- Joined
- 5/2/06
- Messages
- 11,765
- Points
- 273
The fast growth of credit derivatives is too significant to ignore. The annualized growth rate of credit default swap (CDS) trading has been more than 100 percent for the past three years running, something that has never happened in the financial markets before.
Trading in single-name CDS and CDS indices alone more than doubled in 2006, surging to more than $20 trillion by the middle of the year, says the Bank for International Settlements (BIS). And the British Bankers' Association (BBA) predicts the global market in credit derivatives to rise to at least $33 trillion by the end of 2008.
"More opportunities come up in this market each year, not only in our structured credit business but also in our regular bond funds," remarks Rob Mead, head of credit for Europe at Pimco, one of the largest fixed-income portfolio managers in the world with $641.6 billion in assets under management as of September 30, 2006. He says it is often cheaper to trade CDS contracts rather than bonds when taking views on corporate credit risk.
More hedge funds, proprietary trading desks, loan portfolio managers, insurance companies, emerging market investors, as well as pensions and high-net worth individuals (which include a growing number of celebrities, a source in London says) are participating in the credit derivatives market now. This has not only provided the market with a significant amount of liquidity but also a greater variety of products and trades.
"Increased liquidity in the CDS markets has meant you can do more tailored strategies and this has attracted hedge funds of all styles, not just credit ones. Pensions and other traditional investors who might not have had a mandate to trade credit derivatives this time last year are using them to diversify and enhance yield," says Kevin Gould, the head of data products and analytics at Markit.
Constant proportion portfolio insurance (CPPIs) and rated equity of collateralized synthetic obligation (CSO) are some of the strategies still attracting interest in the current tight-spread environment. Ally Chow, global head of structured credit product management and syndicate at Calyon, says: "A potential widening could benefit CPPIs - partly because of the capital guaranteed or newly rated features - so that is one reason why these structures continue to be attractive."
Nonetheless, most structured credit players have never seen spreads so tight. And some people are worried that tighter spreads caused investors to jump into more complex, highly leveraged products in 2006, for example constant proportion debt obligations (CPDOs). This has fueled concern at regulatory bodies on both sides of the Atlantic.
But CPDOs are not the only form of leverage that could force tighter spreads. Credit derivative product companies (CDPCs) have also received a fair amount of scrutiny for potentially adding leverage to the system. "CDPCs could slow down a widening in CDS spreads. You could have credit spreads stay tighter for longer, but then when a certain threshold passes you could have a more severe widening as credit fundamentals change," explains Paul Horvath, head of synthetics at Merrill Lynch in London.
Some sources say that CDPCs could impact the market more than CPDOs do on CDS indices. "The super-senior market, which is where a lot of CDPCs target, is a thinner, more technical market. U.S. index traders quote two-way prices on the U.S. CDX market in amounts of $5 billion. If the estimated amount of CPDOs done today is about $3 billion, with an average starting leverage of around 10, then $30 billion of index risk has been created by CPDOs: $15 billion in iTraxx and $15 billion in CDX. It is new risk, so it will have an exaggerated effect. But this is not a crazy amount of risk considering the size of the CDS market now," adds Paul Levy, head of structuring at Merrill Lynch in London.
Bear Stearns is expected to launch its Blue Ribbon CPDO this year, though all eyes were on Deutsche Bank at press time. In December 2006, it said it would launch NewLands Financial with AXA. AXA-IM will manage the assets, while Deutsche Bank provides risk management, infrastructure and other operational services.
Sources also say that while as many as 24 CDPCs are in the pipeline (not all are backed by investment banks), not even half of them will ever launch. Still, it would be premature to say that these vehicles are failing. "Like SIVs, they just take a long time to build up resources and get going," one dealer in London explains.
"Rating agencies are taking time, but they're also saying this segment of the market is not just about plugging a trade into a model. I know one CDPC that got delayed because the rating agency didn't think the guy who was hired to be CEO was suitable. In that sense, rating agencies are doing a good job at monitoring this market and not letting it turn into a gold rush," he adds.
Most sources expect default rates to remain low and leverage high. "Crowded markets are always going to be difficult to extract value from," explains Mead. "But we think that the negative basis between the spread on CDS versus the spread on the cash bond, e.g., around 15 basis points, is a sensible bid that has both strong positive carry as well as good potential for capital gains. We expect to see opportunities like this in 2007 as the market for single-name CDS and CDS index tranches continue to grow," Mead adds.
