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Banks

CDS may have prompted Deutsche delay on Kellwood-traders

NEW YORK, July 24 (Reuters) - Deutsche Bank's DBKGn.DE about face in participating in Kellwood Co's bond exchange has sparked speculation that the bank may have been waiting first for payments on the company's credit default swaps to be triggered.

Kellwood, which owns clothing brands Phat Farm and Sag Harbor said on Thursday that bondholders including Deutsche Bank had agreed to exchange a $140 million bond that came due last week for new senior secured debt maturing in 2014, saving the company from a possible bankruptcy.

The company had previously said on Kellwood’s on July 16 that the bank, a large holder of the company’s bonds, had “unexpectedly changed its position in recent days and decided not to accept the offer.”

Deutsche Bank spokesperson Michele Allison declined to comment.

Kellwood spokesman Eric Hunter said the company has “no idea” what caused the bank to change its mind.

“It looks like they were trying to have their cake and eat it,” said one CDS trader.

It’s not known whether Deutsche Bank also owned protection on the CDSs, though the timing of its agreement to the exchange offer has sparked widespread speculation that it may have.

Payments on Kellwood’s CDSs were triggered on July 20 due to the company’s failure to repay the bonds, derivatives trade association the International Swaps and Derivatives Association said on Wednesday.

Companies typically have an automatic 3-day grace period to repay a bond before payments on the CDSs are deemed necessary.

If Deutsche Bank had agreed to the bond exchange before its original deadline on July 17, payments on the CDS would not have been triggered, traders said.

“CDS contracts are absolutely critical in restructurings and if Deutsche Bank had protection it makes perfect sense that they would defer supporting the company until they locked in gains on the CDS side,” said Sean Egan, managing director at Egan-Jones Ratings Co in Haverford, Pennsylvania.

Traders have speculated that the bank may have held so-called negative basis trades, in which they owned the bonds and also owned CDS protection.

In this case, the bank would have profited from payments from the CDS contracts, which are expected to stand at around 80 percent of the insurance bought.

The company would also have gained from exchanging its bonds, which traded at 23 cents on the dollar on Thursday, for new debt that is expected to trade at its full value, traders said.

CDSs are used to protect against a borrower defaulting on its debt or to speculate on its credit quality. Kellwood is owned by private equity firm Sun Capital.

CHANGING INCENTIVES

The role CDSs play in the fate of distressed companies has come under increased scrutiny as bondholders that have previously had incentives to take losses outside of bankruptcy, or risk losing more if a company files, are no longer exposed to these losses if they also hold protection.

Net CDS volumes on specific issuers’ are typically smaller than volumes in the same company’s bonds, however holders of a company’s near term debt can wield significant influence on a company if they also own CDS protection.

When a company becomes distressed it will often target near term debt maturities for restructuring to buy more time to turn around their business. If bondholders don’t agree to restructure this debt, in many cases the company will be forced to file for bankruptcy.

Kellwood’s longer dated debt, meanwhile, has jumped more than 10 cents since its credit default swaps triggered, indicating protection holders may be scooping up the debt in order to settle the CDS contracts.

When a borrower is deemed in default of its CDS, protection sellers pay the buyers the sum insured in return for the defaulted debt, or equivalent cash payments.

The 7.625 percent bond due 2017 has jumped to 23 cents on the dollar on Thursday, from 13 cents on July 16, according to MarketAxess.

Reporting by Karen Brettell; Editing by Diane Craft

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