BES bail-in leaves CDS traders struck out

August 5, 2014

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Banco Espirito Santo’s bail-in has been a nice earner for some bond traders. Anyone who bet that Portuguese authorities would save senior creditors but burn bonds lower down has made a killing. But anyone who tried to follow suit with BES credit default swaps will be feeling much less cheery.

On Aug. 4, the day after BES’s rescue was announced, the bank’s senior bond prices jumped to near par value after traders learned they would be put into a new “good” bank. Subordinated debt prices slumped and are trading around 20 cents on the dollar. A classic capital structure arbitrage of buying senior and shorting junior would have been very profitable.

Not so for traders in the occasionally topsy-turvy world of credit default swaps. CDS – highly liquid contracts that protect the holder against corporate or sovereign default – should have behaved like the underlying bonds. But anyone who made that trade forgot about something called succession.

Standard CDS documentation means that if more than 75 percent of a company’s debt is moved to a new entity, the swaps, both subordinated and senior, will move too. The clause helps with corporate mergers, but may backfire in BES’s resolution, according to market observers. The subordinated CDS are expected to move to the healthy bank and won’t pay out if, or when, the junior bonds default. The spread, a measure of credit risk, has almost halved since Aug. 1, hurting anyone who bought them to short.

It’s even worse for anyone who used credit default swaps as a hedge. If you owned the subordinated bond and hedged it by buying CDS, you could lose on both sides of the trade. That would also affect so-called basis traders: speculators who buy bonds and short CDS, hoping to pocket a risk-free spread. Banks had been touting BES basis trades to investors in the weeks before the collapse, according to one fund manager.

It’s not the first time that CDS documentation hasn’t worked: the defaults of Greece and SNS Bank also led to screwy results. The documentation has struggled with the new era of bank bail-ins and government intervention. The guidelines are now being reworked. Once they are, traders should read them more carefully.

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