A disturbing new signal from the CDS market

Back in 2008, investors and journalists obsessively tracked the price of credit default swaps, derivatives contracts that investors use to insure themselves against default.

As the financial crisis unfolded, CDS prices were a financial canary in the coal mine. When it became more expensive to insure a bank bond against default, that signalled severe trouble at the bank. Thankfully, this ghoulish game has ceased: most banks are so much better capitalised that their CDS prices are now boringly stable.

But a new CDS signal is emerging that is worth noting. Not because the trend itself has systemic implications, but because of what it suggests about what is happening to ailing companies.

The issue revolves around what creditors can expect to recoup in bankruptcies. Most CDS contracts stipulate that financiers need to know what a company’s cheapest available bond will be worth at the point the company defaults. That’s because CDS contracts make investors whole by paying them the bond’s original face value minus its market value. When a company goes bust, financiers hold an auction to determine the market price, and the resulting prices offer one guide to what creditors think the company’s remaining assets are worth.

Over the past decade, the average CDS auction prices have moved in a band between 10 and 60 cents on the dollar, but have generally been between 30 and 40 cents. However the nine US auctions conducted in the year to August produced an average price of just 9 cents — and just 2.4 cents if you look at the worst four: Chesapeake, California Resources, Neiman Marcus Group, and McClatchy. “Recoveries for credits with CDS auctions have been alarmingly low,” Brad Rogoff writes in a Barclays note. 

The micro-level explanation for this drop is a change in capital structures. A decade ago, it was hard for distressed companies to raise emergency funding, such as “debtor in possession” loans, when they hit the wall. But this year, such capital “has been readily available for most companies that have sought it,” Mr Rogoff notes. 

This has enabled troubled companies to stagger on for longer, as so-called corporate zombies. And because loans take priority over bonds in a bankruptcy, the practice has also weakened bondholders’ claims, sparking fights in some bankruptcies, including US mattress maker SertaSimmons and California-based beachwear group Boardriders.

Bondholders’ claims have been further undermined by debt exchanges and stealthy asset transfers, including one known as the “J-Crew trap door”. Named after the recently bankrupted US retailer, it refers to a manoeuvre pulled off by the company’s private equity owners in 2016 in which they transferred intellectual property rights across to new lenders, out of the reach of the original creditors. Similar tactics have emerged at other troubled groups such as Travelport.

These trends are just a symptom — not the main cause — of the real reason for low recovery rates: ultra cheap money. The reason DIP financing is so plentiful, as is highly leveraged finance before a company hits a wall, is that asset managers have jumped into the lending business to increase their returns in a low interest rate world. And the reason that distressed companies have been able to engage in games like the J-Crew trapdoor is that creditors have stopped imposing tough covenants that might prevent this. 

Indeed, four-fifths of US loans issued last year were “covenant-lite”, that is they had little or no control over borrower behaviour, up from one-fifth at the start of the decade. That is because investors are so desperate to chase returns in a zero-rate world that they no longer dare to impose covenants. 

Indeed, the hunt for returns is so frenzied that junk bond yields have plunged from 12 per cent in March to below 6 per cent. Cheap money, in other words, is enabling some zombie companies to stagger on, even as creditor value shrivels — until they collapse.

That is why it pays to take note of those low CDS recovery rates. The sample size is so small that it is hard to predict how widespread the problem might be. But investors and policymakers should ask tough questions about corporate zombies — and whether it is wise to let them all keep staggering on with the crutch of cheap money.

Investors also need to insist on tough conditions when they provide loans to risky companies. That is doubly so given the IMF warning last week about the threats of sky-high US corporate leverage — and the risks of a new economic downturn as the Covid-19 pandemic flares up again. 

gillian.tett@ft.com

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