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JFRC 15,4

Credit default swap spread and succession events

Halit Gonenc
Faculty of Economics and Business, University of Groningen, Groningen, The Netherlands

450

Floris Schorer
Credit Trading, ING Financial Markets, Amsterdam, The Netherlands, and

Willem P.F. Appel

London, UK
Abstract
Purpose Credit default swap (CDS) spreads may not represent the accurate credit risk levels (asymmetric spread behavior) of assets with the initiation of corporate events, such as merger, spin-off or other similar events in which one entity succeeds to the obligations of another entity. The International Swaps and Derivatives Association (ISDA) succession language for the denition of succession events misleads the CDS market participants to determine CDS spreads. The purpose of this paper is to provide a conceptual framework for the relationship between the ISDA succession language and CDS spreads in order to clarify the factors behind the asymmetric spread behavior around several corporate activities. Design/methodology/approach The authors develop a conceptual driver model to establish a link between company characteristics and succession issues. Then, a succession model to evaluate the risk levels occurring with succession issues is designed. Findings The ISDA succession language has an inuence on CDS spreads around corporate events. The explanatory approach provides the foundation for the understanding of the relationships between succession issues caused by several corporate events, involving particularly restructuring, renancing and/or guarantee risk, and CDS spreads. Combination of the driver model and the succession model helps to assess the potential inuence of succession events on CDS spreads. Research limitations/implications Market participants should take into consideration the effects of the ISDA succession language on CDS spreads around succession of CDS. Originality/value Prior research related to the CDS has always focused on the economic determinants of CDS spreads. This paper is the rst attempt to explain the relationship between the ISDA succession language and CDS spreads. Keywords Risk management, Credit management, Financial analysis Paper type Conceptual paper

Journal of Financial Regulation and Compliance Vol. 15 No. 4, 2007 pp. 450-463 q Emerald Group Publishing Limited 1358-1988 DOI 10.1108/13581980710835281

1. Introduction A credit default swap (CDS) is an over-the-counter derivative and its design includes a transfer capability of the credit default risk of a corporate borrower among investors. The rst CDS contracts evolved in the late 1990s and in 1999 the International Swaps and Derivatives Association (ISDA) issued denitions on credit derivatives. ISDA altered and extended these denitions in 2003. A CDS gives the participants the opportunity to transfer credit risk without transferring the underlying credit asset (bond or loan). As a derivative instrument, the advantage of the CDS is to encourage trading the risk of a companys obligations

without dealing with these obligations. A CDS provides the ability to diversify portfolio risks without diversifying the portfolio itself. CDS spread as a periodic premium is the price of CDS. The corresponding spread on a CDS also reects the credit risk of the underlying company. Hull et al. (2004) show that CDS spreads should be closely related to bond yield spreads that are good indicators of credit risk. The CDS market attracts all kinds of nancial investors for speculation purposes as well. Therefore, identication of antecedents to CDS spreads has become very important in the literature. Collin-Dufresne et al. (2001) address antecedents to credit spread changes instead of yield changes. Although they still focus on bonds, they show that in general credit spreads should equal CDS spreads; hence their study is an initiation for research on the CDS. Collin-Dufresne et al. (2001) examine proxies for both changes in the probability of future default and changes in the recovery rate. Interestingly, they are not able to identify these proxies inuencing credit spreads signicantly. They nd that local supply and demand shocks drive the dominant component of credit spread changes. The study by Cossin and Hricko (2001) is the rst study to explicitly address antecedents to the CDS. The variables they consider are credit ratings, interest rate, slope of the yield curve, time-to-maturity, stock prices, variance or volatility of the rms assets, leverage, index returns and idiosyncratic factors. Although Cossin and Hricko (2001) address more aspects by using more variables than Collin-Dufresne et al. (2001), the basis of the variables is more or less the same. They nd that, these variables together drive up to 82 percent of the variation in CDS pricing. Credit ratings appear to be most important source of information on credit quality, although Cossin and Hricko recognize that ratings usually lag information in the market and therefore provide little new information. Besides, credit ratings inuencing CDS spreads, interest rates, variance of the company stock price and leverage of the company are also main factors for a companys CDS spreads. Hull et al. (2004) nd a relationship between credit ratings and CDS spreads when they try to predict negative change in CDS spreads from announcements of credit rating changes. Ericsson et al. (2004) are able to explain 60 percent of CDS spreads with the variables rm leverage, equity volatility and risk free interest rate. Abid and Naifar (2006) distinguish ve different variables inuencing CDS spreads: credit ratings, time to maturity (of the CDS contract), risk free interest rate, slope of the yield curve and volatility of equities. This paper is not about identifying variables that inuence CDS spreads in general but focuses on succession events. The ISDA denes succession events as corporate activities such as merger, spin-off or other similar event in which one entity succeeds to the obligations of another entity. A succession event may cause a sudden change in the CDS spreads. When this sudden change in spreads is in contradiction with the underlying change in credit quality, a CDS may lose its connection to the underlying asset with the initiation of corporate activities. Thus, a CDS may fail to cover the credit risk that the participants in the CDS intend to cover initially. Hence, CDS pricing shows imperfections; conicts emerge between the economical antecedents to CDS spreads and ISDAs legal denition. Even though, ISDA had recently solved the problem of obligation-restructuring events and the maturity of possible deliverables by introducing different restructuring clauses, new problems have already arisen.

