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Morgan Stanley & Co. International LtdMorgan Stanley & Co. International Ltd
European Leveraged Loan CDS Trading
2
Please see additional important disclosures at the end of this report.
Leveraged LCDS: Introduction
3
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
• Morgan Stanley has led the development of the European Leveraged Loan CDS market
• Leveraged Loan CDS has enabled European bank loan portfolio managers to transfer leveraged loan risk efficiently to investors whilst still remaining a lender of record and retaining crucial client/sponsor relationships
• Since launching the business in July 2005, Morgan Stanley has traded approximately $3.5 bn in notional contracts value
• More than three dozen investors, both buy- and sell-side, have signed into the Morgan Stanley documentation
• Six other European dealers have agreed to use standard documentation that is substantially similar to the document created by Morgan Stanley
• We anticipate the launch of the first purely synthetic CLO once the liquidity in the market develops
• Morgan Stanley was instrumental in the development of the European Leveraged Loan index product (iTraxx LevX) which launched recently
Executive Summary
4
Please see additional important disclosures at the end of this report.
Leveraged Loan Asset Class
5
Please see additional important disclosures at the end of this report.
High Yield Bonds Leveraged Loans
Interest Fixed/Floating Floating
Coupon/Margin Unchanged Margin Ratchet (e.g., Leverage)
Rated Yes Not usually public
Seniority Senior or subordinated Senior
Security Unsecured Secured
Covenants Incurrence covenants Maintenance covenants
Callability Call protections, premiums Not customary
Investors Funds, Pension Funds, Insurance Companies
Banks, Funds
Volatility High Low
Recovery Low (~20-50%) High (~60-80%)
Leveraged Loan Asset ClassEuropean High Yield Bonds vs. Leveraged Loans
6
Please see additional important disclosures at the end of this report.
Leveraged Loan Asset Class
Type Repayment Maturity (years) Margin (bps)
Senior Debt
Tranche A Term Loan Amortising 7 225
Tranche B Term Loan Bullet 8 275
Tranche C Term Loan Bullet 9 325
Revolver Bullet 7 225
Other potential senior tranches: Acquisition, Integration, Capex
Subordinated Debt
2nd Lien Term Loan Bullet 9-9.5 400-700
Mezzanine(1) Term Loan Bullet 10 9-12% (incl. PIK), plus warrants
High Yield Bond(1) Details depend on the Issuer and market conditions at time of issue. More typical for the larger deals
Note: (1) Subordinated debt will either comprise mezzanine or a high yield bond, not customary for both
European Leveraged Loan Capital Structures
7
Please see additional important disclosures at the end of this report.
US High Yield
Shareholders
Operating Subsidiaries
Support Package (incl. guarantees and security)
Hold Co
HY
Senior Facilities
European Mezzanine
Shareholders
Operating Subsidiaries Support Package (incl.
guarantees and security over all assets)
Hold Co
Mezzanine
Senior Facilities
(1st Lien over assets)
(2nd Lien over assets)
Inter-company loan
European High Yield
Shareholders
Operating Subsidiaries
Hold Co
Intermediate Hold Co
HY
Senior Facilities
Support Package (Guarantees on subordinated basis by operating subsidiaries with fall away provision)
Leveraged Loan Asset ClassLeveraged Structures: Contractual and Structural Subordination
8
Please see additional important disclosures at the end of this report.
Source: S&P LCD
3360 79
40 48 68123
37
242 196 156
133 131
195
246
90
276256
234
173 179
262
369
127
$0B
$100B
$200B
$300B
$400B
1999 2000 2001 2002 2003 2004 2005 1Q06
Europe US
Leveraged Loan MarketOverall New-Issue Leveraged Loan Volume
9
Please see additional important disclosures at the end of this report.
