Features : Credit Where It’s Due


Corporates have largely ignored the rapidly growing credit derivatives market for years. But will it help or hinder them if global growth begins to slow?

credit_derivatives_01 The credit derivatives market has been one of the greatest financial success stories in the past decade, and volumes continue to soar. The notional principal outstanding of credit default swaps (CDSs) grew 33% in the second half of 2006, rising from $26 trillion to $34.5 trillion, following 52% growth during the first half of 2006, according to industry body International Swaps and Derivatives Association (ISDA).

This growth has inevitably invited concern: Both Alan Greenspan and Warren Buffett have highlighted the potential hazards of the market in the past, with the latter memorably describing credit derivatives as “financial weapons of mass destruction.” The most recent bout of soul-searching about the risks of the market has been prompted by a speech made by European Central Bank president Jean-Claude Trichet at ISDA’s conference in Boston on April 18.

In his speech, Trichet acknowledged that credit derivatives and structured credit—such as collateralized debt obligations (CDOs), which divide up pools of credit risk such as bonds and CDSs––are transforming the financial system and have become a major component of even mainstream fixed-income investors’ portfolios. But he added that the credit derivatives industry may have become complacent about the risks it is taking.

In particular, Trichet said that instruments for sharing credit risk had not yet been tested in adverse conditions and that it was therefore difficult to ascertain the resilience of the market. “Aggressive investors display a more volatile risk-taking attitude, and their balance sheets are not necessarily resilient enough to withstand major shocks [such as an increase in defaults],” he said. “In response to unanticipated events, their investment strategies may react in a way that can suddenly lead to dangerous herding behavior.”

This potential problem is intensified by the opacity of the credit derivatives market, and especially of structured synthetic instruments such as CDOs. “The complex interaction between cash instruments and credit derivatives has made it increasingly difficult to monitor where different, possibly sizeable, positions are taken and where risks are concentrated. It is similarly difficult to monitor whether and when simultaneous attempts by market participants to unwind their positions could have an impact on market prices and systemic liquidity,” Trichet said.

The Bottom Line for Corporates
Why does any of this matter for corporates? After all, despite the rapid growth of credit derivatives, they have continued to be of peripheral interest to companies. And despite investment banks’ continuing efforts to convince companies of credit derivatives’ usefulness in managing risk associated with customer accounts receivable, supply contracts, loans to customers and vendors, and counterparty exposures, by most estimates corporate use still accounts for just 5% of the credit derivatives market.

There are many reasons for corporates’ unwillingness to embrace credit derivatives, but in general they center on the fact that the products available fail to provide specific enough protection for companies’ credit risk and are designed for use by financial institutions. But while corporates have so far been able to ignore credit derivatives, the market could have significant implications for them in the future because of the “complex interaction between cash instruments [namely bonds] and credit derivatives [CDSs and CDOs]” that Trichet mentioned in his speech.

In recent years, that interaction has been hugely beneficial to corporate borrowers in the bond markets. Financial institutions putting together synthetic products have bid up the cost of single-name CDSs, which has driven bond spreads tighter; in effect, the tail is wagging the dog. “If that structured bid disappeared because of adverse market conditions, it would obviously have an impact on CDS spreads and, consequently, on bond spreads. And that would raise borrowing costs for corporates,” says Suki Mann, credit strategist at Société Générale in London.

Are those adverse conditions around the corner? The credit cycle has been widely predicted to turn for years, but strong global economic growth and rising corporate profits have staved off the inevitable, and default rates remain historically low. Indeed, Moody’s speculative-grade corporate default rate hit a 10-year low of 1.4% at the end of the first quarter of 2007, while measured on a dollar volume basis the default rate was just 1% for the year to the end of the first quarter of 2007—its lowest level since November 1994.

“We have reached a level of defaults—and of spreads—where it is hard to see how things could improve further,” says Marcus Schüler, head of integrated credit marketing at Deutsche Bank in London. “There is no evidence of a turn in the credit cycle, and fundamentals remain positive, and in all likelihood things are expected to remain strong for this year, although there might be periods of volatility and uncertainty. But at some point, of course, the cycle will turn.”

Moody’s predicts that issuer-weighted default rates will hit 2.7% by the end of 2007 and 3.5% by the end of the first quarter of 2008. While both these figures remain well below the long-term average of 5.1%, any increase in default risk will be a substantial test of the credit derivatives market—it didn’t exist in any size during previous downturns—and there are concerns that liquidity could suffer, with potential consequences for corporate bond issuance costs.

Not So Bad After All
In reality, previous temporary corrections have shown that structured credit buyers are often opportunistic when spreads widen and tend to buy, thus helping settle the market, according to Deutsche Bank’s Schüler. “There would have to be a significant deterioration in credit conditions for those buyers not to come into the market [something no market observers have predicted]. And, more generally, we have seen no diminished appetite for credit risk in recent months despite an increase in event risk,” he says.

Moreover, the credit derivatives market could play a major role in helping to prevent or minimize any worsening in the credit market by limiting the “dangerous herding behavior” described by Trichet in his speech. “For the first time ever, market participants will be able to hedge their exposure to the credit market in a downturn,” says Schüler. “Almost all buyers of credit now have active hedging strategies, which means that whereas previously they would have had to sell their cash positions with inevitable consequences in terms of worsening spreads, now they hedge themselves using index [tranches on iTraxx in Europe and CDX in the United States] and sit tight. It makes the system much more stable.”

In addition, many investors are now less restricted on the ratings of what they can hold—the gulf between investment grade and high yield has almost become meaningless for some—meaning that in the event of downgrades, there is less forced selling and less instability.

Jonny Goulden, head of European credit derivatives research at JPMorgan in London, says that the broader benefits of credit derivatives to the global financial system are important. “A key feature of credit derivatives is their ability to split up risk and distribute it to a number of parties willing to take it on,” he says. “That means that if conditions do worsen, losses will be less concentrated and liquidity—including liquidity in the cash bond market—is less likely to be interrupted.” The credit derivatives market has ultimately been beneficial for corporates by lowering the cost of capital in the cash bond market and it is highly likely that they will be beneficial in a weaker credit environment also—however, far off that is.

Laurence Neville