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Succession language on the CDS seems to become an important issue for CDS spreads because corporate activities have been rapidly increasing, largely fuelled by increasing merger & acquisitions (M&A) and leverage buyout (LBO) activities. While numerous ways of structuring of these events exist, management of the companies participating in these activities has little (if any) concerns about the consequences of a deal for CDS participants in contradiction to their concerns about strategic and operational issues. Credit Suisse (2006) provides a clarifying analogy about the confusion that some of these event structures cause: If you changed the name of your rst child on the birth date of your second child, and named the second child with the rst ones original name, do you think the name change would create confusion? This paper begins with a theoretical presentation by stating that succession language in ISDA credit derivatives denitions together with an initiation of corporate activities confuses the market on the behavior of CDS spreads in comparison to the underlying credit risk levels. Thus, CDS spreads do not seem to represent the accurate credit risk levels. Because of the content of the succession language, CDS market participants are afraid of a lack of deliverable obligations left at the reference entity of the CDS contract after a given corporate activity. As a result, spreads tighten while the underlying credit risks of the companies do not change or possibly even worsen. Examples of recent cases on CDS are the companies Sainsbury, Rentokil, ProSieben, VNU, ITV, Alltel and Cendant. The asymmetric spread behavior increases the risk of trading the CDS as the behavior decreases the predictability of CDS spreads around corporate event announcements. This, in turn, can result in unforeseen losses not related to a change in credit risk. A study which can clarify this asymmetric behavior related to succession language would therefore enhance the understanding of the behavior of CDS spreads and would even help with anticipating changes in spreads especially around corporate activity announcements. The issues around succession of a CDS and deliverability into a CDS are new. Data and cases on the issue are limited. Therefore, this paper follows an explorative approach by focusing on relationships between the various aspects of the problem and presents a conceptual model for the relationships between determinants of corporate event categories and succession issues. The paper presents an analysis of the issues related to CDS, corporate activities and succession language in Section 2, the theoretical discussions and the model in Section 3, and conclusions in Section 4. 2. CDS and corporate activities 2.1 Description of CDS The buyer of the CDS protects himself against the loss of principal due to a credit event in the underlying asset. This means that, the buyer insures himself against the loss of payments on money he lent to a third party. Although, the buyer of a CDS lent money to a company, he now does not have to worry anymore about getting his money back as the CDS provides an insurance (hereby ignoring counterparty risk). The seller of the CDS is therefore the party that insures the payments; the insurer. In exchange for this protection the buyer pays a periodic premium, CDS spread, quoted as basis points per annum over the contracts principal (the insured amount), to the protection seller until the contract matures or a credit event occurs, whichever is earlier.

