UK credit checking firm Experian’s decision to incorporate a change of control coupon step-up clause into the documentation for its 2013 bonds was a rare example of a corporate taking into account (at a cost) the needs of the CDS market in restructuring events. The fallout from such events is usually bad news, as CDS investors in Rentokil, WPP, ITV, VNU and Cablecom will readily testify. But just because GUS caved in, does that necessarily mean other names are more likely to do so in future disputes?
One very important factor needs to be taken into account in the GUS case: most of the investors holding the CDS held the cash bond as well, and it is this that gave them their voice. More and more investors in CDS also buy the underlying bond (with covenant language) in order to have a place at the table if and when an event occurs. The vocal lobbyists in the GUS/Experian case were hedge fund prop desks that held cash bonds and CDS – indeed, anecdotal evidence suggests that the majority of bondholders in the 2013 bond held both. So these weren’t just investors who had happened to take a punt on GUS, they were funds that had lent it money (a factor that will not have been lost on the corporate itself). This has to have influenced the way in which their concerns were received.
Perhaps another interpretation of events is that if you are going to take a CDS position you are well advised to protect it by making sure you have a position in the underlying bond as well. But the Experian decision should not be dismissed as merely that – it is indeed a milestone event in the credit market. This is because rather than illustrating a shift in the balance of power between one investor constituency and another it underscores the extent to which the market is now integrated. As one credit derivative veteran puts it: “There is no longer a bond market and a CDS market, there is simply a credit market.”
Many companies have traditionally taken the view that they cannot be responsible for derivative contracts that they are not party to and that are written in a market in which they have no involvement – a not unreasonable position to take. But what decisions such as Experian’s show is that corporates simply cannot afford to take this stance any more. Yes, they are not party to CDS contracts and have no responsibility for them but the CDS market itself has an influence on every part of their activities in the debt capital markets.
First, companies need to recognize that the investors buying their bonds are also buying their CDS – they are the same people. So if they do not incorporate covenant language into the bond documentation to protect the CDS, they will simply not be able to sell as many bonds. Secondly, cash bonds price off where the CDS is trading and the latter is therefore fundamental to any new funding. Thirdly, the CDS market can actually create demand for bonds: for example, where there is a significant negative basis, demand for the bond will be created by people wanting to do basis trades. In these circumstances corporates are able to issue more debt at spreads they may not have otherwise been able to achieve simply due to the demand for paper to satisfy negative basis trade opportunities.
Corporates therefore need to recognize that they do need to care about their CDS investors and that the old attitude of concentrating on the requirements of bondholders alone will simply no longer wash. Sophisticated investors now invest in a sophisticated way: if they buy the cash bond and then decide that they don’t like the credit then they no longer sell it they just write protection against it. People invest in an integrated way and if corporate treasurers do not accept that then they misunderstand the entire market for their securities.