In some ways the tight-spread environment has put more focus on education too. "The bottom line is that institutions are becoming more intuitive, and therefore are demanding better information, e.g., real-time data," says Gould. "Most products are built around baskets of credit now, so you need more information in order to find the value. Tighter spreads mean players are looking for products that allow them to add yield. This requires independent valuations," he adds. Gould says dealers have become particularly concerned about the compliance and reputational risk issues associated with giving a poor valuation.
Mead says it is important for banks and managers to make sure the appropriate product is marketed to appropriate investors. "There has been an increasing focus on making sure new investors understand what credit derivatives are and how they can be used in all kinds of portfolios, not just credit ones or with collateralized debt obligations (CDOs). Single-name CDS and CDS index trades are efficient ways to take short positions. And the negative basis trade, which we see as a carry-driver of any portfolio, without taking a long or short position in credit, provides opportunities for a broader set of investors," he adds.
The investor base for structured credit continues to expand. Pensions, particularly those in Europe, made headlines for trading CDS contracts and buying more CDO tranches and CPPIs. Investment banks in London started beefing up pension advisory groups last year as a way to market more structured credit products to these kinds of funds. Retail investors also attracted some attention. Kathy Sutherland, JPMorgan's global head of product management and syndicate, explains: "High-net worth individuals typically want principal protection and more diversified returns than what they usually get from private equity assets."
Even so, no other type of player has received as much attention for its use of credit derivatives as hedge funds. Some sources say hedge funds now make up at least half of the activity in credit derivatives trading. Despite recent scrutiny for potentially using inside information on CDS contracts based on the companies that they lend to, hedge funds' participation in this market is only expected to increase. The inside information issue has also fueled regulators' concern about hedge funds' influence on the underlying debt markets.
"The hedge fund market is a trillion dollar market and only a small proportion of them, probably less than 10 percent, invest in credit. But this asset class is a growing allocation for many types of funds, considering that the most successful strategies for hedge funds over the past year have involved credit," Sutherland remarks.
Investors have warmed up to CDS contracts on asset-backed securities (ABS), commercial mortgage-backed securities (CMBS) and leveraged loans. "Strong volumes in leveraged loan CDS (LCDS) and increasing liquidity in ABCDS and CDS on CMBS have got firms interested in developing businesses, both bespoke and franchise, across the different asset classes," proclaims Ian Wilson, head of global synthetic structured credit marketing at JP Morgan. "Technology around the correlation of the underlying assets is similar, so there are bound to be more correlation services. Banks would be leveraging on the credit correlation desk's experience in investment grades," he adds.
Tom Price, head of leveraged loan CDS (LCDS) at Markit, is quick to add that the development of synthetic indices last year has attracted more investors. "With the recent launch of the LevX index in Europe and the forthcoming launch of the LCDX index in North America, investor interest in loan CDS is growing fast." He said that by the end of 2006 notional outstandings in LCDS contracts had grown to an estimated $40 billion.
ABCDS contracts could also lead to a lot more structured credit trades, not least since they allow players to buy ABS assets in different currencies. "Before these contracts were developed, if you wanted to sell U.S. home equity loan ABS in cash you had to find people who were willing to invest in U.S. dollars. Now you have all sorts of investors, from Norwegian krona to Japanese yen ones," explains Horvath.
Nonetheless, a few wrinkles in the LCDS contracts still need to be ironed out, namely the fact that the U.S. and Europe treat loan refinancings differently. Kimberly Summe, general counsel for Isda, says: "Hedge funds are probably the most active players but they aren't always the ones with issues [e.g., regarding succession events, such as financial restructurings, wholesale debt redemptions or leveraged buyouts]. The players who have issues with some of the definitions are portfolio managers at banks. They do not like non-cancellable products because they potentially lose their hedge."
Increased standardization has been an important driver of growth in all of the CDS markets. "It's challenging because although we have an increasingly diverse membership we have to go with what the majority of players want in terms of standardisation. This doesn't mean we cannot accommodate minority views by providing optionality in the template," adds Summe.
A research analyst from an American bank in London agrees with many other sources who say that structured credit investors are thinking more global than this time last year. "When I meet clients for the first time, I immediately ask if they can do non-European exposure. Many of them do now because the advancements in the credit derivatives markets have made it so easy to hedge mismatches," he comments.