A credit event triggers the CDS, meaning that settlement of the contract will occur. A credit event is basically what a CDS buyer originally protects himself against. Each separate CDS contract denes the credit event. In a standard CDS contract, however, credit events include always bankruptcy and failure to pay. OKane et al. (2003) call bankruptcy and failure to pay as hard credit events. Restructuring of a bond is also considered a credit event in certain situations. However, this event is different from the rst two and is known as a soft credit event. This is because after such an event, obligations do not become immediately due and will continue to trade. The 2003 ISDA denitions consider a debt obligation as restructured in one of the following situations: (1) a reduction in the interest rate on the obligation; (2) a reduction of the principal or premium; (3) an extension of the maturity of the obligation; (4) a change in the priority ranking of payments; or (5) a change in the currency or composition of the payment of principal or interest. A protection buyer or seller can claim an event of default if any of these ve different restructurings of bonds occurs. When a credit event occurs, that is when the reference entity (the company the CDS is based on) cannot meet its obligations; the protection buyer delivers the credit asset to the seller. In return the seller pays the par value of that asset to the buyer. As a result, the seller now owns the asset which has decreased in value because of the credit event, whereas the buyer gets his money back. The participants have now settled and terminated the contract. This way of settling is known as physical settlement. Another possibility that depends on the agreements at the contract is to use cash settlement. In this case, the seller does not receive the credit asset. The seller only pays the difference between the par value and the market value of the credit asset to the buyer. For example, if the value of a bond after the credit event is 40 percent of its notional amount, the seller just pays 60 percent of the notional amount to the buyer. With cash settlement, the buyer therefore does not even have to own the credit asset to settle the contract after a credit event. 2.2 Relationships between CDS and succession events Corporate activities such as mergers, acquisitions, spin-offs and disposals can cause succession events. A succession event is not a credit event. A restructuring of a bond itself causes a credit event, but the restructuring of a company or its capital structure possibly causes a succession event that will not trigger a settlement of the CDS. Figure 1 shows a framework for determination of CDS spread. There are two important and inuential steps in this Figure: (1) The characteristics of the company as economical antecedents to the CDS spread, of which the capital structure is the most important, determine the credit risk of a rm and in turn inuence the CDS spread. (2) The characteristics are also related with upcoming corporate activities. ISDA succession language for corporate activities, which lead to succession events, causes several succession issues that also inuence the CDS spread. Therefore, credit risk and succession issues are two factors inuencing CDS spread.

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Corporate Borrower (Reference Entity) 1 Characteristics

454

2 Corporate Activity ISDA Succession Language Capital Structure

Credit Risk Level Antecedents Succession Issues

Figure 1. Determination of CDS spread

Credit Default Swap Spread

The 2003 ISDA denition for a succession event is as follows: succession event means an event such as a merger, consolidation, amalgamation, transfer of assets or liabilities, demerger, spin-off or other similar event in which one entity succeeds to the obligations of another entity, whether by operation of law or pursuant to any agreement. Not withstanding the foregoing, succession event shall not include an event in which the holders of obligations of the reference entity exchange such obligations for the obligations of another entity, unless such exchange occurs in connection with a merger, consolidation, amalgamation, transfer of assets or liabilities, demerger, spin-off, or other similar event. Succession is a two-step process. The rst step involves establishing whether or not an actual succession event occurred according to ISDA denitions. The second step, after the agreement on a succession event, consists of determining one or more of the successor entities that will become the new reference entities in the CDS contracts. This paper focuses on these two important aspects of the denition of succession event: rst, because of the exchange exclusion in the second part of the denition of succession event, the timing of activities can be crucial to whether these activities would qualify as succession events or not. An exchange without a connection with a corporate activity (no succession event) would possibly leave the CDS without a deliverable obligation as the CDS can refer to a reference entity without any debt in such a situation. The CDS will then become worthless because such a CDS insures debt that does not exist. A CDS without deliverable obligations is also called an orphaned CDS; the instrument that derives the derivative ceases to exist or the parent of the CDS is gone. The second aspect relates to the issue of which reference entity the CDS can and will refer to, following a corporate activity. In some cases this entity can be different from the entity any given debt obligation will transfer to. The 2003 ISDA denitions explain the term succeed as well: succeed means, with respect to a reference entity and its relevant obligations (or, as applicable, obligations), that a party other than such reference entity:

Assumes or becomes liable for such relevant obligations (or, as applicable, obligations) whether by operation of law or pursuant to any agreement. Issues bonds that are exchanged for relevant obligations (or, as applicable, obligations), and in either case such reference entity is no longer an obligor (primarily or secondarily) or guarantor with respect to such relevant obligations (or, as applicable, obligations).

