Sears Found Some Useful Bonds

In simplest terms, credit-default swaps are contracts that pay off when a company defaults on its debt, allowing their buyers to bet against the company’s credit, or to hedge their exposure to its debt. But when we talk around here about CDS, we are almost never talking about it in its simplest terms. Instead, we talk about the tricky intricacies of CDS that make it not work the way you’d simplistically expect it to.

For instance, we’ve recently discussed a couple of stories about “orphaning” CDS. There’s a company that issues debt, and people write CDS on that debt. Then the company pays off the debt and doesn’t issue any more, replacing it with other debt of a different but related company that doesn’t “count” for CDS purposes: Perhaps the company is acquired and the acquirer issues new debt to repay the target’s old debt, or perhaps the company just issues debt out of a new subsidiary to pay off debt issued out of an old subsidiary. Either way, the old debt issuer goes away, so CDS on it can’t pay out, so people who wrote that CDS have a windfall and people who bought that CDS have a loss. If a company issues $1 billion of debt out of Subsidiary X and there’s a thriving CDS market on Subsidiary X, and one day it issues $1 billion of new debt out of Subsidiary Y and uses the proceeds to pay off the Subsidiary X debt and never issues out of Subsidiary X again, the Subsidiary X CDS investors are out of luck, because it has no more debt that could possibly default.1