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 (CDS), except that the underlying reference obligation is limited strictly to syndicated secured loans, rather than any type of corporate debt. Loan credit default swaps are also referred to as “loan-only credit default swaps.”
How a Loan Credit Default Swap (LCDS) Works
The LCDS was 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 was largely seen as a CDS with the reference obligation shifting to syndicated debt instead of corporate debt. The International Swaps and Derivatives 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.
[Important: A loan credit default swap (LCDS) uses syndicated secure loans as its reference obligation rather than corporate debt.]
The LCDS comes in two types. A cancellable LCDS is often referred to as a U.S. LCDS and is 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. A non-cancellable LCDS, or European LCDS, is a hedging product that incorporates prepayment risk into its makeup. The non-cancellable LCDS remains in force until the underlying syndicated loans are repaid in full (or a credit event triggers it). As a U.S. LCDS has the option to cancel, these swaps are sold at a higher rate than comparable non-cancellable swaps.
Loan Credit Default Swaps vs. Credit Default Swaps
As with a regular CDS, these derivatives can be used to hedge against credit exposure the buyer may have or to obtain credit exposure for the seller. A LCDS 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 a LCDS and a CDS is the recovery rate. The debt underlying an 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 a LCDS leads to higher recovery values if that loan defaults. As a result, LCDSs generally trade at tighter spreads.
Interestingly, studies have shown that LCDSs and CDSs from the same firms with the same maturity and clauses traded at parity during the 2007-2008 financial crisis, but the payoffs of the LCDS were higher in almost every case. In a real sense, holding a LCDS in this scenario offered a strong, risk-free premium over the comparable CDS.