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A related issue concerns subsidiaries (newly acquired) giving guarantees to their parent companies. However, the succeed denition excludes guarantors of debt from succession events. When company A acquires company B and A assumes all of Bs debt, a succession event occurs unless B guarantees the assumed debt. Hence, the reference entity in the CDS contract in such situation will be changed from B to A if B does not still guarantee the (by A) newly assumed debt. This is a subtle difference, but one with huge consequences for the CDS. The structure of guarantees and even the presence of guarantees are often not clear at the time of the announcement of a corporate activity. When a succession event occurs, the issue of which part of the debt is actually transferred to which company arises. This is important in the determination of any change in a CDS reference entity. The following example (Table I) lists different scenarios with their consequences for the CDS contracts. As an example; Company X assumes 30 percent of a Company Ys debt and Company Z assumes the other 70 percent. The reference entity for a CDS on Y will change following this transaction. According to the ISDA denitions, this CDS will be split equally between X and Z even though Z assumed 70 percent of the debt. This means, that the notional amount initially protected for default on the deliverable obligations of Y will now be split between the deliverable obligations of X and Z. 3. Conceptual model This paper presents a conceptual model to reect the dynamics of CDS spreads around corporate activities classied as succession events. The previous section argues that succession issues are important as much as antecedents to CDS spread. When CDS spreads do not reect the true credit risk of a company, especially around announcements of corporate activities, we may talk about the asymmetric behavior of CDS spreads. Consequently, a model that analyzes succession issues leads to a better understanding of CDS price behavior. 3.1 The driver model Figure 2 shows driver model that shows how company characteristics cause succession issues through corporate activities. The model determines
Debt assumed by 1. Company ABC assumes $ 75 percent 2. One or more entities assume 25-75 percent 3. No entity assumes more than 25 percent New reference entity Company ABC is the successor Contract equally divided among these entities (all successors) Original legal entity stays reference entity (no changes)

Table I. Determining successors in the ISDA denition

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- Poor stock performance - Poor operating performance

Figure 2. Driver model; empirically identied catalysts for succession issue risk grouped by corporate event risk category
SUCCESSION ISSUES
Structure / Capital Structure Corporate Structure - Mutually independent divisions - Holding company - Non-core assets - Many fixed assets - Short debt maturity profile - Low leverage - High costs of funding - Complicated capital structure - Bond covenants and Debt at holding C. Stakeholders Performance - Poor stock performance - Poor operating performance - Shareholder activism Stakeholders - Maintain relationship with banks / bondholders

Performance

RESTRUCTURING RISK
External Variables - Change in regulation - Tax implications Competitors - Benchmarking

REFINANCING RISK
External Variables - Change in regulation - Tax implications - Lower interest rates

Competitors

- Consolidation battle

Competitors -

guarantee risk only appears together with restructuring and/or refinancing risk

External Variables - Change in regulation - Tax implications

Performance -

GUARANTEE RISK

Stakeholders - Maintain relationship with bondholders and / or CDS holders Structure / Capital Structure

- Holding company Finance company / Operating company - High costs of funding - Restrictions on outstanding debt

three corporate event categories that lead to succession issues. The three categories are: (1) restructuring; (2) renancing; and (3) the insertion or withdrawal of a guarantee. A restructuring relates to the organization of a company and a renancing includes besides the replacement of debt also the addition of extra debt. Furthermore, each corporate event category includes several company characteristics that are incentives for these events. The driver model classies the company characteristics in ve different categories: corporate structure (which also comprises capital structure), performance, stakeholders, competitors and external variables. For instance, shareholder activism is an identied driver for a restructuring related to the stakeholders of a rm while a stakeholder-driver for restructuring risk. The model identies general drivers for each company characteristic for three different corporate event categories. 3.1.1 Restructuring. First driver for this corporate event category is corporate structure. Holding companies with independently operating divisions that have diversied operations provide a good example to corporate structure and incentives for restructuring, succession issues may occur in case of a spin-off of several operating divisions in such companies. Similarly, M&A are important activities in the life cycle of rms and reect strategic expansion views. Performance as the second driver reects the historical performance of frims. A deterioration of operating performance can lead to the introduction of a corporate activity in the near future. A rm may also initiate a takeover due to poor stock performance of a possible target rm. Third driver is stakeholders that are more likely to have a big inuence on the rms strategies. Especially, shareholders have important inuence with increased shareholder activism. Bondholders, other creditors, employees and clients as other stakeholders can also have inuence on restructuring activities. One can also argue to include CDS holders as stakeholders. Although, they might not directly inuence a company, they do so indirectly by pricing a companys default risk. In relation to restructuring risk, shareholder activism is the main catalyst. A rms competitors for the fourth driver can inuence its strategy and therefore the occurrence of a corporate activity. Current consolidation battles in certain sectors can lead to numerous corporate activities. Firms feel the need to keep growing through acquisitions if they do not want to become a takeover target themselves. External variables determine the fth driver. Tax and regulatory issues are examples of external variables with inuence on the structure of a company or inuence on a sector that a company is operating in. Therefore, external variables may cause several corporate activities. For instance, a company may want to establish a tax-free transaction. Also, European Law prohibits a company to guarantee another companys acquisition debt as nancial assistance of third parties. 3.1.2 Renancing. The term renancing includes signicant changes in the capital structure of a rm, besides the replacement of existing debt. For instance, when a rm is involved in an LBO, the existing debt might stay in place, but a lot of additional debt will be issued. This constitutes a renancing as well under this denition.

