By Mike Kentz
Fri Feb 20, 2015 2:45pm EST
NEW YORK, Feb 20 (IFR) - An auction for RadioShack credit default swaps next month is expected to be more complex than usual due to a scarcity of bonds that is likely to make it hard to value the securities.
The International Swaps and Derivatives Association (ISDA) is holding the auction to determine the value of credit default swaps written on RadioShack's 6.75% US$324m May 2019 issue that is bid at just 13.5 cents on the dollar.
It is the first case of its kind since ISDA changed the way auctions can be settled in 2009 in a overhaul known broadly as the "Big Bang," according to ISDA.
Those changes ultimately allowed the contracts to be settled in cash as well as physical delivery.
Analysts said it would be difficult to predict the extent of losses sellers of CDS may face or, if they are lucky, an elevated CDS recovery final auction price.
CDS contracts are settled through an auction where buyers deliver a physical bond to sellers and then receive a cash payout based on the bond's price. Buyers and sellers can also choose to settle financially.
The final price is determined by the net demand by participants to physically deliver or physically receive the bond. The majority of contracts are cash-settled, but the auction price on the first week of March that determines payouts across all CDS contracts will be determined by the net physical settlement demand.
In most cases, supply and demand even out. But in this case, the shortage of bonds relative to CDS has some worried that more requests could come in on either side that would skew the final price of the bond.
Participants that hold both the bond and CDS would want to physically deliver the bond because it would remove the price risk associated with the auction. Sellers of CDS would want to receive the bond to guarantee themselves a spot in the bankruptcy process and at least some return rather than only paying out.
"While the auction process typically functions well, we would not be surprised to see significant volatility in the RadioShack 6.75s around the auction and an elevated CDS recovery final auction price," said Eric Gross, credit analyst at Barclays.
If Gross turns out to be right, CDS holders will get more bang for their buck, but others said it was just as feasible for the opposite to happen.
"There have been a number of notorious bond squeezes when there have been a lot of CDS outstanding and fewer deliverable bonds," said Paul Forrester, a partner in Mayer Brown's structured finance practice.
"It can drive up the price of the scarce bonds if more CDS settle physically, and in such a situation CDS buyers could get smaller payouts than they might otherwise have expected."
Market participants explained that sellers of CDS that don't own the bond would want to receive the bond because it gives them rights in the bankruptcy proceedings, primarily.
"It's difficult to predict because there's low visibility, but in this case we think the risk skews towards higher demand to receive the bond rather than deliver it, which would raise the CDS recovery price," said Jigar Patel, another credit analyst at Barclays.
But any rush to stock up on bonds could push their value higher, and ultimately lower the payout on CDS, and vice versa.
Some players have already sought to avoid any potential upset on payouts. While the US$476m outstanding in CDS is significantly higher than the available bonds outstanding, the number is markedly down from previous month's levels.
That signals some participants have already closed out positions ahead of the auction.
One month ago, RadioShack CDS net notional outstanding totaled US$532m. A year ago, it was over US$1bn.
"Unless you're a holder of both the CDS and the bond, you're probably not thinking you need to hold on to the contract any longer," said Patel. "Investors have kind of gotten the result they expected now, so it appears that people have been reducing positions."
THE PROCESS
The final payout is a two-stage process. First, dealers pool net demand from clients holding CDS positions to determine the 'open interest' for the bonds and provide two-way markets to establish an initial price indication.
In the second phase, market participants have several hours to submit either bids or offers, as required, to clear the open interest. The final price is determined by the price at which the open interest is cleared.
RadioShack filed for Chapter 11 bankruptcy this month. It plans to close 1,700 stores this month and sell 2,400 stores to Standard General, which is also the chain's leading lender.
The restructuring process is expected to be a long, drawn out affair, with unsecured creditors saying the company should have filed for bankruptcy in May when it first planned to close more than 1,000 unprofitable stores. (Reporting by Mike Kentz; Editing by Natalie Harrison and Shankar Ramakrishnan)
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