Leveraged Loan MarketAverage Contributed Equity to Leveraged Buyouts
Source: S&P LCD
34% 34% 34%32%
34% 33% 33%31%32%
34% 35%37%
35%33%
30%33%
0%
10%
20%
30%
40%
50%
1999 2000 2001 2002 2003 2004 2005 1Q06
Europe US
Equity as a Percent of Total Sources
10
Please see additional important disclosures at the end of this report.
Leveraged Loan MarketAverage Leveraged Buyout Purchase Price Multiple
Source: S&P LCD
7.67
7.327.06 6.99
6.81
7.567.29
7.57
8.318.718.79
7.09
6.62
5.99
7.40
6.63
5.00
6.00
7.00
8.00
9.00
1999 2000 2001 2002 2003 2004 2005 1Q06
Europe US
11
Please see additional important disclosures at the end of this report.
Leveraged Loan MarketMoving Up The Capital Structure
L+150
L+250
L+350
L+450
L+550
L+650
L+750
L+850
L+950
L+1050
1Q97
4Q97
3Q98
2Q99
1Q00
4Q00
3Q01
2Q02
1Q03
4Q03
3Q04
2Q05
1Q06
EUR HY Loans EUR HY Bonds US HY Loans
Source: S&P LCD, Morgan Stanley
12
Please see additional important disclosures at the end of this report.
Convergence of MarketsInstitutional Investors’ Share of the Primary Market for Leveraged Loans
0%
15%
30%
45%
60%
75%
1999 2000 2001 2002 2003 2004 2005 LTM 1Q06
Europe US
13
Please see additional important disclosures at the end of this report.
Leveraged LCDS: Introduction
14
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
• CDS terminates upon full repayment of underlying loan – No Basis Risk
• Ability to hedge the right part of the capital structure – No Recovery Risk
• Ability to hedge private leveraged loans
• Ability to mitigate risk without risking sponsor / company relationship
• Ability to trade out of protection and recover cost of hedge over remaining life of loan
• Free up regulatory capital
• Ultimately improved liquidity over the cash market
Morgan Stanley has developed a trade confirmation for use with European leveraged loans
Intention is to create a different CDS market for each level of the capital structure: i.e., senior secured, second lien and mezzanine loans
Users can now mitigate risk on private leveraged loans, without crystallizing losses
Restructuring as a credit event will enable bank loan portfolio managers to efficiently reduce regulatory capital usage
Tenor of hedge can be chosen by protection buyer
Benefits to Buyers of Protection
15
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
• Ability to access credits that no longer are trading in the cash market
• Ability to access private transactions (i.e., that have no public securities)
• No prepayment risk – if loan is fully repaid, CDS terminates
• No margin ratchet concerns
• Ability to sell in GBP, USD or EUR, regardless of underlying currency of loan
• CLO managers can add more recent transaction exposure to vintage vehicles
• Cash settlement option available to Seller only
• Capital efficient means of gaining exposure to credits given leveraged nature of product
Seller of protection can access credits that no longer actively trade in the secondary market, without the risk of early prepayment
Seller can choose the currency of exposure, regardless of underlying currency of loan
Cash settlement option available to Seller if unable to take delivery of loan on a Credit Event
Tenor of exposure can be chosen by Seller of protection
Benefits to Sellers of Protection
16
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
• Ability to close trades on T + 1 vs. T + 10 (par) vs. T + 20 (distressed)
• Ability to choose tenor of credit exposure (1 – 10 years)
• Tax efficient means of exposure to credits
• Avoids borrower / agent consent issues
• Avoids transfer fees
More efficient trading and risk/reward transfer through: T + 1 settlement Tax efficient Consent avoidance Fee avoidance Ultimately greater liquidity
Benefits to Buyers and Sellers of Protection
17
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
• Reference Entity – all obligors
• Reference Obligation – Reference Credit Agreement, plus, New Tranches (permits the ability to add tranches, for e.g., in the instance of a recapitalization, provided certain tests are met)
• Termination Event – full refinancing of all tranches relating to CDS
• Any tranche within credit agreement can be delivered – cheapest to deliver concept
