6: Critique on CDS

Mini Chapter Six

Critique on CDS - Cheapest to Deliver and other reference obligations vs the Recovery Rate

CDS pricing theory and the recovery mechanisms seem standard when we read about it but in practice the reference obligations that come under the purview of a CDS contract convolute the valuation and hedge effectiveness of the instrument. I’ll list down some commonly discussed idiosyncrasies of a CDS contract that sometimes prove to be hurdles for the fixed income/credit world in using them as risk mitigating innovations.

• The concept of ‘cheapest to deliver’ (CTD) reference obligation comes into play when a CDS contract is triggered in the event of default. ‘Cheapest’ by definition is the lowest recovery value obligation at the time of default that the protection buyer can and would deliver (in case of a physical settlement) or that would be used to value the CDS (in case of a cash settlement).

• A CDS contract with a wide variety of reference obligations might result in over-hedging the concerned credit exposure for which the CDS protection was bought in the first place. The inherent CTD option value exercised in the event of default could lead to a net cash flow (Par minus RV of the CTD) that’s larger than the assumed net value if the protected credit exposure was delivered.

• A low coupon bond in a high interest rate environment is likely to become CTD for reference CDS contracts except in the event of default.

• Trivia

Recently talked about stalemate in the US debt ceiling debate pushed US CDS levels higher – 1y CDS shot up to ~178bps levels (on May 1, 2023) vs 72bps couple of months back. The low coupon 2050 Treasury bonds (ISINs US912810SN90 and US912810SP49) after a 500bps fed hike turned out to be the cheapest to deliver instruments. The worst-case scenario here would have been a technical default, but the lower implied recovery value of the CTD nudged the CDS levels significantly higher, even though the market implied a lower probability of default this time vs previous such episodes. One needs to be mindful of the recovery risk on the CTD here. A potential risk-off at the time of default would mean large flight to safety flows to Treasuries which might significantly erode the expected gains on the CTD.

CTD option value is the premium that CDS spreads have over the credit spreads (positive basis) of the individual bonds. Another way to think about it is that CDS spreads show divergence with observed credit spreads of underlying obligations as the CTD option value increases.

The value of the CTD option would differ depending on:

• The diversity and breadth of reference obligations of the underlying entity, option value is higher with higher diversity.

• Types of liability structures/complexity of it for the entity on which protection is being bought, for instance banks on the one end of the spectrum have complicated liability structures (more on this in the risk section) that have different levels of seniority (even inclusion) in the event of default, while corporates on the other end of the spectrum have much simpler/limited market traded liabilities

• The nature of the reference entity and the treatment of their debt in the event of default. For instance, the event of default (EoD) for a sovereign typically amounts to exchange offers/Debt restructuring and differing treatments for reference obligations and the value of a CTD option is higher here than for a corporate EoD that’s oftentimes met with liquidation (all reference obligations trade at the same level).

• Higher the probability of default higher the value of the CTD option as the probability of exercising it also goes up.

Typical CDS transaction’s terms and conditions, including its maturity date (the Scheduled Termination Date) and the Credit Events covered in the contract, are defined in the trade “Confirmation” exchanged between the counterparties. Standard Confirmations reference the ISDA Credit Derivatives Definitions and the various supplements issued from time to time including the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement. These provide the basic documentation for CDS contracts and the standard set of definitions, provisions that govern the majority of CDS transactions. For those interested in further details I’d request you to read these documents to get a better understanding of the timeline and sequence of events post the event of default in determining the settlement (Recovery) value of CDS contracts.