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A company renancing just a small part of its deliverables is less likely to have succession issues with its CDS than a company renancing all of its deliverables. Renancing is often initiated as part of a restructuring, in which case the drivers for renancing are related to that restructuring. In some cases, however, a company renances without a (signicant) restructuring; a stand-alone renancing. The structure-drivers in this category are, on the contrary to the restructuring category, mainly related to the capital structure of a company instead of the organizational structure. Stand-alone renancing drivers related to the rst driver of renancing event category, which is the companys structure, include the following items. Many xed assets: if a large part of a companys assets consist of xed assets like property, an incentive to securitize these assets arises in order to reduce nancing costs. Short debt maturity prole: a company with outstanding obligations which mature in the near future can have a reason to renance that debt, thereby improving its liquidity and nancial exibility. Low leverage: a company with relatively less outstanding debt has an incentive to optimize its capital structure by adding debt. This leads to a change in this capital structure and thus a change in its deliverable obligations. High costs of funding: a company that is able to borrow money at a cheaper rate than the companys current borrowings has an incentive to renance the current debts. Complicated capital structure: a company with a very complicated capital structure might decide to tidy up and renance its capital structure. All the foregoing drivers can lead to a stand-alone renancing but they can also lead to a renancing in connection with a restructuring. The next drivers, however, should in most cases only appear in connection with a restructuring. Bond covenants: bond documents usually contain restrictions on an issuers actions. A change of control clause, for example triggers a put option on the bond if the company changes owner. A negative pledge restricts a company from issuing secured debt as a common practice in LBOs. Step-up language increases the cost of the debt usually following downgrades of rating agencies. Renancing these types of bonds is a method of circumventing these covenants, which creates a path for a planned restructuring. Debt at holding company: in a restructuring scenario, a holding company might become redundant. This can create a reason to renance the debt issued from this holding company and issue the new debt from a different (operating) company. Drivers for performance, stakeholders, competition and external variables have similar reasons to cause succession issues with the same drivers in restructuring event category. Past operating and stock performance may lead renancing to improve the rms performance. Regarding stakeholders, an incentive to renance can be the relationship with existing debt providers. Benchmarking can be a reason for a renancing related to competitors. Companies like to follow the industrys best practice, which might result in a change of capital structure. Risk free interest rate is an external variable leading to a renancing of debt. Decreasing trend in the risk free rate in the market may encourage a rm to renance its debt; as such a change can lead to opportunities for cheaper funding. 3.1.3 Guarantees. In the rst two types of corporate event categories (restructuring and renancing), all the drivers reect incentives to initiate such an activity, whereas with guarantees, the drivers include, incentives but also disincentives to give guarantees. The reason for this is that both giving a guarantee and refraining from

