can create various cascading credit qualities within one single type of risk. Alternatively, by agreeing to unwind a trade if a trigger or covenant is hit, an issuer can improve or reduce the credit quality of the various parties in the transactions. Triggers or covenants are particularly useful for taking care of various contingent risks, such as the need to unwind an interest rate swap if the credit quality of the risk deteriorates dramatically. Our previous example had only one tranche, but as we saw in Section 1, there may be several tranches, each with a different risk structure.
- The Bank transfers risk in loan portfolio by entering into default swap with "ring-fenced" SPV
- The SPV buys gilts
- The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
- Tranche A absorbs the first 25% of losses on the portfolio
- Tranche B absorbs the next 25% of losses
- Tranche C the next 25%
- Tranche D the final 25%
- Tranches B, C and D are sold to outside investors
- Tranche A is bought by bank itself
Case Studies
Pricing Considerations
Documentation
Credit Derivatives (for Client Facing Staff)
Applications of Credit Default Swaps
Securitised Products and Collateralised Debt Obligations
Credit Pricing
Pricing CDS and Other Credit Derivatives
Legal, Regulatory and Documentation Aspects of Credit Derivatives
Key concepts of the credit derivatives market
The idea of credit derivatives is to avoid direct ownership of the securities referenced in the transaction. This is achieved, as elsewhere in financial markets, by the use of reference concepts such as:
- Reference entity (aka reference credit)
- A specified legal entity, which may be a sovereign, financial institution, corporation, or one of a number of specified entities.
- Reference Obligation
- A generic term for any holding, obligation, debt or other form of credit instrument that is "referenced" in the transaction
- Reference Security
- Usually, a public security issued by the reference entity, but also a reference asset or reference obligation such as a loan or other financial asset.
- Credit Event
- An event defined within the credit derivatives contract, that happens in respect of the reference entity. It is usually defined in the Master Agreement of a credit derivatives contract. The three credit events under ISDA (2003) definitions are Bankruptcy, Failure to Pay, Restructuring.
Credit default swap
- Main article: credit default swap
The credit default swap or CDS has become the main engine of the credit derivatives market, offering liquid price discovery and trading on which the rest of the market is based. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event happening in the reference entity. The contingent payment usually replicates the loss incurred by creditors of the reference entity in the event of its default. It covers only the credit risk embedded in the asset, risks arising from other factors such as interest rate movements remaining with the buyer.
Pricing
The calculation of an approximate price for a credit default swap requires the use of arbitrage arguments. Compare
- (a) the return achieved by one who pays £100 for a risky bond B maturing at time T, and
- (b) the return achieved by one who invests £100 at the risk-free interest rate, until time T, and simultaneously sells protection via a CDS on bond B.
Clearly both positions have a similar risk, which is that the issuer of bond B goes into default. In case (a) the investor gets only the recovery rate attached to B (the amount given a creditor of this type can recover on liquidation), in case (b) the seller of the CDS must purchase bond B for its face value, £100, which entails liquidating the risk free investment, and selling B at its recovery value. Arbitrage arguments suggests that similar risks should be compensated by a similar excess return. Thus the premium paid to the seller of the CDS should be approximately equal to the difference between the coupon of B, and the risk free rate.
To facilitate pricing, premium on a CDS is paid at a similar frequency to that in the swap and bond markets (typically quarterly).
The pricing method is approximate in that it ignores the credit risk of the CDS seller, who may be unable to buy the bond in the event of default (suppose in an extreme case that the seller is also the issuer of the bond which is protected).
Collateralized debt obligations (CDO)
- Main article: Collateralized debt obligation
Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is known as a tranche.
In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap.
Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.
Total return swap
- Main article: total return swap
A total return swap (a.k.a. Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets.
The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset.
The essential difference between a total return swap and a credit default swap (qv) is that the credit default swap provides protection against specific credit events. The total return swap protects the against loss of value irrespective of cause, whether default, widening of credit spreads or anything else.
Credit-linked note
- Main article: credit linked note
A note whose cash flow depends upon a credit event, which can be a default, credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note.
A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its regular-note features, a CLN is an on-balance-sheet asset, in contrast to a CDS.
Typically, an investment fund manager will purchase such a note to hedge against possible down grades, or loan defaults.
CDS swaption
This is an option on a credit default swap. A CDS option represents the right but not the obligation to buy or sell protection on an underlying reference credit at a specified strike spread at a specified date in the future. There are two types of options that can be bought or sold:
1. The right to buy credit protection (payer option)
2. The right to sell protection (receiver option)
CDS Options can also have a special feature called a knock-out clause. A knock out clause refers to a situation where following a credit event by the underlying credit occurs before the expiry date of the option and the CDS option knocks out.
Levels and flows
The Bank for International Settlements reported in December 2004 that notional amount on outstanding credit derivatives was $4.477 trillion with a gross market value of $131 billion (Regular OTC Derivatives Market Statistics).