Loan Credit Default Swap (LCDS)

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Loan Credit Default Swap (LCDS)

Key takeaways

  • An LCDS is a credit derivative that transfers the credit risk of a syndicated secured loan from one party to another in exchange for premium payments.
  • Structurally it is like a standard credit default swap (CDS), but the reference obligation is limited to syndicated secured loans.
  • LCDS typically have higher recovery rates and tighter spreads than CDSs on bonds because the underlying loans are secured.
  • Two main forms exist: cancelable (U.S.) LCDS, used primarily for trading, and non‑cancelable (European) LCDS, used for hedging.

What is an LCDS?

A loan credit default swap (LCDS), sometimes called a loan‑only credit default swap, is a bilateral contract in which one party (the protection buyer) pays periodic premiums to another party (the protection seller) in exchange for protection against a credit event on a specified syndicated secured loan (the reference obligation). If a credit event occurs, the seller compensates the buyer according to the contract terms.

How it works

  • Parties agree on a reference syndicated secured loan, the premium (spread), contract term, and settlement mechanics.
  • The protection buyer pays the agreed premium to the protection seller for the life of the contract or until a credit event occurs.
  • If the reference loan experiences a credit event (default, restructuring, etc.), the protection seller pays the buyer the agreed settlement amount, netting the buyer’s loss on the loan.

Types of LCDS

  • Cancelable LCDS (U.S. LCDS): Designed primarily as a trading product. The buyer has the option to cancel the contract at predetermined dates without penalty. Because of this optionality, cancelable LCDS are typically sold at higher rates than comparable non‑cancelable contracts.
  • Non‑cancelable LCDS (European LCDS): Designed mainly for hedging and remains in force until the underlying loans are repaid or a credit event triggers settlement. These contracts incorporate prepayment risk (the risk that the underlying loans are repaid early), which affects pricing and hedge effectiveness.

History and standardization

LCDS contracts emerged around 2006 alongside increased use of syndicated secured loans in leveraged buyouts. The International Swaps and Derivatives Association (ISDA) helped standardize documentation and market conventions as LCDS trading developed.

Uses

  • Hedging: Lenders or investors holding syndicated loans can hedge credit exposure.
  • Risk transfer: Financial institutions can move loan credit risk off their balance sheets.
  • Speculation: Traders can take directional views on the credit quality of the borrower without owning the loan.

LCDS vs. CDS

  • Reference obligation: LCDS reference syndicated secured loans; CDS can reference a wider range of corporate debt instruments.
  • Recovery and priority: Syndicated secured loans are secured by assets and have higher seniority in bankruptcy proceedings, producing higher expected recovery rates than many bonds referenced by CDS.
  • Pricing: Because of higher recovery expectations and stronger collateral, LCDS generally trade at tighter spreads than CDS on unsecured or subordinated debt.
  • Contract features: Some LCDS (cancelable) include termination options that affect pricing relative to non‑cancelable CDS-style contracts.

Conclusion

LCDS provide a standardized way to transfer or assume credit risk tied specifically to syndicated secured loans. Their secured nature leads to different risk and pricing characteristics compared with traditional CDS, making them useful tools for hedging, risk management, and trading in loan markets.