Bullet LCDS should trade up to 20% tighter, calculates JP Morgan

In a report published last week, JP Morgan calculates that the new single name LCDS contract, which is due to launch in April, should price 10-20% tighter than existing cancellable contracts. The new “bullet” loan-only credit default swaps differ from the existing products in that they are not cancelled when loans are repaid and have a fixed maturity. There are also new rules on succession to avoid situations in which the contract ends up referencing a debt-free entity and fixed coupons.

Bullet contracts should trade tighter than old-style LCDS because in the new product credit events can occur in which there are no deliverables. In addition, points out JP Morgan, the better quality credits are more likely to repay their loans, and therefore protection sellers in cancellable contracts should demand higher returns to compensate for the possibility of their upside being cancelled if spreads rally.

Based on an analysis of Reuters data, JP Morgan found that historically, there has been an average annual cancellation rate of between 5% and 10% for US leveraged loans.