• Credit Events:1) Failure to Pay2) Bankruptcy3) Restructuring:
- Restrictions apply only if Buyer triggers under Restructuring- Maturity limited to later of Mod Mod R or longest dated tranche before Restructuring- Security diminished in Restructuring causes credit event, but cannot be delivered by Buyer
• Physical settlement is the default, however, Seller has cash settlement option if unable to receive physical or unwilling to accept participation
Morgan Stanley has developed the leveraged loan CDS from the standard ISDA form as a baseline
The CDS is not linked to any single tranche, rather to a ranking within the capital structure
Adjustments were made to accommodate the unique nature of the loan product and to enable the ISDA form to deal with security and ranking
Voting rights were added to ensure the Seller had the ability to influence any future creditor decisions
Key Features of Trade Confirmation
18
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
PhysicalSettlement
Date
EventDetermination
Date
Noticeof PhysicalSettlement
(NOPS)
30 calendar days 30 Business Days afterNOPS Fixing Date
Protection Buyer must deliver NOPS by the 30th calendar day after the Event Determination Date (NOPS Fixing Date)
Voting Rights pass on delivery of NOPS
Cash Settlement
Election Date
(Participation)
Participation Settlement
Decision Date
5 Business Days 5 Business Days
• Protection Buyer notifies Seller of its intention to create a Participation (with elevation rights) OR• Transaction terminates• No time limit to close Participation if so elected
Cash Settlement
Election Date
Seller notifies Buyer of intention to cash settle no later than 5 Business Days after the NOPS Fixing Date
19
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
ValuationDate
Cash Settlement
Decision Date
Cash Settlement
Date
3 Business Days
Later of (i) 5 Business Days after Cash Settlement Election Dateand (ii) 10 Business Days after the NOPS Fixing Date
• Final Price = highest bid• If no firm quotations obtained then Physical Settlement applies
Cash Settlement Mechanics
20
Please see additional important disclosures at the end of this report.
Differences Between: European & US LCDS and European Bond CDS
European Bond CDS European LCDS US LCDS
Reference Entity • ABC plc and anySuccessor
• Any borrower/guarantor/obligor or surety under the credit agreement
• Successor provisions do not apply
• ABC plc and anySuccessor
Reference Obligation
• Typically a Bond • All tranches or facilities under the credit agreement (including new tranches)
• Loan of the Designated Priority specified on the Reference Obligation Secured List
Obligation • Borrowed Money • Reference Obligation Only • Borrowed Money
Credit Event • Bankruptcy
• Failure to Pay
• Modified Modified Restructuring
• Bankruptcy
• Failure to Pay
• Modified Modified Restructuring
• Bankruptcy
• Failure to Pay
21
Please see additional important disclosures at the end of this report.
• Trade terminates if no Substitute Reference Obligation is identified
• Trade terminates if all of Reference Obligations are redeemed/repaid
Differences Between: European & US LCDS and European Bond CDS
European Bond CDS European LCDS US LCDS
Deliverable Obligation
• Bond or Loan• Not Subordinated• Specified Currency• Not Contingent• Assignable Loan• Consent Required Loan• Transferable• Maximum Maturity: 30 yrs• Not Bearer
• Reference Obligation or any obligation of the Reference Entity that is senior to the Reference Obligation and secured on same assets
• Loan• Not Subordinated• Specified Currency• Not Contingent• Assignable Loan• Consent Required Loan• Participation Loan• Maximum Maturity: 30 yrs• Syndicated Secured
Excluded Deliverable Obligations
• None. Usually the Reference Obligation is a Deliverable Obligation
• The Reference Obligation if security is released and materially diminished following a Restructuring credit event exercised by the Buyer
• Reference Obligation if it fails the Syndicated Secured or Specified Currency characteristic
Early Termination • Not Applicable
22
Please see additional important disclosures at the end of this report.
