UK retailer’s struggle sparks warning on ‘flawed’ derivatives

The $11tn market for credit derivatives is coming under renewed criticism in Europe because of concerns that one of the region’s riskiest companies is heading for a debt restructuring that could expose shortcomings in default insurance.Hedge fund Sona Asset Management and JPMorgan Chase & Co have flagged risks from a possible restructuring by UK retailer New Look because of flaws in the way credit-default swaps are designed to compensate for losses. The founder of London-based Sona sent a letter to dealers this month asking for improvements in the protection provided by high-yield contracts.Investor confidence in the derivatives has already been tested this year by challenges settling swaps linked to Spanish lender Banco Popular Espanol and commodity trader Noble Group despite a series of corrections since the debt crisis. Weaknesses remain after the market was overhauled globally in 2009 to improve transparency and standardise settlements, and in Europe in 2014 to address problems in sovereign and financial contracts.“I love the product, but it is hugely flawed, and until we fix those flaws it will remain severely below its potential,” Sona founder John Aylward wrote in the letter. “I want to see high-yield credit-default swaps work better/properly.”Aylward proposed changes to several “problem areas” for high-yield swaps in Europe that he said would be highlighted by a New Look restructuring. The letter focused on how payouts could be distorted if the UK clothing retailer were to write down its debt – a scenario that’s rarely occurred with companies covered by swaps. He wrote that he doesn’t hold contracts on New Look and declined to comment beyond the letter.While New Look says it has adequate liquidity and cash, market participants have been assessing debt-restructuring options. Its swaps are the second riskiest in Europe’s high- yield benchmark and signal an 85% probability of default within five years, according to data compiled by Bloomberg and CMA.Chief executive officer Anders Kristiansen stepped down in September after first-quarter earnings fell 37%. The retailer cited weaker UK consumer demand following last year’s vote to leave the European Union and said in June that it needed to be faster at responding to shifting trends and consumer habits. New Look has £177mn ($237mn) of senior unsecured bonds and about £1.1bns of secured notes, according to data compiled by Bloomberg.New Look is owned by South African investment firm Brait. External spokesmen for both firms in London declined to comment on a possible debt restructuring.Aylward suggested aligning rules governing credit-default swaps on high-yield companies with those linked to governments and financial firms. Corporate contracts were left out of the 2014 overhaul, which sought to ensure payouts when sovereign or bank debt is wiped out or converted into equity.Under those changes, which sought to address flaws exposed by Greece’s debt restructuring and the Dutch government’s seizure of bonds issued by lender SNS Reaal, traders can deliver debt or equity they receive in a restructuring in place of original bonds into swap-settlement auctions.Sona is calling for the principle of asset-package delivery to be extended to high-yield companies because of the risk that a writedown could leave traders without obligations to settle swaps. JPMorgan and other market participants have also warned that a restructuring by New Look could eliminate assets to determine payouts.“There could be a very ugly situation with New Look where the bonds are wiped out or moved to a different entity and the credit-default swaps don’t pay at all,” said Jochen Felsenheimer, the Munich-based managing director of XAIA Investment. “Asset-package delivery is seen as crucial for financial credit swaps and now the same is true for corporates.”Sona is also seeking to replace multiple swap settlement auctions based on contract maturities with a single auction to determine compensation after restructuring events.Maturity buckets became the market standard in 2009 to smooth payouts on swaps triggered by debt reorganisations in Europe. Still, they complicate trading because the timing of a restructuring determines which bonds can be used to set compensation for each group of swaps and can skew results, according to Sona and JPMorgan.While uncommon, cracks appeared from the beginning. Less than a year after bucketing was adopted, credit-default swaps tied to Thomson, the Paris-based owner of film processor Technicolor, paid some holders 30% less than those with contracts expiring a day later.