Pay-As-You-Go Credit Default Swaps (PAUG CDS)

In case of ABS CDS, the reference asset is a specific security. Because of this, the physical settlement is impractical. At the same time, even cash settlement is complex because it is difficult to assess the market value of the ABS tranche. Dues to these problems, a new form of settlement called Pay As You Go (PAUG CDS), is developed. PAUG CDS are designed to mirror the cash flows on the underlying reference obligation.

In case of PAUG, unlike cash and physical settlement, there is no single payment (or exchange of reference obligation).  Under PAUG, protection sellers make contingent cash payments equivalent to any write-downs on the note/bond. These are called Floating Amount Events. These are soft “soft” credit events, i.e., they do not constitute an event of default under the reference obligation but affect its cash flows, thereby requiring partial cash settlement.

The floating payment works as follows: suppose the reference asset notional value is $100. If there is a $5 principal write-down, the notional value will reduce to $95, and the protection seller will make a payment of $5 to the protection buyer. Similarly, if there is a principal write-up, the protection buyer will have to make the equivalent payment to the protection seller.

A standard CDS covers credit events such as default, rating downgrade, and permanent write-downs. Apart from these credit events, a PAUG CDS will also cover principal write-downs, interest short-falls, and non-payment of principal.

PAUG structures also provide the protection buyer the option (right, but not the obligation) to physically settle the contract.

PAUG CDS provide a more realistic exposure to the investors in the ABS market.