What is a Loan Credit Default Swap (LCDS)
A loan credit default swap (LCDS) is a type of credit derivative in which the credit exposure of an underlying loan is exchanged between two parties. A loan credit default swap's structure is the same as a regular credit default swap, except that the underlying reference obligation is limited strictly to syndicated secured loans, rather than any corporate debt. Loan credit default swaps are also referred to as "loan-only credit default swaps."
BREAKING DOWN Loan Credit Default Swap (LCDS)
Loan credit default swaps were introduced to the market in 2006. At the time, the hot market for credit default swaps showed that there was still an appetite for more credit derivatives, and the LCDS were largely seen as CDS with the reference obligation shifting to syndicated debt instead of corporate debt. The International Derivative and Swap Association (ISDA) helped to standardize the contracts being used at the same time as the creation of syndicated secured loans for the purpose of leveraged buyouts was also increasing.
Loan Credit Default Swaps vs. Credit Default Swaps
As with regular CDS, these derivatives can be used to hedge against credit exposure the buyer may have or to obtain credit exposure for the seller. These products can also be used to make bets on the credit quality of an underlying entity to which parties have not had previous exposure. The biggest difference between loan credit default swaps and credit default swaps is the recovery rates. The debt underlying the LCDS is secured to assets and has priority in any liquidation proceedings, whereas the debt underlying a CDS, while senior to shares, is junior to secured loans. So the higher quality reference obligation for LCDS leads to higher recovery values if those loans default. As a result, LCDS generally trade at tighter spreads.
Interestingly, studies have shown that LCDS and CDS from the same firms with the same maturity and clauses traded at parity during the financial crisis, but the payoffs of the LCDS were higher in almost every case. In a real sense, holding the LCDS in this scenario offered a strong, risk-free premium over the comparable CDS.
Cancellable and Non-Cancellable LCDS
Loan credit default swaps come in two types. Cancellable LCDS are often referred to as U.S. LCDS and are generally designed to be a trading product. As the name suggests, the cancellable LCDS can be cancelled at an agreed-upon date or dates in the future without penalty costs. Non-cancellable LCDS, or European LCDS, are hedging products that incorporate prepayment risk into their makeup. The non-cancellable LCDS remains in force until the underlying syndicated loans are repaid in full (or a credit event triggers it). As U.S. LCDS have the option to cancel, these swaps are sold at a higher rate than comparable non-cancellable swaps.