A couple recent reports in the WSJ and Bloomberg shed light on an interesting aspect of the credit default swap markets: CDS on companies without public debt.
GAP
WSJ highlights the case of major retailer Gap Inc. saying
“Apparel retailer Gap has avoided debt for the past few years, having run into trouble last decade when it levered up. As recently as Thursday’s investor meeting, the company reiterated its long-held philosophy of not relying on debt capital markets for financing.
Yet curiously, there is a market for credit default swaps on Gap debt, and prices have crept higher in recent months. Five-year insurance on $10 million of debt costs $128,000 a year, compared with $60,000 six months ago, according to Markit.
That means someone is expecting a big change. After all, credit insurance currently has no use, since right now there is no debt on the balance sheet aside from an undrawn revolving credit facility.”
Why would investors ever buy credit default swaps when there is no credit to default on? Aside from a $500 million credit line (currently untapped) which Gap could tap in the case of an emergency, WSJ mentions the possibility that
“Gap’s CDS’s are being used as a bet on a private-equity group taking control in a leveraged buyout. Assuming a roughly 20% takeover premium, Gap might be bought for over $14 billion.
On the face of it, such a deal would require several billion dollars in financing, pushing the limits of the bond market. That said, the company has very strong cash flow and needs little cash for capital expenditures, making it a good candidate.
Indeed, a bet on the CDS’s would generate healthy returns in the event of an LBO. With billions of dollars of new debt, Gap’s CDS’s might trade more like those of Jones Apparel, which cost more than $200,000 per $10 million in debt, says Robert Samuels of Phoenix Partners. That would be a return of more than 50%.
Yet the downside for the CDS’s is daunting. If the company never levers up, the CDS’s may drift slowly back to zero. Investors hoping for a takeover are better off owning the shares.”
Investors can confirm Gap’s liabilities by having a look through the company’s most recent quarterly filing this year. In it, the company states:
“As of July 31, 2010, cash and cash equivalents and short−term investments were $1.70 billion, with no debt outstanding. Our cash flow generation and cashposition remain strong. We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations,including growth initiatives, planned capital expenditures, and dividend payments for the foreseeable future. We are also able to supplement near−term liquidity, if necessary, with our existing $500 million revolving credit facility.”
EMI
Bloomberg highlights the case of music titan EMI saying,
“Default swaps may trade on companies that don’t have public debt, such as EMI, as investors bet a refinancing will create new bonds or loans linked to the derivatives, according to Rupesh Tailor, co-founder of Breogan Global Financials Fund in Madrid.
The premium for insuring EMI debt dropped from a record last week, according to data provider CMA. Swaps protecting 10 million euros ($14 million) of debt for five years cost 1.04 million euros upfront and 500,000 euros annually [works out to approximately 900 bps on a purely running basis using a 70% recovery rate]. That compares with 550,000 euros a year and nothing in advance in April, and a record 1.07 million euros upfront Oct. 5.
The swaps now imply a 77.6 percent likelihood EMI will default within five years, assuming a 70 percent recovery on the debt in the event, CMA prices show.”
EMI swaps have been more active of late as current EMI owner Terra Firma Capital Partners battles Citigroup in court.
“Guy Hands’s Terra Firma is accusing Citigroup in a trial starting today in New York of tricking it into overpaying for EMI, the music publishing company whose stars have included the Beatles and Miles Davis. The buyout firm claims it paid too much because Citigroup said private-equity firm Cerberus Capital Management LP planned to submit a competing bid.”
General Motors Corporation
Another WSJ report focused in on the new credit default swap market that has emerged on (future) debt of the newly IPO’d American automaker, GM.
“Barclays Capital and Goldman Sachs started quoting prices on credit default swaps tied to senior unsecured General Motors Co. (GM) debt Tuesday.
Tens of millions of dollars in notional volume traded hands, even though the recently revived GM has not yet issued any bonds for the swaps to reference……
Spokesmen for Barclays and Goldman confirmed that the firms had sent out CDS prices and completed trades referencing GM Co. Sources familiar with the trades said both firms acted opportunistically rather than in response to reverse enquiries.
A senior trader at another major dealer said his firm was looking to quote CDS on GM Co., but wanted more legal and operational certainty over the exact entity the CDS would reference because of potential confusion with debt tied to old GM entities.
The Detroit auto maker, which underwent a bankruptcy reorganization in 2009 and last month completed a $23 billion initial public offering of fresh common shares and convertible junior preferreds, has a $5 billion credit facility at General Motors Holdings LLC, but no bonds……
After the bankruptcy filing on June 1, 2009, buyers of CDS tied to old General Motors Corp. unsecured debt received 87.5 cents on every dollar of CDS protection they bought. Protection tied to old GM Corp. loans was valued at 97.5 cents on the dollar. At that time, there was around $2.4 billion of old GM debt outstanding.
The thinking is that should the new GM issue bonds in the New Year or beyond, it would do so at the General Motors Co. level rather than from General Motors Holdings, and that having CDS levels in the market would help investors get comfortable with how a potential bond offering might price.
It is unclear when GM plans to tap the debt capital markets, but investors have been using Ford Motor Co. (F) CDS as a proxy for future GM Co. bond pricing…….
GM Co. has a long-term family corporate rating of Ba2 from Moody’s Investors Service, while the bank loan facility at General Motors Holdings is rated Baa3.
Barclays quoted CDS on GM Co. in the range of 325/340 basis points, according to sources familiar with the firm’s pricing runs, but the cost of the CDS rose to 340/350 basis points intraday. Goldman quoted the CDS at 335/355 basis points.
A basis point equals $1,000 annually on a contract protecting $10 million of debt for five years. CDS costs rise when investors buy protection since their interest in default insurance is a sign that the underlying bonds are viewed as riskier.
Five-year bid/offer spreads on CDS tied to Ford Motor Co. bonds were quoted Tuesday at 270/278 basis points and then later in the day at 275/285 basis points–significantly cheaper than the CDS on GM Co.
In addition to the two dealers distributing GM Co. CDS prices to clients, a pair of interdealers were looking to match trades between dealers at a spread of a 330/360 basis points. One of them, ICAP, was thought to have been successful, while the other, Standard Credit Group, a subsidiary of Tradition North America, was not.
Because GM hasn’t issued bonds, it means that if the credit default swaps had to be settled, the CDS could potentially be worthless. When CDS are triggered for settlement, protection buyers deliver debt into an auction and receive the face value of those bonds, minus the market value of the defaulted debt set at auction.
If there is no debt to deliver, or in GM’s case if the $5 billion credit facility is not deemed to be eligible as a deliverable obligation, the CDS could not be settled in exchange for cash.
Such decisions on CDS settlement criteria are made by a special committee of the International Swaps and Derivatives Association on a case-by-case basis.
“To trade CDS you don’t need a reference obligation, you only need a reference entity,” said one trader familiar with the GM Co. CDS. “We are comfortable with the risk there will be a deliverable [security] at some point between now and five years down the line.”
Buyers of the default swaps were essentially betting that future leverage in the capital structure of the new GM will chip away at its creditworthiness, forcing the cost of protection higher. Sellers of the default swaps were betting the company’s future leverage and its CDS would stay in check.”