Default Swaps on Junior Debt Undervalued, Morgan Stanley Says

Investors are undervaluing outstanding credit-default swaps on subordinated financial debt as they anticipate changes to the market will make future contracts more effective, according to Morgan Stanley.

The Markit iTraxx Financial Index of swaps on the subordinated debt of 25 European banks and insurers fell to 177 basis points, the lowest in almost three years, on May 22. That was after the International Swaps & Derivatives Association proposed changing the contracts to explicitly protect against debt writedowns, exchanges or conversions into equity. The gauge climbed seven basis points today to 218 basis points.

The index dropped as investors shunned existing contracts out of concern they provide insufficient coverage when governments impose losses as part of bank bailouts and that they’ll become hard to buy and sell when the improved terms are adopted. The changes are part of the biggest overhaul to the swaps market in a decade, seeking to fix flaws that resulted in buyers of protection on SNS Reaal NV’s bonds losing out after the notes were expropriated by the Dutch government.

“This proposed change is clearly valuable for buyers of protection in a new contract, in specific scenarios,” Morgan Stanley analysts led by Phanikiran Naraparaju in London wrote in a note to investors. “We think the market underestimates the utility of existing contracts.”

The swaps proved effective when Iceland’s banks defaulted and Irish banks were restructured, according to Morgan Stanley

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A basis point on a contract protecting 10 million euros ($13 million) of debt from default for five years is equivalent to 1,000 euros a year.

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