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Fitch Follow-Up: High Yield Credit Default Swaps - Restructuring as a Credit Event.

NEW YORK -- As a follow-up to 'High Yield Credit Default Swaps - Restructuring as a Credit Event,' Fitch stresses certain key points and provides further clarification on this subject. The article highlights the fact that high yield entities have in the past been subject to higher loan and bond restructuring risks than investment-grade entities and that this potentially has ramifications for players in the CDS market, especially to the extent such events are not 'covered' by CDS.

The focus of the article in particular was on distressed exchanges of bond issues and the fact that a meaningful number of high yield issues over the past few years were ultimately classified as 'D', default, by the rating agencies, directly as a result of a distressed exchange, which is itself the culmination of a deterioration in the underlying creditworthiness of the issuer. Under such exchanges, a credit event would typically not have taken place under current ISDA language, with or without restructuring as a credit event, a clarification that needs to be made. However, while this would not necessarily be the case with restructured loans which are frequently amended, given that high yield CDS generally excludes restructuring as a credit event, such events would also typically not be covered. Inclusion of restructuring as a credit event may provide an extra layer of security for the protection buyer in the event of credit deterioration of the reference entity that results in a restructured loan, while potentially imposing a greater cost on the protection seller.

While we cannot predict how the incidence of distressed exchanges as a percentage of all bond defaults (as classified by the agencies) will evolve in the future, it is clear that the overall default rate will rise from current levels at some point, so this issue may become more relevant going forward. While distressed exchanges might be considered technically 'voluntary' in nature, such exchanges can result in a reduction of principal or coupon, a tender at a level considerably below par, and the like, and are typically an effort to avert the prospect of bankruptcy. It should also be noted that while credit protection should remain in place as protection against bankruptcy and failure to pay, even bondholders that do not tender could be affected, assuming a sufficient number of other bondholders do tender, given the expected loss of liquidity for that particular issue, the stripping away of covenant protection, and the like. The fact that such exchanges and the credit impairment that they represent typically would not be a credit event is therefore something that the investor should be aware of.

All this said, Fitch believes CDS contracts, including for high yield, have an important role to play as an alternative investment/hedging vehicle, so long as the distinctions between the cash and CDS market are properly understood and valued by the market place. For more information, see the Fitch Ratings Credit Derivatives web site
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Publication:Business Wire
Date:Dec 10, 2004
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