What is a recovery lock CDS and why would an investor want one?

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AcadiFi · Accepted Answer

A recovery lock (or recovery swap) is a CDS variant where the recovery rate is fixed at contract inception rather than determined by post-default auction. Standard CDS contracts settle based on the ISDA auction-determined final recovery price, introducing uncertainty about payout magnitude. A recovery lock eliminates this uncertainty by agreeing upfront on a specific recovery level — say 40% — that both parties accept regardless of actual auction outcome.

Consider Portman Asset Management buying recovery-lock CDS on Saltire Shipping. They agree: if default occurs, the protection payment equals 1 − 0.40 = 60% of notional, period. If actual post-auction recovery turns out to be 25%, Portman receives less than they would under standard CDS (which would pay 75%). Conversely if recovery is 55%, they receive more than standard CDS.

Two related products exist: (1) fixed recovery CDS — recovery locked at inception, premium adjusted accordingly; (2) recovery swap — two parties exchange fixed recovery for floating (auction-determined) recovery, essentially a bet on recovery levels without default exposure. The spread on fixed recovery CDS differs from standard CDS by the market's expected recovery level vs. the locked rate.

Why use them? Pension funds and insurers may prefer certainty of cash flow for ALM purposes. Sophisticated credit funds use recovery swaps to express pure views on recovery rates without default probability exposure. Banks hedging loan portfolios may prefer fixed recovery to match internal risk assumptions. The market for recovery locks is thin but exists for major reference entities. This is an advanced Level III topic.

What is a recovery lock CDS and why would an investor want one?

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