Conversation surrounding the U.S. loan credit default swap index (LCDX) was buzzing last week as both investors and traders at The Loan Syndications and Trading Association's Loan Only Credit Default Swaps conference in New York on Wednesday, geared up for the index's May 22 launch. And despite initial skepticism about the product's success, market players were optimistic about its acceptance.
"The launch date is set, chisel it in stone, get your tattoo, it is six days away from trading," said panelist Tom Price, managing director and the global head of CDS and loans at Markit Group. And hopes were high. "Every dealer is going to trade this index and in big size," said panelist Doug Grossberg, vice president in the syndicated loan group at Credit Suisse.
While the loan only credit default swap (LCDS) product has grown in popularity to almost $60 billion so far in 2007 from $6.3 billion in 2005, it has not even come close to the leveraged loan amount outstanding, which stood at $450.6 billion in 2007 year-to-date, according to Lisa Watkinson, managing director in the structured credit business development group at Lehman Brothers. However, the LCDX could double the LCDS market's popularity by the end of the year, she said.
And demand for senior secured risk is growing beyond anyone's imagination, said Alan Alsheimer, vice president in leveraged finance at Goldman Sachs. This extends beyond traditional cash loan players. "There are a slew of new names that have come to market, and there are new allocations to accounts that have come in from other parts of the market," he said. Among the flood of players that will be tapping the LCDX will be index tranche traders that will use the product as a hedging tool, and CLOs that will use the index to help them ramp up more quickly and put cash to work, Credit Suisse's Grossberg said.
And the LCDX product comes to market with a lot of underlying liquidity, Grossberg said. Investors will probably buy in at 120 to 150 basis points, he suggested.
The new spread
The LCDX index will be composed of 100 equally weighted loan only credit default swaps, each of which will reference a senior secured loan. And the index will be traded on price with a fixed spread and subject to net physical settlement in the event of default, the same auction process that is used in the unsecured credit default swap market.
"The LCDX will incorporate a seasoned and tested model for recovery," said Alsheimer. The LCDX trades will be settled by an auction format, which combines the cash and physical settlements giving investors the option to cash settle at the final price or obtain physical delivery of the loan through the auction where the loans can be bought or sold at the final price.
And if there is no credit event but instead a prepayment, the index would factor down by the one coupon that is prepaid, and the index will still trade, Alsheimer said. If there is no credit event at all, the index will "reroll" in October and take out and replace 10 to 15 names in order to create more liquidity.
But there are skeptics. Indeed, several years ago Credit Suisse launched the Select Aggregate Market Index (SAMI), which referenced 50 syndicated bank loan names with a buy in at 245 bps. However, at that time there was not much market for the single name LCDS and 2003 through 2005 had a significant number of refinancings, said Grossberg, which really chopped the index down. Currently, the SAMI index has about five names and is really just unwinding, he said.
Moreover the high number of covenant-lite deals is a concern for investors and traders, who think these structures will have an impact with a 25% lower trigger to recovery, Alsheimer said.
Whether there will be more sellers than buyers, or vice versa, remains to be seen according to the panelists, though all agreed that the index will see action from both sides. However, Credit Suisse's Grossberg suggested that the buy side might start off a bit heavier. "When the dust settles, more people will want to take loan risk than sell loan risk," he said. "[The index] may initially trade at par or below."
While the LCDX is the first index in its series, it is called the series eight, in reference to the family of indices that launched before it. Following the format of the ABX index that launched its first series at number six and then with another series at number seven, the LCDX will continue the count so that it is pari with the other markets in the CDX family.
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