giving a guarantee can cause succession issues. General drivers for guarantees are hard to dene, because the decision, whether to guarantee a bond or not, is usually based on very case-specic details. Also, unlike restructuring and renancing, the guarantee risk category always comes together with one of the two other event categories. Nonetheless, the driver model identied some obvious drivers. The issues for guarantees seem to occur in cases such as the following: an entity A assumes the debt of another entity B with a guarantee from B. When entity A issues new debt without the guarantee of B, this will result in limited deliverables on Bs CDS and eventually causes an orphaned CDS. This scenario is graphically shown in Figure 3. A structure-driver for guarantees is holding company in forms of nancing or operating holding company aiming at a situation where the issuer of debt is a shell company or nancing subsidiary. Such a situation encourages an operating company and a holding company to, respectively, give guarantees. However, in a future situation, to predict which entity would be the issuer of new debt, especially after a restructuring, is very hard. Therefore, the predictive value of this driver might be diluted. Another structure-driver is high costs of funding as a guarantee gives bondholders usually more asset-coverage and thus the cost of capital should be lower. A rms (capital) structure can also discourage the guaranteeing of debt because of restrictions of outstanding debt; ensuring a guarantee might breach a companys existing debt covenants, hence the company cannot give a guarantee. Maintaining the relationship with bondholders is a stakeholder-driver for guarantees in the same way as for renancing. If a company transfers its debt for instance, bondholders would like to see a guarantee from the entity they initially based their investment on in order to hold their bonds. Recent developments show that maintaining the relationship with CDS holders can also be a driver for guarantees. However, succession issues will certainly not arise from this driver as CDS holders would not be happy if succession issues surface. Therefore, this driver is a catalyst for guarantees but insignicant for succession issues.
Debt EVENT A B CDS A B CDS Debt guarantee

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Company boundary

No Succession (because of guarantee)

New Debt

Old Debt guarantee

CDS

New Debt

CDS

Maturing of old debt resulting in orphaned CDS

New debt issuance (without guarantee)

Figure 3. Guarantees leading to an orphaned CDS

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This study is unable to identify drivers based on rms performance and competitor characteristics for guarantees. However, benchmarking could possibly be a guarantee driver as well. External variables can also provide both encouragement and discouragement to guarantee debt. 3.2 The succession model The driver model in Figure 2 shows the relationships between corporate event categories and succession issues. Besides, classifying these reasons among different categories, the model also distinguishes the corporate activities in relation to succession issues with three different corporate event categories. Moreover, the driver model can be useful for helping with assessing the likelihood of the occurrence of such event category risk in the future. As an objective of this paper is to increase the understanding of succession issues, an elaboration on the relationship with succession issues is certainly necessary. This elaboration follows next. Using the distinction of the two main different categories in corporate activities; restructuring and renancing as a starting point, the possibility to design a model that elaborates on the relationship with succession issues arises. The succession model omits the third category (guarantees) because a generalization of this category is not possible, the insertion or withdrawal of a guarantee being very case-specic. In the model, the two axes represent the restructuring and renancing categories. They have a continuum characteristic measured along the impact of the restructuring/renancing on the company. The guarantee-characteristic is binomial (either yes or no) and to take this risk into account even though the risk is not represented in the model is therefore still possible. The descriptions make clear that succession issues become more likely to surface along with the increasing number of the cell an event would qualify for. The existence of guarantee risk would increase the risk on succession issues even more. Because of the nature of the two axe-dimensions and their continuum characteristics, valuing different activities along the two axes is subjective. The lines that indicate the cross-over of one cell to the other are therefore not hard boundaries. Therefore, the separation line between cells 1 and 3 cannot be interpreted as the difference between no restructuring and a complete restructuring. The intention is to distinguish between a small, low-impact restructuring and an intense, high-impact restructuring. As continuums represent the both dimensions, not only the cells matter, but also the relative placement within those cells. The names of cells provide an indication of the events that would possibly qualify for the cell (Figure 4). 3.2.1 Cell 1 low risk. One would not expect much action in this cell. However, an insignicant restructuring (insignicant for the corporate structure) can have an enormous impact on a CDS. An adaptation to external variable changes would generally cause such a restructuring because changing things without an evident effect is usually no internally grown incentive. As this is the low-risk cell, whenever an event does happen here, such an event comes unexpected. 3.2.2 Cell 2 stand-alone. As this cell comprises renancing only, the company structure stays the same. Therefore, this is the stand-alone cell; a company initiates and completes the renancing on its own, usually as part of a strategic change. The likelihood of succession issues is higher in this cell than in a cell-1 event because of the renancing. 3.2.3 Cell 3 spin-off/merger. This cell is typically the domain restructurings, such as spin-offs and mergers. Usually, in these cases, management tries to complete the

