What Is a Loan Credit Default Swap (LCDS)?
Let me explain what a Loan Credit Default Swap, or LCDS, really is. It's a type of credit derivative where two parties exchange the credit exposure of an underlying loan. The structure of an LCDS is identical to a regular credit default swap (CDS), but here's the key difference: the underlying reference obligation is strictly limited to syndicated secured loans, not just any corporate debt.
You might also hear it called a 'loan-only credit default swap.' That's straightforward enough.
Key Takeaways
An LCDS lets one counterparty transfer the credit risk on a reference loan to another in exchange for premium payments. It shares the same general structure as a regular CDS, but remember, the reference obligation in an LCDS is exclusively syndicated secured loans.
Understanding a Loan Credit Default Swap (LCDS)
The LCDS entered the financial market in 2006. Back then, the credit default swap market was booming, and there was clear demand for more derivatives like this. People saw the LCDS as essentially a CDS but with the reference shifting to syndicated debt rather than corporate debt. At the same time, the International Swaps and Derivatives Association (ISDA) standardized these contracts, just as syndicated secured loans were ramping up for leveraged buyouts.
There are two types of LCDS you should know about. The cancelable version, often called a U.S. LCDS, is designed as a trading product. As the name implies, you can cancel it on agreed dates without penalties. On the other hand, the non-cancelable LCDS, or European LCDS, is more of a hedging tool that factors in prepayment risk. It stays active until the underlying syndicated loans are fully repaid or a credit event occurs. Since the U.S. version offers cancellation options, it trades at higher rates than the non-cancelable ones.
Important Note on Recovery Rates
One crucial point: the recovery rate for LCDS is significantly higher than for CDS on bonds. That's because the underlying assets are syndicated secured loans, which give you better protection in case of default.
Loan Credit Default Swaps vs. Credit Default Swaps
Just like regular CDS, an LCDS can hedge against credit exposure you already have or let the seller gain exposure to credit risk. You can even use it to bet on the credit quality of an entity without prior involvement.
The main difference boils down to the recovery rate. The debt in an LCDS is secured by assets and takes priority in liquidations, while CDS debt is senior to shares but junior to secured loans. This higher-quality reference in LCDS means better recovery if the loan defaults, so LCDS usually trade at tighter spreads than ordinary CDS.
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