• Buyer delivers DO with an outstanding principal balance equal to the Physical Settlement Amount
• Seller can elect for Cash Settlement to apply if assignment/participation not completed within the required time period
• Buyer/Seller may elect settlement at any time in a form which reflects the economics of the trade
Differences Between: European & US LCDS and European Bond CDS
European Bond CDS European LCDS US LCDS
Physical Settlement • Buyer delivers Deliverable Obligations with an outstanding principal balance equal to the Physical Settlement Amount
• Buyer delivers Deliverable Obligations with an outstanding principal balance equal to the Physical Settlement Amount
• Seller can elect for Cash Settlement to apply in relation to all/part of the Deliverable Obligations
Delivery Timeline • Notice of Physical Settlement (“NOPS”) must be sent within 30 calendar days of Event Determination Date (credit event notice and notice of publicly available information)
• NOPS must be sent within 30 calendar days of the Event Determination Date
• NOPS must be sent within30 calendar days of theEvent Determination Date
23
Please see additional important disclosures at the end of this report.
Differences Between: European & US LCDS and European Bond CDS
European Bond CDS European LCDS US LCDS
Delivery Timeline (continued)
• Deliverable Obligations must be delivered within 30 business days of satisfaction of Conditions to Settlement (i.e., delivery of NOPS)
• Deliverable Obligations must be delivered within 30 business days of the day that is 30 calendar days after the Event Determination Date
• Deliverable Obligations must be delivered within 30 business days of satisfaction of Conditions to Settlement
24
Please see additional important disclosures at the end of this report.
Leveraged LCDS:Trading Strategies
25
Please see additional important disclosures at the end of this report.Source: Morgan Stanley
Back-of-the envelope Pricing
Two possible approaches:
• Calculate premium/discount of loan in basis points (i.e., loan trading at 101 = 100bps premium)• Divide premium/discount by number of years to maturity/repayment (i.e., assuming 2yr takeout: 100/2 = 50bps)• Add discount to or subtract premium from spread of underlying loan (i.e., 225 – 50 = 150bps) OR
• Assume bond CDS and Loan CDS have same default probability and the recovery rate for LCDS is 70% and for bond CDS is 40%• Spread LCDS/Spread bond CDS = 1-R/1-R (where R is the recovery rate)• 1-70%/1-40% = 30/60 = 0.5 (LCDS spreads should be 0.5 times bond CDS spreads)
26
Please see additional important disclosures at the end of this report.Source: Morgan Stanley
What Views Do You Express in Long/Short Trades?
Capital Structure Trades and Curve Trades
Senior vs. Sub Sub vs. Senior Curve Steepener Curve Flattener
Trade Strategies
Long 1st Lien vs. Short 2nd Lien
Long Unsecured vs. Short 2nd Lien
Long 3yr vs. Short 5yr 1st Lien
Long 5yr vs. Short 3yr 1st Lien
Rationale • Defensive trade, positive carry.
• Benefits from rising default probability and wider recovery rate spread
• Bullish trade on deleveraging and IPO
• Long convexity
• LBO-exit play• Assumes average
life of LBO ~36mths
• Long credit, positive carry but also positiveJTD risk
Hedge-Ratio • Loss-given-default neutral
• Carry-neutral • Carry-neutral • Flat notional
Economics • Positive carry• LGD neutral
• Flat carry • Flat carry• LGD negative
• Positive carry• DV01 long
Risks • Sharp deleveraging, IPO
• Wide recovery rate differential
• Default • Limited spread widening
• Debt repayment• Curve steepening
27
Please see additional important disclosures at the end of this report.
Leveraged Loan CDS: Relative ValueComparing Value Across Capital Structures
0
100
200
300
400
500
600
700
800
900
1,000bps
KBW Unity Basell ATU WDAC KDG Rexel Cognis ONO Telenet Grohe Invensys
Spread to 1st Lien
Spread to 2nd Lien
Unsecured
Source: Morgan Stanley
28
Please see additional important disclosures at the end of this report.
