Too Big to Ignore

Debt derivatives markets are encroaching on corporate finance decisions.

No market worth nearly $30 trillion can be easily ignored. But until recently that’s what most CFOs did when it came to credit-default swaps. And not without good reason. Default-swap investors make bets on a company’s creditworthiness without necessarily owning the underlying bonds, and with no legal claim on corporate assets, why should CFOs care about the derivative traders’ concerns?

“Put simply, derivatives trading is nothing but gambling,” says Richard Nevins, a London-based corporate lawyer specialising in complex transactions at Cadwalader, Wickersham & Taft (CWT). “CFOs may find it somewhat distasteful to take this marketplace into account because, let’s face it, it’s the world’s biggest casino.”

After doubling in size annually for over a decade, the default-swap market is now ten times the size of the corporate bond market. Whereas once bondholders bought default swaps as protection against default, investors these days purchase corporate debt to protect default-swap positions. Not surprisingly, more than 60% of trading is now accounted for by hedge funds, according to consultancy Greenwich Associates.

Some default-swap bets are so large that investors “manipulate the bond market as a result,” according to Robert McAdie, head of global credit strategy at Barclays Capital in London. And when the wishes of derivatives investors clash with the priorities of corporate borrowers, CFOs can’t help but take notice.

Some recent examples show how the booming debt derivatives markets are encroaching on corporate decision-making.

Avis: Protection Money

Last year, Avis Budget Group became the sole legal corporate descendent of Cendant, after the American conglomerate split into four companies. As a result, the default swaps written on Cendant’s debt were worthless. However, by convincing Avis to issue an essentially meaningless parent-company guarantee on bonds issued by its main subsidiary, Cendant default-swap investors reactivated their contracts.

To that end, a group of default-swap investors paid $14m to Avis Budget Group in February to guarantee the bonds of its subsidiary, Avis Budget Car Rental — a strange move, given that the parent company’s credit rating was lower than its subsidiary. “Any additional asset protection that the parent could offer at the current moment is minuscule at best,” wrote analysts from CreditSights at the time. A multi-million dollar return for a minor legal tweak was certainly a shrewd move by David Wyshner, CFO of Avis.

“We can truly say that this ‘consent fee’ wasn’t expected and reminds us that the mechanics of the credit-default swap market remain open to new strategies in the absence of more definitive rules and regulations,” noted the CreditSights analysts.

“The economics must have been hideous to push the investors to pony up cash and, in essence, bribe the company to achieve a certain outcome,” notes Nevins of CWT.

Experian: Stepping Up

In another corporate break-up last year, Experian, which produces personal credit reports, inherited its parent’s debt when U.K. retail group GUS split itself up. Experian soon found itself a buyout candidate, spooking bondholders. To allay their fears, Experian offered a change-of-control clause, which included a small consent fee and the option to redeem bonds at par. To the company’s surprise, holders of its 2013 bond rejected the change in terms. Several hedge funds with large default-swap positions had bought the bonds in order to resist a tender, which would “orphan” their derivatives contracts.

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