Avon’s bonds slumped this week after payouts on credit derivatives linked to the bankrupt beauty brand were far larger than traders had anticipated.
The price of Avon's 2043 bonds plunged to 32% of face value on Tuesday from 54% the previous day, according to LSEG data, in the wake of an auction to establish payouts on the roughly US$900m of credit default swaps referencing the company's debt. The decline capped a remarkable run of losses for holders of Avon's bonds, which had traded near par just days before the company filed for bankruptcy on August 12.
CDS auctions are designed to establish a market price for defaulted bonds and therefore determine how much money CDS sellers should pay CDS buyers. Anyone can participate in the process, meaning auctions often represent a good opportunity for investors to buy or sell the defaulted securities.
The result of the Avon CDS auction implied that the company's bonds were worth just 34% of their face value, despite bond dealers having quoted them at a much higher price only hours before. That meant CDS holders received a payout of 66 cents for every dollar of protection they bought.
Auction controversy
The run-up to the Avon CDS auction had its share of controversy due to the tiny amount of bonds (just one security with US$22m of principal) that had been identified to settle the nearly US$888m of Avon CDS that Depository Trust & Clearing Corp said was outstanding as of September 20. There have previously been concerns that constraining the amount of debt in CDS auctions could produce unusual results.
Barclays had argued that more debt should be included in the auction in the form of a US$405m promissory note that Avon had with an affiliate of its Brazilian parent company, Natura. “[The Credit Derivatives Determinations Committee] should seek to enhance the scope, functionality and liquidity of the market for credit derivatives, by enlarging the universe of deliverable obligations rather than narrowing it,” law firm Milbank wrote in an September 17 memo on behalf of Barclays and other market participants.
This motion failed to gain support, though, and the Credit Derivatives Determinations Committee – the industry body that rules on matters in the US$8.5trn CDS market – stuck with its initial decision that only the US$22m Avon bond could be used. Barclays declined to comment.
In the end, the small amount of Avon bonds didn't do any harm to CDS protection buyers. CDS auctions comprise two rounds. First, bond dealers provide quotes to give an initial indication of the value of a company's debt. Then, in the second round, physical CDS settlement requests are filled (where the protection buyer delivers the relevant bonds in return for an appropriate cash payment) by dealers placing limit orders.
The final price at which these physical requests are filled becomes the CDS payout for everyone else that is settling their contracts with cash. This dynamic means that an imbalance between buyers and sellers of the bonds in the second round can affect the final CDS payout.
Bond dealers on average indicated the Avon bonds were worth about 63% of their face value in the first round – higher than where LSEG data shows them being quoted in the wider market at the time. However, the second round of the auction produced a much lower final settlement price of 34 cents on the dollar, amid flagging demands to fill the US$13m of net demand to sell Avon’s bonds via physical settlement.