European LeveragedLoan CDS Market
29
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
* Public Transactions
AA
Ahold Supermercados
Ahlsell
Amadeus
ATU*
Autobar
Balta
Basell*
Brenntag
BSN Medical
Cognis*
Debenhams
Debitel
Demag
Elior
Elis
Credits Available to Trade
eircom*
Eutelsat*
EWT
Frans Bonhomme
Focus*
Gala
Gambro
Gardena
Gerresheimer*
Global Garden
Grohe*
Ineos*
Invensys*
ISS*
KBW*
KDG*
Kloeckner Pentaplast*
Kwik-Fit
Linpac
M. Greisheim
Man Utd
Moeller
MTU Friedrich.
Multikabel
New Look*
NTL B’Cast
NTL/Telewest
Numericable
ONO*
Ontex
Pirelli Cable
Rexel*
Rockwood
Ruhrgas
Saga
Sanitec
SBS
Seat*
SigmaKalon
Smurfit Kappa*
Springer/KAP
SSP
Stabilus
Sulo
Symrise
TDC*
TDF
Telenet*
TMD Friction
Travelex
TUI*
United Biscuits*
UPC*
Vendex*
Vetco
Vivarte
Waste Recycling*
WDAC*
Weetabix
Wind*
Xsys
Yell
Yellow Brick Road
30
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
31
Please see additional important disclosures at the end of this report.
Leveraged LCDS: Future Developments
32
Please see additional important disclosures at the end of this report.
European Leveraged Loan CDS Market
• Tradable Senior Secured, Second Lien and Mezzanine iTraxx indexes
• Macro hedging instruments for portfolio management
• CLO tranche hedging
• Synthetic CLO vehicles
• Constant Proportion Portfolio Insurance (CPPI)
• Recovery Trading
• First to Default Baskets
Once the single-name trading business develops, the market should follow the recent development of the traditional investment grade and HY bond CDS markets
Future Developments
33
Please see additional important disclosures at the end of this report.
European Leveraged Loan Indexes
1) Lev X – Senior• 35 1st lien credits only
2) Lev X – Subordinated• 35 2nd and 3rd lien credits only• Weighting of 2nd and 3rd lien between 40% and 60%
• June 2011 maturity
• Traded on price-basis with fixed coupon – only premium or discount exchanged
• Zero factor applied to credits refinanced or credits defaulted; coupon paid on remaining
• Physical settlement
LevX Indexes
The underlying contract will be similar to the single-name contract
Trading on a price basis allows for easy inter-dealer assignments and unwinds
Index will roll and re-balance March 20 and September 20, in line with other European indexes
Physical settlement is initially intended, however, a cash settlement protocol may be adopted in future
34
Please see additional important disclosures at the end of this report.
Recovery Trading: Recovery Is Only 40% on AverageRecovery Varies a Great Deal Sector to Sector
Source: Morgan Stanley
0
10
20
30
40
50
60
70
80
90
100
Rec
ove
ry R
ate
(%)
0
10
20
30
40
50
60
70
80
90
100
Median
Minimum
Maximum
35
Please see additional important disclosures at the end of this report.
Appendix AEuropean Loan Trading Process
36
Please see additional important disclosures at the end of this report.
