Distressed Wave Tests Traders Mettle in $10 Trillion Swap Market

(Bloomberg) -- The rising tide of distressed companies in Europe is boosting the appeal of a much-criticized corner of the $10 trillion market for credit insurance.

Credit-default swaps -- derivatives that pay out when a company defaults on debt -- have brought at least $1 billion in windfalls to their holders in Europe this year, more than double the 2018 total, according to a Bloomberg analysis of settlement auctions. Credit Suisse Group AG and hedge funds Diameter Capital Partners and Sona Asset Management are among investors that made money by using CDS to bet against stressed firms this year.

Read More: Titans of Junk - Behind the Debt Binge That Now Threatens Markets

CDS insure bondholdings against default and can be used by hedge funds to bet on borrowers going bust. The pickup in payouts is the result of more companies struggling amid slowing growth in Europe and shifting consumer habits.

“When a company is in distress, CDS is one of the best ways to trade the risk,” said Duncan Sankey, head of credit research at Cheyne Capital in London.

The collapse of travel group Thomas Cook, a debt restructuring at U.K. fashion retailer New Look and court protection for the owner of French supermarket chain Casino Guichard-Perrachon SA all triggered CDS payouts this year, making money for the traders that held them.

Credit Suisse emerged as one of the winners from this year's CDS market. The bank's high-yield credit team posted its best ever half-year revenue, with winning bets against Thomas Cook before it collapsed in September and profiting from credit insurance on French equipment rental firm Loxam, according to two people familiar with the matter.

Credit Suisse also used the CDS market to successfully bet on a company rebound. It sold swaps on debt collector Lowell, putting the bank on the hook to pay out in case of default, but the company's performance improved and the CDS tumbled, according to the people.

Jonathan Moore, head of credit for Europe, the Middle East and Africa at the bank acknowledged the team's winning strategies but declined to comment on individual trades.

U.S. hedge fund Diameter Capital Partners profited from swaps on Rallye SA, the parent of French retailer Casino. Diameter's co-founder Scott Goodwin recommended buying three-year CDS tied to Rallye last year and the contracts were triggered for total compensation of $522 million in June.

Thomas Cook was also a winning trade for London-based hedge fund Sona Asset Management which also bet against New Look and posted more than 9% returns net of fees this year, according to a person familiar with the matter who spoke on condition of anonymity because the information isn't public.

Representatives for Diameter and Sona declined to comment on the firms' trades.

Losing Trades

While some investors used distressed CDS for successful bets, others lost money, highlighting they are a risky bet that few outside the hedge fund community are prepared to touch.

The contracts were widely criticized for their role in the 2008 financial crisis and more recently they've been at the center of a crackdown on manufactured credit events where investors entice companies to miss bond payments they could otherwise make. Even the Pope has linked the swaps to “extremely immoral actions.”

Even JPMorgan Chase & Co, the firm that invented them in the 1990s, tripped up on swaps positions this year. It was on the wrong side of trades on Rallye and telecom company Altice Europe NV, according to people familiar with the matter.

Citigroup Inc.'s high-yield desk faced losses earlier this year as the seller of credit insurance on Thomas Cook. The bank also took a hit after it bought credit protection on Altice before the swaps declined, according to people familiar with the trade.

Another investor to lose money on Rallye CDS was former GSO trader Akshay Shah, known for creating manufactured credit events in 2013. Shah's fund Kyma Capital sold credit swaps on Rallye, according to people familiar with the matter.

Representatives for JPMorgan, Citi and Kyma all declined to comment on their trades.

Busy Outlook

Investors are now preparing for what could be an even busier year for CDS traders. Slowing European growth is likely to mean more companies downgraded to junk and increases in default rates.

Traders are pricing in 80% odds of default within five years for British restaurant chain PizzaExpress Ltd., which may be in line for a debt restructuring, according to ICE Data Services. Dutch retailer Hema and British food producer Boparan both have more than 65% odds of missing debt payments, the data show.

“Going into 2020, it may be even easier to make money out of single-name CDS,” said George Kaknis, a portfolio manager at LNG Capital in London. “It's going to be an environment where you really have to pick your battles.”

To contact the reporter on this story: Katie Linsell in London at klinsell@bloomberg.net

To contact the editors responsible for this story: Vivianne Rodrigues at vrodrigues3@bloomberg.net, Chris Vellacott

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