New terms expected to revitalise LCDX tranche trading

The new bullet LCDS standard terms documentation (SCI passim) was published on 5 April, in tandem with the implementation of market practice changes to the trading convention for North American LCDS transactions. As well as increasing liquidity in single name LCDS, the move is expected to revitalise LCDX tranche trading.

The new bullet LCDS standard terms documentation allows parties to enter into LCDS transactions with a fixed 'bullet' maturity that is not subject to acceleration in the case where the reference entity's loans are repaid. The cancellation feature in the old LCDS documentation had limited the expansion of single name and portfolio products.

However, LCDX index and tranche trading are now expected to approach the levels of liquidity seen in CDX HY. The composition of the two indices have almost a 40% overlap.

Among the trading opportunities likely to arise from the changes are: LCDX index arbitrage; secured versus unsecured trades; and - since the old contracts would continue trading - the ability to determine the market-assumed probability of cancellation, by comparing bullet and cancellable contracts. Certainly, structured credit analysts at Citi suggest that LCDX tranches should now offer good relative value post the 2009 rally.

For example, LCDX tranche prices have climbed since the first half of 2009, in tandem with the rally in cash CLOs. But investors are nonetheless expected to look at the relative merits of both products.

The Citi analysts suggest that the choice of product ultimately depends on the investor's risk threshold. "Those who are bullish on the loan class and believe that the refinancing needs post-2013 will not be a major challenge should buy CLO equity," they explain. "We have argued for this trade recently on the basis of attractive current carry and overall returns. However, those looking for a little more protection than the first-loss piece will find many reasons to debate between the LCDX 12%-15% tranche and a CLO single-A, for example. Both offer approximately 9% yield."

However, LCDX tranches have a shorter life (ending before the refinancing window kicks in) and a higher running spread. In this context, the CLO single-A's longer life looks negative - although it does have the benefit of higher subordination.

On the other hand, investors are exposed to single name risk with LCDX tranches. The more junior the position, the greater that risk is.

By way of an example, the LCDX10 index includes Boston Generating, US Airways, United and Swift Transportation, as well as several other high-spread names. "While the first is considered to have significant default probability prior to 2013, the current 6% subordination below the 12%-15% tranche should [provide] adequate protection for even a reasonably bearish scenario. All of these factors leads us to conclude that senior LCDX tranches should be on the due-diligence list of most credit investors," the analysts note.

Away from tranches, the new trading convention for single name LCDS transactions will be similar to those that have been adopted for other standardised CDS contracts over the course of 2009, in which the industry successfully adopted fixed coupons for CDS contracts in North America, Europe, Asia and emerging markets.

Under the changes, firms will trade North American LCDS with standard coupons of 250bp, 100bp and 500bp going forward. 250bp will be the most liquid strike, with the others being used for tight or wide names respectively. Firms will also now trade with full first coupon and T+3 upfront settlement.

The LCDS market practice changes are the result of coordinated efforts among market participants and serve to further promote standardisation and liquidity in the market, according to ISDA.

CS