The Loan Market does not benefit from a central clearinghouse
Key trade issues are negotiated on each trade
Standard documentation has been developed by the LMA, but it is not the only method to document a trade
Trade settlement process can be drawn out and require close supervision
Anatomy of a Trade Bank Debt Bond Credit Default Swap T-x Buyer and Seller exchange
Confidentiality Letter (if necessary)
T Trade Date (telephone or otherwise) Trade Date (telephone or otherwise) Trade date (telephone or otherwise)
Seller sends Confirmation to Buyer
T+1 Seller sends:
Confirmation to Buyer
Request to Agent for Borrower consent (if required)
Credit Documentation to Buyer (unless sent prior to the Trade Date)
Effective Date, Buyer now protected
Buyer returns Confirmation to Seller
T+2 Buyer returns Confirmation to Seller; Agent sends consent request to Borrower
T+3 Seller sends draft Completion Documents to Buyer
Settlement Date Date on which any assignment, unwind or upfront fees are made
T+2 - T+7 Buyer's due diligence on Credit Documentation (unless completed prior to Trade Date)
T+5 Signing of Completion Documents (subject to any necessary consents) and delivery to Agent (if required)
T+7 Borrower's approval of trade (or failure to approve trade)
T+10 Settlement Date
T+11 Giving of any necessary notices
Not earlier than T+1m First premium cashflow (for trades not paid for with an upfront fee). Premium is paid quarterly in arrears aligned with the maturity date. First cashflow period long if it would otherwise have been shorter than one month.
European High Yield Credit Sales & Trading
37
Please see additional important disclosures at the end of this report.
The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated ("Morgan Stanley"). Morgan Stanley does not undertake to advise you of changes in its opinion or information. Morgan Stanley and others associated with it may make markets or specialize in, have positions in and effect transactions in securities or instruments of companies mentioned and may also perform or seek to perform investment banking services for those companies.
Morgan Stanley & Co. Incorporated, Morgan Stanley DW Inc. and/or their affiliates will deal as principal in the securities recommended herein.
Morgan Stanley & Co. Incorporated, Morgan Stanley DW Inc. and/or their affiliates or their employees have or may have a long or short position or holding in the securities, options on securities, or other related investments of issuers mentioned herein.
The investments discussed or recommended in this report may not be suitable for all investors. Investors must make their own investment decisions based on their specific investment objectives and financial position and using such independent advisors as they believe necessary. Where an investment is denominated in a currency other than the investor’s currency, changes in rates of exchange may have an adverse effect on the value, price of, or income derived from the investment. Past performance is not necessarily a guide to future performance. Income from investments may fluctuate. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. Price and availability are subject to change without notice.
To our readers in the United Kingdom: This publication has been issued by Morgan Stanley & Co. Incorporated and approved by Morgan Stanley & Co. International Limited solely for the purposes of section 21 of the Financial Services and Markets Act 2000. Morgan Stanley & Co. International Limited and/or its affiliates may be providing or may have provided significant advice or investment services, including investment banking services, for any company mentioned in this report. NOT FOR DISTRIBUTION TO PRIVATE CUSTOMERS AS DEFINED BY THE U.K. FINANCIAL SERVICES AUTHORITY LIMITED.
This publication is disseminated in Japan by Morgan Stanley Japan Limited and in Singapore by Morgan Stanley Asia (Singapore) Securities Pte Ltd.
To our readers in Australia: This publication has been issued by Morgan Stanley & Co. Incorporated but is being distributed in Australia by Morgan Stanley Dean Witter Australia Limited, a licensed dealer, which accepts responsibility for its contents. Any person receiving this report and wishing to effect transactions in any security discussed in it may wish to do so with an authorized representative of Morgan Stanley Dean Witter Australia Limited.
To our readers in Canada: This publication has been prepared by Morgan Stanley & Co. Incorporated and is being made available in certain provinces of Canada by Morgan Stanley Canada Limited. Morgan Stanley Canada Limited has approved of, and has agreed to take responsibility for, the contents of this publication in Canada.
To our readers in Spain: Morgan Stanley Dean Witter, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission (CNMV), hereby states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations.
Past performance is not indicative of future returns. Certain assumptions may have been made in this analysis which have resulted in any returns detailed herein. No representation is made that any returns indicated will be achieved. Transaction costs (such as commissions) are not included in the calculation of returns. Changes to the assumptions may have a material impact on any returns detailed.
Disclaimer