Secured loan-only credit default swaps (LCDS) are credit default swaps where settlement is linked to the syndicated secured loans of a company, rather than all of its senior debt. The product has generated a lot of interest in 2006, because it has the potential to change the traditionally long-only loan market into one where participants can short risk or take on risk synthetically.
Volumes can be expected to grow as market standard documentation comes into practice and as investors see the benefits of the product. These contracts may appeal to protection sellers who cannot find a cash loan to buy or who have a high cost of funding. The appeal for protection buyers is that they are able to short loans.
The reference obligation of an LCDS is one of the reference entity’s senior, secured loans. Issuers of secured loans are usually high yield rather than investment grade companies. Typical credit events are bankruptcy and failure to pay, and US high yield corporates exclude restructuring as a credit event.
Loan-only credit default swaps settle physically like standard credit default swaps, with the buyer of protection delivering a senior secured loan (such as a term loan, revolving loan or multicurrency loan) to the seller of protection.
A credit event can be triggered by a default on any debt obligation (that falls within the category of borrowed money), but only obligations that are not subordinated to the reference obligations (typically loans) can be delivered into the contract. This means that a loan-only credit default swap has a similar probably of default as a conventional CDS, but recoveries would normally be higher. As a result, CDS loan spreads are generally lower than bond and conventional credit default swap spreads for the same issuer.
LCDS spreads have so far also been lower than cash loan spreads on the same names. This partly reflects the premium that cash loans receive to compensate the lender for the issuer’s option to refinance the loan at lower spreads. (Loan credit default swaps generally remain outstanding if the loan is refinanced.) The basis also reflects the fact that the LCDS maturity is fixed for, say, five years, while a cash loan can be amended or extended in some cases.
Another part of the appeal of these instruments is that their spreads should move in line with loans rather than following bond spreads, which means they can be used for strategies such as going short loans, and trading the basis between the underlying cash loan and LCDS, as well as allowing capital structure investors to express views on secured loans in relation to other securities such as bonds and stock.