But the question that few structured credit players seem to discuss is how much bigger the CDS markets could get. Considering that the corporate market is already said to be 10 times the size of the underlying bond one, this is bound to become a more critical point in 2007.
http://www.fenews.com/fen54/euro_angles/euro_angles.html
Trading in single-name CDS and CDS indices alone more than doubled in 2006, surging to more than $20 trillion by the middle of the year, says the Bank for International Settlements (BIS). And the British Bankers' Association (BBA) predicts the global market in credit derivatives to rise to at least $33 trillion by the end of 2008.
"More opportunities come up in this market each year, not only in our structured credit business but also in our regular bond funds," remarks Rob Mead, head of credit for Europe at Pimco, one of the largest fixed-income portfolio managers in the world with $641.6 billion in assets under management as of September 30, 2006. He says it is often cheaper to trade CDS contracts rather than bonds when taking views on corporate credit risk.
More hedge funds, proprietary trading desks, loan portfolio managers, insurance companies, emerging market investors, as well as pensions and high-net worth individuals (which include a growing number of celebrities, a source in London says) are participating in the credit derivatives market now. This has not only provided the market with a significant amount of liquidity but also a greater variety of products and trades.
"Increased liquidity in the CDS markets has meant you can do more tailored strategies and this has attracted hedge funds of all styles, not just credit ones. Pensions and other traditional investors who might not have had a mandate to trade credit derivatives this time last year are using them to diversify and enhance yield," says Kevin Gould, the head of data products and analytics at Markit.
Constant proportion portfolio insurance (CPPIs) and rated equity of collateralized synthetic obligation (CSO) are some of the strategies still attracting interest in the current tight-spread environment. Ally Chow, global head of structured credit product management and syndicate at Calyon, says: "A potential widening could benefit CPPIs - partly because of the capital guaranteed or newly rated features - so that is one reason why these structures continue to be attractive."
Nonetheless, most structured credit players have never seen spreads so tight. And some people are worried that tighter spreads caused investors to jump into more complex, highly leveraged products in 2006, for example constant proportion debt obligations (CPDOs). This has fueled concern at regulatory bodies on both sides of the Atlantic.
But CPDOs are not the only form of leverage that could force tighter spreads. Credit derivative product companies (CDPCs) have also received a fair amount of scrutiny for potentially adding leverage to the system. "CDPCs could slow down a widening in CDS spreads. You could have credit spreads stay tighter for longer, but then when a certain threshold passes you could have a more severe widening as credit fundamentals change," explains Paul Horvath, head of synthetics at Merrill Lynch in London.
Some sources say that CDPCs could impact the market more than CPDOs do on CDS indices. "The super-senior market, which is where a lot of CDPCs target, is a thinner, more technical market. U.S. index traders quote two-way prices on the U.S. CDX market in amounts of $5 billion. If the estimated amount of CPDOs done today is about $3 billion, with an average starting leverage of around 10, then $30 billion of index risk has been created by CPDOs: $15 billion in iTraxx and $15 billion in CDX. It is new risk, so it will have an exaggerated effect. But this is not a crazy amount of risk considering the size of the CDS market now," adds Paul Levy, head of structuring at Merrill Lynch in London.
Bear Stearns is expected to launch its Blue Ribbon CPDO this year, though all eyes were on Deutsche Bank at press time. In December 2006, it said it would launch NewLands Financial with AXA. AXA-IM will manage the assets, while Deutsche Bank provides risk management, infrastructure and other operational services.
Sources also say that while as many as 24 CDPCs are in the pipeline (not all are backed by investment banks), not even half of them will ever launch. Still, it would be premature to say that these vehicles are failing. "Like SIVs, they just take a long time to build up resources and get going," one dealer in London explains.
"Rating agencies are taking time, but they're also saying this segment of the market is not just about plugging a trade into a model. I know one CDPC that got delayed because the rating agency didn't think the guy who was hired to be CEO was suitable. In that sense, rating agencies are doing a good job at monitoring this market and not letting it turn into a gold rush," he adds.
Most sources expect default rates to remain low and leverage high. "Crowded markets are always going to be difficult to extract value from," explains Mead. "But we think that the negative basis between the spread on CDS versus the spread on the cash bond, e.g., around 15 basis points, is a sensible bid that has both strong positive carry as well as good potential for capital gains. We expect to see opportunities like this in 2007 as the market for single-name CDS and CDS index tranches continue to grow," Mead adds.
