U.K. Retailer’s Struggle Sparks Warning on `Flawed’ Derivatives

LONDON (Capital Markets in Africa) – The $11 trillion market for credit derivatives is coming under renewed criticism in Europe because of concerns that one of the region’s riskiest companies is heading for a debt restructuring that could expose shortcomings in default insurance.

Hedge fund Sona Asset Management and JPMorgan Chase & Co. have flagged risks from a possible restructuring by U.K. retailer New Look because of flaws in the way credit-default swaps are designed to compensate for losses. The founder of London-based Sona sent a letter to dealers this month asking for improvements in the protection provided by high-yield contracts.

Investor confidence in the derivatives has already been tested this year by challenges settling swaps linked to Spanish lender Banco Popular Espanol SA and commodity trader Noble Group Ltd. despite a series of corrections since the debt crisis. Weaknesses remain after the market was overhauled locally in 2009 to improve transparency and standardize settlements, and in Europe in 2014 to address problems in sovereign and financial contracts.

“I love the product, but it is hugely flawed, and until we fix those flaws it will remain severely below its potential,” Sona founder John Aylward wrote in the letter. “I want to see high-yield credit-default swaps work better/properly.”

Problem Areas
Aylward proposed changes to several “problem areas” for high-yield swaps in Europe that he said would be highlighted by a New Look restructuring. The letter focused on how payouts could be distorted if the U.K. clothing retailer were to write down its debt — a scenario that’s rarely occurred with companies covered by swaps. He wrote that he doesn’t hold contracts on New Look and declined to comment beyond the letter.

While New Look says it has adequate liquidity and cash, market participants have been assessing debt-restructuring options. Its swaps are the second riskiest in Europe’s high-yield benchmark and signal an 85 percent probability of default within five years, according to data compiled by Bloomberg and CMA.

Chief Executive Officer Anders Kristiansen stepped down in September after first-quarter earnings fell 37 percent. The retailer cited weaker U.K. consumer demand following last year’s vote to leave the European Union and said in June that it needed to be faster at responding to shifting trends and consumer habits. New Look has 177 million pounds ($237 million) of senior unsecured bonds and about 1.1 billion pounds of secured notes, according to data compiled by Bloomberg.

New Look is owned by South African investment firm Brait SE. External spokesmen for both firms in London declined to comment on a possible debt restructuring.

New Assets
Aylward suggested aligning rules governing credit-default swaps on high-yield companies with those linked to governments and financial firms. Corporate contracts were left out of the 2014 overhaul, which sought to ensure payouts when sovereign or bank debt is wiped out or converted into equity.

Under those changes, which sought to address flaws exposed by Greece’s debt restructuring and the Dutch government’s seizure of bonds issued by lender SNS Reaal NV, traders can deliver debt or equity they receive in a restructuring in place of original bonds into swap-settlement auctions.

Sona is calling for the principle of asset-package delivery to be extended to high-yield companies because of the risk that a write-down could leave traders without obligations to settle swaps. JPMorgan and other market participants have also warned that a restructuring of New Look could eliminate assets to determine payouts.

Ugly Situation
“There could be a very ugly situation with New Look where the bonds are wiped out or moved to a different entity and the credit-default swaps don’t pay at all,” said Jochen Felsenheimer, the Munich-based managing director of XAIA Investment GmbH. “Asset-package delivery is seen as crucial for financial credit swaps and now the same is true for corporates.”

Sona is also seeking to replace multiple swap settlement auctions based on contract maturities with a single auction to determine compensation after restructuring events.

Maturity buckets became the market standard in 2009 to smooth payouts on swaps triggered by debt reorganizations in Europe. Still, they complicate trading because the timing of a restructuring determines which bonds can be used to set compensation for each group of swaps and can skew results, according to Sona and JPMorgan.

Maturity Buckets
While uncommon, cracks appeared from the beginning. Less than a year after bucketing was adopted, credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later. New Look’sbonds maturing in July 2023 — the only obligations covered by credit-default swaps — wouldn’t be eligible to settle five-year contracts if they’re restructured before June, JPMorgan wrote in a note to investors.

Separately, Sona is calling for clarity on whether the U.K. scheme of arrangement process constitutes a bankruptcy or restructuring credit event. Bankruptcy is more straightforward for credit-default swaps because all contracts are triggered and settled automatically.

“Corporate restructurings have become more complex and credit derivatives haven’t been able to keep up,” said Louis Gargour, chief investment officer of London-based LNG Capital, an alternative investment management firm. “A cleaner, conclusive process would be better for everyone.”

Shrinking Market
Despite the flaws, traders may resist Aylward’s proposals. Unlike sovereign debt overhauls or government interventions in financial markets, where writedowns can be imposed on creditors, corporate restructuring plans are typically subject to a vote. Some bondholders may be incentivized to accept an asset package that’s bad for other creditors and protection sellers if they’re allowed to exchange it for an insurance payout.

Similarly, bondholders and swap sellers may prefer imperfect buckets to a single settlement auction because payouts more closely reflect how different bond maturities are affected by corporate debt restructurings. Dealers may be reluctant to introduce new contracts that can’t be offset by existing swaps on their balance sheets.

The credit derivatives market has shrunk since the crisis as regulations put banks off from taking risk and unpredictable payouts discourage investors. Outstanding volumes have contracted by 20 percent in the past two years, according to the International Swaps & Derivatives Association, which oversees the market.

“ISDA’s industry working groups periodically discuss potential modifications to the credit derivatives definitions that are raised by ISDA members,” spokesman Nick Sawyer said in response to a request for comment on contract flaws. “Any updates tend to reflect changes in trading practices that have emerged, and require consensus across all relevant parts of the industry.”