Morgan Stanley creates CDS on leveraged loans

Morgan Stanley has extended the realm of the credit default swap (CDS) market from the traditional investment-grade and high-yield asset classes to European leveraged loans. It is hoped that broadening the credit derivative product will also help promote growth of the loan market.

It is understood that Morgan Stanley has been working on this project for a number of months and is close to redeveloping and structuring CDS referencing leveraged loans. Morgan Stanley initially plans to price protection on between 25 and 30 of the most actively traded loans in the European market, some of which also have publicly traded high-yield debt. More names will be added in the future.

By using CDS, banks and fund managers will be able to hedge out any risk on existing names in portfolios, as well as trade and take short positions. The move will open the door to more complex strategies such as taking long or short positions based on secured, second lien and mezzanine leveraged loans.

CDS contracts will be provided in either US dollar, euro or sterling format. Also the leveraged loan CDS will be callable, in contrast to prevailing high-grade and high-yield CDS, in the event of a redemption of the contract, a change of control or a fully underwritten new deal.

The triggering of a credit event will result in the settlement with a loan tranche that ranks pari passu in the capital structure or more senior debt. This means that a senior loan CDS contract could be settled by any similar term loan or revolver, while a senior mezzanine CDS contract could be settled using mezzanine, second lien or senior debt.

Although the contracts will follow existing 2003 International Swaps and Derivatives Association definitions on what is a credit event, it is understood that Morgan Stanley has adjusted these terms to suit the loan market.

The product will be available across the wide spectrum of maturities although when the market becomes more sophisticated it is expected that a liquid point on the curve will materialise. This is expected to be in the most popularly traded three- to five-year maturities.