460

Spin-off / Merger

LBO

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restructuring impact

high

3 1 Low Risk

4 2 Stand-alone

low

low

refinancing impact

high

Figure 4. The succession model

transaction with low renancing. In some cases restrictions in bond and loan documents force a company to renance. Therefore, spin-offs and mergers can sometimes not classify for cell-3. Nonetheless, spin-offs and mergers are initiated from a restructuring perspective and a renancing will at the most be a side-effect of this restructuring, hence the association of spin-offs and mergers with cell-3. The likelihood of succession issues in cell-3 is higher than in the low risk (cell-1) and stand-alone (cell-2) cells. These two cells are cells with a low-impact restructuring, which is precisely why the risk in cell-3 is higher than in those two cells; an increase in restructuring impact usually implicates the involvement of more entities in the event, which in turn increases the risk of succession issues. 3.2.4 Cell 4 LBO. In cell-4 companies endure some huge changes. Both the corporate and capital structures are turned inside out. LBOs typically qualify for this cell. Since, this cell captures the cases that suffer most signicant changes, this cell has the most succession uncertainty. However, LBOs tend to have a structure where non-deliverable obligations are usually not an issue. Nonetheless, the fear of orphaning often dominates the CDS market in the early stages of an LBO. Besides, LBOs, cell-4 would include plenty of other restructuring and renancing activities that succession issues usually do surface. The practical use of the succession model is important. Therefore, Figure 5 shows a scope for several frequently occurring events in the succession model: . Mergers. Merger activities always involve some restructuring. However, mergers where the two companies are still operating very independently afterwards also exist. In those situations, the restructuring impact is limited. Therefore, the scope for mergers is situated on a medium to high impact considering the restructuring factor. With respect to renancing, either the debt stays in place, or the company renances all of the debt in case of a merger. . Spin-offs. Spin-offs usually face a higher impact from restructuring than mergers, because, unlike mergers, spin-offs have no situations in which the

restructuring impact

462

high

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Spin-offs

Mergers

3 1

4 LBOs 2

Figure 5. Scope for three sorts of frequently occurring corporate events

low low

refinancing impact

high

restructuring factor is offset. Therefore, the spin-off scope has a higher place on the model than the merger scope. In a spin-off scenario, the company usually manages to allocate some of the debt to the surviving entities. Therefore, in these scenarios only a portion of the outstanding debt is likely to be renanced. A complete renancing or no renancing at all is less likely in a spin-off. LBOs. LBOs characteristically include a high-impact renancing as they inherently increase the leverage. Besides, that, every LBO constitutes a change of ownership, thereby typically involving at least a limited restructuring. Moreover, usually these events lead to quite a signicant restructuring by means of asset sales or just general reorganizations including the introduction of a new corporate structure.

4. Conclusion This paper sets a conceptual framework to capture the relationship between CDS spreads and ISDA succession language. The denitions related to succession events in the ISDA credit derivatives denitions inuence CDS spreads. In some recent cases, CDS spreads show considerable tightening following the announcements of corporate activities. The ISDA language failed to mirror the markets perception of the CDS in a legal sense in these cases. Even though the credit risk of a company did not improve, spreads tightened considerably because of the structure of the language. The ISDA language distorts CDS price behavior. The model in this paper provides the foundation for the understanding of succession issues. The driver model in combination with the succession model provides a help to assess the potential inuence of the ISDA succession language on CDS spreads. The need for future research in the CDS market will remain high, just like any other topic that is relatively new and complicated. Such research would enhance the pricing for the assessment of credit risks and would stimulate the perfection of the nancial markets.

References Abid, F. and Naifar, N. (2006), The determinants of credit default swap rates: an explanatory study, International Journal of Theoretical & Applied Finance, Vol. 9, pp. 23-42. Collin-Dufresne, P., Goldstein, R.S. and Martin, J.S. (2001), The determinants of credit spread changes, The Journal of Finance, Vol. 56, pp. 2177-207. Cossin, D. and Hricko, T. (2001), Exploring for the determinants of credit risk in credit default swap transaction data, working paper. Credit Suisse (2006), European credit strategy and trades CDS: orphans and confusing name changes, Fixed Income Research, March. Ericsson, J., Jacobs, K. and Oviedo-Helfenberger, R. (2004), The determinants of credit default swap premium, working paper. Hull, J., Predescu, M. and White, A. (2004), The relationship between credit default swap spreads, bond yields, and credit rating announcements, Journal of Banking & Finance, Vol. 28, pp. 2789-811. OKane, D., Pedersen, C. and Turnbull, S. (2003), Pricing the restructuring clause in credit default swaps, Lehman Brothers, Fixed Income Quantitative Credit Research. Corresponding author Halit Gonenc can be contacted at: h.gonenc@rug.nl

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