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Canada Notes Roil Catastrophe Credit Swaps on Unwind Concerns

The cost of derivatives protecting against economic meltdown have jumped to the highest since May on speculation banks will need to buy the contracts as funds seek to restructure a type of Canadian structured note, according to Citigroup Inc.

The so-called super senior slice of the seven-year Markit CDX North America Investment Grade Index Series 9, a credit swaps benchmark that was created in 2007, has climbed 6 basis points since Nov. 9 to 29 basis points, Citigroup data show.

The super-senior contract, which pays out if more than 30 percent of corporate bonds underlying the swap are wiped out, is climbing on concern investors may liquidate bonds that were created in 2007 to restructure C$32 billion ($31.9 billion) of insolvent Canadian commercial paper, said Mikhail Foux, a credit strategist at Citigroup in New York. The full corresponding gauge that loses value after any of the 125 companies in the index default, gained 0.8 basis point over the same period.

“It’s nothing more than just speculation,” Foux said in a telephone interview yesterday. While possible, a widespread unwind of the notes isn’t likely because it would require the agreement of other parties in the deal, he said. “It would be extremely complicated.”

The bank recommended investors sell protection on the super-senior contracts to benefit from ‘overdone’ concerns in a Dec. 8 report.

Canada’s market for non-bank administered asset-backed commercial paper collapsed in August 2007 on concern that part of the short-term debt was backed by U.S. subprime mortgages. More than 100 companies and 1,765 individuals were saddled with paper that couldn’t trade until a court-ordered plan to convert the short-term debt into longer-term notes was completed 17 months later.

Hedge Funds

While the cost to protect against unprecedented losses is climbing, the restructured debt is gaining in value as credit markets stabilize and the notes move closer to maturity.

U.S. hedge funds were offering companies holding the debt as much as 73 cents on the dollar for the highest-quality notes, said Colin Kilgour of Kilgour Advisory Group, a Toronto-based firm advising companies on the debt. That’s 20 percent more than at the start of the year and about 60 percent better than the first trades in 2009 after the debt swap.

The restructured bonds, known as MAV Notes, are largely backed by the most senior pieces of so-called synthetic collateralized debt obligations that guarantee against default on corporate debt.

Synthetic CDOs package credit-default swaps, and slice them into securities of varying risk.


Because of their rank, super-senior swaps were designed to lose on the bets only after all of the lower-ranked pieces had been wiped out. To generate yields higher than similarly rated investments, the securities, called leveraged super seniors, guaranteed debt that was up to 10 times the initial investment.

Banks that created the structures and sold them to investors used other derivatives, including the super senior slice of the Markit CDX index, to offset the risk of losses from their side, or leg, of the CDO trade.

Some of the owners of the MAV notes may seek to cash in on their debt by unwinding the structures, including the banks’ hedges, potentially requiring the dealers to buy more protection to keep the risks on their books balanced, Citigroup’s Foux said.

The anticipation of such a move has pushed the cost of the super-senior slice of the Markit CDX index to climb, he said.

Investors should buy protection on the entire five-year Markit CDX investment-grade index Series 9 and sell protection on the super-senior portion of the index, Foux said in the report, to profit from the market “overreaction.” As the super senior slice drops relative to the full index, the trade gains.

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