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CDS Spleen

24 August 2017 by pdonnat

ELEPOR (EDP – Energias de Portugal, S.A.) credit default swap rallied by 16 bps today on orphaning risk per a publication from a major CDS market maker. ELEPOR is currently issuing new bonds through a Dutch subsidiary, EDP Finance BV. ELEPOR is not issuing any bond anymore directly from the operating company. Surprisingly there is only a keepwell agreement between the financing company and the operating company. According to the basics of banking only unconditional, irrevocable and at first demand guarantees are worth to be considered. ELEPOR bond investors are confident that the light recourse on the operating company is enough. Credit default swap investors are not so confident - a default on the bond does not trigger an ELEPOR credit default swap event. The ELEPOR CDS should be rolled into a CDS referencing directly the financing company. This does make no sense. There are so many cases where the financing vehicles are transformed and the buyers of CDS are left with an orphaned CDS. This has happened so many times for members of the European high yield universe. Investing in CDS on a financing vehicle is a bet - not a hedge - due to the orphaning risk for the buyer and the subordination risk for the seller. As a rule of thumb, CDS on operating companies only are worth to be invested in rationally. CDS on financing vehicles should be avoided.
Meanwhile, the credit market is on standby waiting for the omen from Jackson Hole.