Milestones : Corporate Bond Credit Quality Threatens Derivatives


The bond market used to be a place that was safe for widows and orphans, but recent developments, including the fast growth of credit derivatives and hedge funds, are changing this formerly quiet corner of the capital markets. The potential impact of widespread volatility in the corporate bond market on these complex new financial products, such as credit default swaps and collateralized debt obligations, or CDOs, is difficult to predict, according to the Basel, Switzerland-based Bank for International Settlements.

Although credit derivatives held up relatively well during the market tumult triggered by the downgrades in May of General Motors and Ford Motor, the second- and third-largest corporate borrowers in the world, the BIS says it remains to be seen how credit markets might perform if confronted with a widespread deterioration in credit quality.

This isnt the first warning on the topic from the BIS. In a report released earlier this year, it said there has clearly been some degree of concentration in the market-making activities associated with credit-derivatives transactions. The exit of a single major dealer could be disruptive, it noted.

Meanwhile, credit derivatives have become more tightly integrated with the corporate bond market, the BIS says, in part because of the
emergence of speculative capital ready to take advantage of profitable arbitrage between the two markets. Hedge funds and private-equity funds seeking higher returns are also playing a greater role in holding the equity portions, or the riskiest slice of CDO risk, which is the first to absorb any losses.

The Federal Reserve Bank of New York called a meeting with major market participants in September to discuss back-office problems in this fast-growing market, which now totals $8.4 trillion (see story, page 106).

Gordon Platt