In some ways the tight-spread environment has put more focus on education too. "The bottom line is that institutions are becoming more intuitive, and therefore are demanding better information, e.g., real-time data," says Gould. "Most products are built around baskets of credit now, so you need more information in order to find the value. Tighter spreads mean players are looking for products that allow them to add yield. This requires independent valuations," he adds. Gould says dealers have become particularly concerned about the compliance and reputational risk issues associated with giving a poor valuation.
Mead says it is important for banks and managers to make sure the appropriate product is marketed to appropriate investors. "There has been an increasing focus on making sure new investors understand what credit derivatives are and how they can be used in all kinds of portfolios, not just credit ones or with collateralized debt obligations (CDOs). Single-name CDS and CDS index trades are efficient ways to take short positions. And the negative basis trade, which we see as a carry-driver of any portfolio, without taking a long or short position in credit, provides opportunities for a broader set of investors," he adds.
The investor base for structured credit continues to expand. Pensions, particularly those in Europe, made headlines for trading CDS contracts and buying more CDO tranches and CPPIs. Investment banks in London started beefing up pension advisory groups last year as a way to market more structured credit products to these kinds of funds. Retail investors also attracted some attention. Kathy Sutherland, JPMorgan's global head of product management and syndicate, explains: "High-net worth individuals typically want principal protection and more diversified returns than what they usually get from private equity assets."
Even so, no other type of player has received as much attention for its use of credit derivatives as hedge funds. Some sources say hedge funds now make up at least half of the activity in credit derivatives trading. Despite recent scrutiny for potentially using inside information on CDS contracts based on the companies that they lend to, hedge funds' participation in this market is only expected to increase. The inside information issue has also fueled regulators' concern about hedge funds' influence on the underlying debt markets.
"The hedge fund market is a trillion dollar market and only a small proportion of them, probably less than 10 percent, invest in credit. But this asset class is a growing allocation for many types of funds, considering that the most successful strategies for hedge funds over the past year have involved credit," Sutherland remarks.
Investors have warmed up to CDS contracts on asset-backed securities (ABS), commercial mortgage-backed securities (CMBS) and leveraged loans. "Strong volumes in leveraged loan CDS (LCDS) and increasing liquidity in ABCDS and CDS on CMBS have got firms interested in developing businesses, both bespoke and franchise, across the different asset classes," proclaims Ian Wilson, head of global synthetic structured credit marketing at JP Morgan. "Technology around the correlation of the underlying assets is similar, so there are bound to be more correlation services. Banks would be leveraging on the credit correlation desk's experience in investment grades," he adds.
Tom Price, head of leveraged loan CDS (LCDS) at Markit, is quick to add that the development of synthetic indices last year has attracted more investors. "With the recent launch of the LevX index in Europe and the forthcoming launch of the LCDX index in North America, investor interest in loan CDS is growing fast." He said that by the end of 2006 notional outstandings in LCDS contracts had grown to an estimated $40 billion.
ABCDS contracts could also lead to a lot more structured credit trades, not least since they allow players to buy ABS assets in different currencies. "Before these contracts were developed, if you wanted to sell U.S. home equity loan ABS in cash you had to find people who were willing to invest in U.S. dollars. Now you have all sorts of investors, from Norwegian krona to Japanese yen ones," explains Horvath.
Nonetheless, a few wrinkles in the LCDS contracts still need to be ironed out, namely the fact that the U.S. and Europe treat loan refinancings differently. Kimberly Summe, general counsel for Isda, says: "Hedge funds are probably the most active players but they aren't always the ones with issues [e.g., regarding succession events, such as financial restructurings, wholesale debt redemptions or leveraged buyouts]. The players who have issues with some of the definitions are portfolio managers at banks. They do not like non-cancellable products because they potentially lose their hedge."
Increased standardization has been an important driver of growth in all of the CDS markets. "It's challenging because although we have an increasingly diverse membership we have to go with what the majority of players want in terms of standardisation. This doesn't mean we cannot accommodate minority views by providing optionality in the template," adds Summe.
A research analyst from an American bank in London agrees with many other sources who say that structured credit investors are thinking more global than this time last year. "When I meet clients for the first time, I immediately ask if they can do non-European exposure. Many of them do now because the advancements in the credit derivatives markets have made it so easy to hedge mismatches," he comments.
But the question that few structured credit players seem to discuss is how much bigger the CDS markets could get. Considering that the corporate market is already said to be 10 times the size of the underlying bond one, this is bound to become a more critical point in 2007.
http://www.fenews.com/fen54/euro_angles/euro_angles.html