Spreads on Distressed Debt

A lot of times, people in the industry talk about various spreads on distressed debt. Unfortunately, one has to clarify that because the definition is so wide. When I talk about spreads on distressed debt, I will make sure that I am giving you some sort of index in reference. Warning this is a technical post that is trying to lay some groundwork for the future.

Some of the more liquid securities in the distressed debt market are the MarkIt HY and Loan Indexes, abbreviated as HY[Series] or LCDX[Series]. These indices are easy way to get exposure to the High Yield or Leveraged Loan market. Markit is currently quoting the 12th series of their HY index (HY12 for short) at a price of 73.75 at a spread of 1398. This is a LIBOR based spread (i.e. it is a swap). This index has a coupon of 5.00% (coupons vary per series) which means if I sell protection on the index, I will receive 5.00% per annum.

Now that is pretty simple right? Actually, its a whole lot more complicated than that. These MarkIt indices are an aggregation of 100 different credit default swaps. We will talk a lot about credit default swaps in the coming months. Essentially, a credit default swap is a way to hedge out credit risk, specifically default risk. You pay a premium for the insurance, and if the underlying defaults (many different definition), you will receive proceeds as determined by an auction. As an example, in 2006, you could of bought Lehman protection for essentially nothing - call it 30 bps per annum. A very large hedge fund bought $1 billion dollars worth of this protection and it cost them 3 million per year (1000 * 30 basis points). When Lehman filed for bankruptcy, those CDS contracts were worth 90 points per million...which means this hedge fund got paid $900M dollars. Fantastic trade.

Ok, back to the indexes. When you sell protection, you guarantee to make these insurance payments in case one of the underlying defaults. Of course, it is spread over 100 different securities so the impact will be far less than the Lehman example above. For example, if one of the 100 defaulted, and the underlying CDS was worth 50 points, you would owe 50 points on 1% (1/100) or 50 bps. But now the index has a "par" value of 99 - i.e. one less issuer in the index.

At the end of 5 years, which is the usual maturity length of these indexes, the seller of protection gets all the dollars that have not been paid out by underlying defaults. So let's say you sell some protection at 100. If no one defaults, you get to keep your 5.00% coupon that you made each of the past 5 years, and you get to keep your 100 dollars. The problem becomes, like now, when everyone thinks everyone is going to default, and then the index is only priced at 73.

The chart above (sorry for the size I am just learning this whole "Blogger" thing), is a graph of the Credit Suisse High Yield index on a Spread to Worst basis (spread versus treasuries). As you can see, there has been a dramatic move to the upside, with some tightening more recently.

Now you may be asking? Why is this all important? Well its important because when deciding where something should trade, we look at it on an absolute and a relative value basis. Just like people do comps for equity investing, we debt investors do relative value analysis. If I think XYZ company is riskier than ABC company, then I think (all else being equal) that is should trade at a wider spread. Continuing this theme, if I think the High Yield Telecom sector is better positioned than the High Yield Universe, I would think that the High Yield Telecom should trade tigher to the overall index.

If you want more technical information, here is a great Credit Index Primer from Markit.


Anonymous,  4/09/2009  

Similarly, almost a third of all the bonds on the Merrill Lynch high-yield index are trading at prices below 50 cents on the dollar: http://blogs.wsj.com/deals/2009/04/09/junk-bonds-now-selling-below-50-cents/?mod=djemDeal


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.