Once a relatively simple investment product, credit default swaps (CDSs) have steadily gained popularity in recent years, and have become more esoteric and complex in the process. No longer used purely for hedging and passive investment, they have become an opportunistic, stand-alone investment strategy.
A CDS is a derivative transaction that essentially acts as a form of insurance for bondholders and creditors when a company or sovereign issues a loan, or credit, in order to raise funds. Since every debt obligation carries the risk of default, a CDS allows the creditor to shift that risk onto the CDS protection seller in exchange for a certain premium, depending on the level of risk involved with the debt obligations and the chance of default. In return, the CDS protection seller insures the return of the debt obligation’s principal amount to the creditor in the event of a default. If there’s no default, the CDS protection seller keeps the premium as profit.
Previously controversial due to the role some CDS trades played in the financial crisis, these transactions have since evolved and the market has generally expanded, with sophisticated investors now taking both long and short CDS positions — essentially anticipating whether the debt issuer will default — which has naturally spawned increasingly activist behavior from CDS participants seeking to achieve particular outcomes. These trades have given rise to a new technique involving an “unconventional” credit event. Kramer Levin has been a thought leader on this evolution in the CDS market, identifying the opportunities presented in the cases of Codere and iHeart, and more recently in the ongoing case of Hovnanian Enterprises Inc.
In the Hovnanian example, the distressed company was offered a favorable refinancing package in exchange for agreeing to miss a payment on certain bonds it had issued. It was anticipated that this would trigger the CDS contracts issued on its debt, thereby providing a windfall to those offering the favorable refinancing to the company. In addition, Hovnanian issued long-dated, inexpensive paper designed to trade significantly below par, likely as an economic incentive for CDS market participants to offer the improved refinancing terms. In the ensuing and ongoing litigation, SDNY Judge Laura Taylor Swain referred to a Kramer Levin article outlining certain options available to the CDS market to address concerns about the proliferation of unconventional credit event strategies. While the ramifications of such cases remain to be seen, the CDS market will have to decide whether these unconventional strategies simply need to be priced into the market, or whether contracts need to be changed to limit the availability of these strategies to market participants in the future.