What it means
Credit protection contracts cannot pay out on vague deterioration, because the parties need certainty about when money changes hands. Standard documentation therefore lists the exact events that count, the grace periods that apply and the minimum amounts involved, so that a missed $2,000 invoice does not trigger a $50,000,000 payout.
Failure to pay is the most common trigger and usually requires a missed payment above a threshold, often $1,000,000, that remains unpaid after any contractual grace period. Bankruptcy covers formal insolvency proceedings, while restructuring covers changes forced on lenders such as a maturity extension, coupon reduction or subordination.
The decision is not made by the parties to the trade. An industry determinations committee rules on whether an event has occurred, which prevents endless bilateral disputes and means the same answer applies to every contract on that borrower.
Once an event is declared, settlement is normally by auction. Market participants submit bids for the defaulted debt, a single final price is established, and every contract settles in cash against that price rather than through physical delivery of bonds.
The nuance that catches people out is that a credit event is not the same as a default in ordinary speech. A company can be widely regarded as distressed, trading at a fraction of par, without any contractual credit event having occurred, and protection buyers receive nothing until one does.
In practice
Real-world examples.
Example
A retailer with $600,000,000 of bonds misses a $22,000,000 coupon and lets the 30-day grace period lapse. A failure-to-pay credit event is declared, an auction sets recovery at 18%, and protection buyers receive 82 cents on the dollar of notional.
Example
An airline negotiates with bondholders to extend maturities by four years and cut the coupon from 7% to 4%. Because the change is imposed across the class of holders, it is ruled a restructuring credit event even though no payment was actually missed.
Example
A property group files for formal insolvency protection. The bankruptcy credit event triggers immediately with no grace period, and a bank that had bought protection on $40,000,000 of exposure receives settlement within about five weeks.
Formula
Calculation
Cash Settlement Payout = Notional x (1 - Final Auction Price)
An investor holds $5,000,000 of protection on a telecoms borrower. The borrower misses a coupon, the grace period expires, and a determinations committee rules that a failure-to-pay credit event has occurred. An auction is held and the final price is set at 30% of face value.
Cash Settlement Payout = $5,000,000 x (1 - 0.30) = $3,500,000
The protection buyer also owes accrued premium from the last payment date up to the credit event date. On a 300 basis point spread, which is 3%, an accrual of 45 days works out at $5,000,000 x 0.03 x (45 / 360) = $18,750. The net receipt is therefore $3,500,000 - $18,750 = $3,481,250, and the contract then terminates rather than continuing to the scheduled maturity.Case study
Seen in the real world.
Halden Marine Logistics is an invented shipping group used here as an illustrative case. Its bonds fell to 42 cents on the dollar over eight months as freight rates collapsed, and a fund holding protection on $20,000,000 of Halden debt assumed it was close to being paid out.
No credit event occurred. Halden kept meeting every coupon on time by selling vessels, and it renegotiated its bank facilities voluntarily with unanimous lender consent, which fell outside the restructuring definition in the fund's contracts. The fund paid three further years of premiums at 500 basis points, roughly $1,000,000 a year, and the contracts expired worthless even though the underlying bonds had lost more than half their value.
The illustrative lesson is that credit protection pays on defined events, not on distress. Mark-to-market pain and contractual triggers are two different things.
Watch out
Common mistakes.
- Assuming a falling bond price signals a credit event. Price reflects market opinion; a credit event requires a specific contractual failure to have actually happened.
- Overlooking grace periods. A missed payment cured inside the contractual grace period is not a credit event, however alarming it looked at the time.
- Believing the counterparties decide. An independent determinations committee rules on the question, and its decision binds all contracts on that borrower.
Questions
People also ask.
What are the recognised categories?
The main ones are bankruptcy, failure to pay and restructuring, with obligation acceleration and repudiation used in some sovereign and emerging market contracts.
How quickly does settlement happen?
The auction typically takes place within roughly a month of the determination, and cash settles a few business days afterwards.
Does a credit event mean investors lose everything?
No, holders recover the auction price, so a 40% recovery means bondholders keep 40 cents on the dollar and protection pays the remaining 60.
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