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Lehman aims to kick-start pref CDS: Dealer launches new index
Creditflux Ltd. (September 30, 2005)

Lehman Brothers has introduced a new layer of the capital structure to the credit derivative index market, after launching an index referenced to 40 issuers of preferred securities. Thirty North American entities are referenced by the index across the Reits, insurance, banking and utility sectors. In addition there are 10 European entities. Nine of these are so-called yankee banks such as Abbey National and BNP Paribas that have issued prefs in the US market to fund their North American lending business. The other European name is insurance company Prudential.

The index, which is called PDX, started trading on 15 September and rolls semi-annually. PDX has a Moody's weighted average rating of Baa1 and was priced with a 0.65% coupon. On 21 September it was quoted at 65/65.5bp. Trades are documented with modified restructuring for North American names and 'Mod Mod R' for European entities. Lehman Brothers says it is making a market in the index with a bid-offer margin of one half basis point.

Says Thomas Corcoran, managing director and head of hybrid capital at Lehman Brothers in New York: "We had traditional investors in preferred securities participating on day one of the index, as well as leveraged type investors doing their first ever trade in the preferred part of the capital structure."

Adds Ashish Shah, co-head of credit strategy at Lehman Brothers, New York: "This is a way for traditional investors to diversify their risk and to hedge their existing cash preferreds. There are many opportunities for basis trades. Leveraged type investors are taking directional views on both sides, and there is trading versus the CDX and iTraxx indices, as well as single name versus PDX."

The launch of PDX builds on Lehman Brothers' activities in single name preferred credit default swaps. The bank has been making a market in single names since February 2005.

"We make daily markets in 60 names," says Corcoran, "and away from those names on request." According to the bank, trading volumes in the more liquid of these names can total more than $100 million of notional a day. Other dealers that are making prices in preferred credit default swaps are Bear Stearns and JP Morgan. Lehman Brothers says it is making 4bp to 5bp markets in single names.

Although credit derivatives referenced to subordinated bank debt are widely traded, preferred securities mark a new frontier for the default swap market. Such securities rank below subordinated debt but above common stock. They are issued either as perpetuals, or in the case of trust preferreds, have very long dated final maturities. Coupons or dividend payments can be deferred. Such payment deferrals count as a credit event in the contract developed by Lehman Brothers, in addition to bankruptcy, failure to pay and restructuring.

Most types of preferred and trust preferred securities can be delivered into the contract, but mandatory convertibles - convertibles which must convert into the common stock - are not deliverable. Securities that rank higher than the preferred are also eligible.

Traditional investors in the North American preferred securities market are money managers, insurance companies and preferred funds. Historically these have been long-only investors, but Shah says the introduction of credit derivatives is changing that.

Heavy issuance volumes in recent months, partly fuelled by the introduction of more favourable rating agency treatment, have created a growing desire by some banks and investors to hedge bank names at this point in the capital structure. But until the advent of preferred credit default swaps, these securities were difficult to short because of repo restrictions.

Meanwhile, for offshore leveraged trading accounts, tax disadvantages are a barrier to entering the cash preferred market in North America. The development of a synthetic contract removes that barrier.

Corcoran says he anticipates other dealers joining the index as market makers.

Preferred credit default swaps have typically been trading at around two-and-a-half to three times the senior default swap spread. Corcoran says the PDX is currently trading at around 2.6 times where a senior index of those names would trade.

As with credit derivatives on interest-deferring asset-backed securities, opinions in the market have varied on the best way to treat payment deferrals on preferreds. Says Lehman Brothers' Shah: "If you do not treat payment deferral as a credit event, all you are left with is a low recovery senior credit default swap. The value here is actually the deferral trigger. Deferral is a major credit event for most companies. The feedback from clients was that this was the feature that made the product most interesting and useful."

Euan Hagger



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