The Sainsbury Rollercoaster

Friday’s statement from a group of private equity houses that they were “in the preliminary stages of assessing” a possible offer for Sainsbury saw its shares rally 17% and the CDS market jump from spreads in the mid 27 bps out to 75 bps. CDS (credit default swaps) reflect the cost of ‘insuring’ against an issuer defaulting on its debt – the higher the risk of credit deterioration, the higher the premium.

During the first half of 2005 Sainsbury’s CDS contracts traded in a range of 90 bps to 130 bps reflecting the rather poor performance the company was experiencing in a demanding sector. The second half of the year saw a gradual tightening in spreads reflecting an improving credit profile as management began to show signs of turning things around. By the end of the year Sainsbury CDS was trading at around 57 bps, largely in line with its peers.

 

However, by the end of February 2006 Sainsbury’s CDS had collapsed from the high 50s to the mid 20s and eventually settled in around the high teens a month later. The driver for this move is a technicality in the CDS market. If a credit event takes place, the ‘insured’ party has an obligation to deliver qualifying bonds or loans, and in exchange receives his/her payout from the protection seller (in the same way that if you crash your car, the insurer pays out, but then owns the wreck). The issue in February 2006 was that Sainsbury announced they intended to re-finance their outstanding debt in a move which included buying back their outstanding bonds. This meant that if a credit event was to occur then a protection buyer would be unlikely to be able to fulfil his/her part of the bargain – thus making the value of insurance dramatically lower. (The reason the CDS didn’t trade to zero will become apparent.)

So why is Sainsbury’s CDS currently trading around 90 bps? If private equity were to get their hands on Sainsbury, far from a certainty, then they would be very likely to lever up the balance sheet (by issuing loans and bonds) thus increasing the probability of a default. In theory this should see the CDS trade above the highs of 2005. The reason why the CDS hasn’t yet reached new highs is twofold: firstly we don’t know what the ultimate fate for Sainsbury will be, but crucially we don’t know whether any debt issued would ‘qualify’ as deliverable under the existing CDS contracts. In theory the CDS price should be a function of weighted sum of the various potential outcomes for Sainsbury and that is very much open to interpretation and guesswork. I imagine we will yet see some more volatility in Sainsbury CDS.

 

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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