Preferred credit default swap (PCDS)

Preferred credit default swaps (PCDS) represent another tweaking of standard single name credit default swaps with the aim of extending trading to a new asset class. In this case, the assets in question are preference shares and other preferred securities.

These instruments fall between debt and equity in the corporate capital structure, and banks in particular make extensive use of them for financing. Although they are generally regarded as fixed income products, they do not fall within the definition of borrowed money. As a result, they are not eligible to trigger default in a standard credit default swap contract.

The two major changes to the standard CDS contract for a PCDS are the addition of preferred stock as a deliverable obligation and an additional credit event - deferral of the payment of preferred stock dividends.

The emergence of loan-only and preferred credit default swaps may eventually generate interest in investors taking a view on recovery rates on different levels of debt for the same reference entity. This trading strategy is called capital structure arbitrage. Loan-only CDS represents senior secured debt, whereas market standard single name CDS references senior unsecured and preferred CDS represents very subordinated debt.