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Squeezing Into the Latest Derivative Fashions
A CLASSIC SHORT SQUEEZE is helping to send the cost of corporate credit tumbling.
The squeeze is taking place in the huge but opaque and arcane market for credit derivatives. One genus of the species, credit default swaps, is basically an insurance policy on whether a company won't make good on its debt.
With a credit default swap, an investor can buy protection against the default on a credit, just as a homeowner takes out a flood insurance policy. Or an investor can sell an insurance policy that the credit won't go bust, just as Allstate does on a home, to make a profit.
Investors who buy a CDS are buying the functional equivalent of a put option -- a negative bet -- on the company's credit. As the corporate bond market keeps strengthening, these put options are losing value. And so these investors -- or more accurately, traders -- are scrambling to cover by selling these instruments, just as a short seller who bets on a stock's decline is forced to buy back that stock if it rises, which push the price even higher.
Investors looking to take on credit risk can sell credit protection in the CDS market. Just as put sellers profit in a bull market, sellers of credit protection have made out well.
If all that sounds a bit complicated and convoluted, as they say on late-night infomercials -- Wait, there's more.
CDOs, for their part, also are eminently tradable; far more so, in fact, than corporate bonds, which require a company to be of the mind to issue a bond to the public. A CDO can be created by a derivative dealer to meet the desires of its customer, who can than take a position in that credit in the absence of a bond and without worrying about such nonsense as where interest rates are headed.
CDOs also can be assembled into indexes. The CDX is like the Dow of the credit derivative world, tracking major investment-grade issuers, while the iTraxx is the European equivalent. And, of course, those indices are dandy trading vehicles for anybody (hedge funds, especially) who has an opinion about corporate credit.
And those index products can be reassembled into new structures. The latest and greatest is the Constant Proportion Debt Obligation, or CPDO. Leaving out the details, which are comprehensible only to derivatives professionals, suffice it to say that, with the magic of 15-to-1 leverage, CPDOs provide the marvelous combination of upwards of 200 basis points (two percentage points) over Libor (the London interbank offered rate, the money-market benchmark) for a something deemed a triple-A credit. Real high-grade bonds, when you can find them, trade at only a handful of basis points over governments.
Not surprisingly, CPDOs have caught fire. And that's rippled through the credit derivatives market.
"When CPDOs are priced, index trades are executed," explains Lisa Watkinson, head of Global Structured Credit Business Development at Lehman Brothers. "The leverage in the trades could mean billions need to trade in the CDX and iTraxx indices. The daily volumes in the indices are anywhere from $30-50 billion per day."
"Billions would have to print in the CPDO market to be the sole catalyst behind significant spread tightening," she adds. But Jeffrey A. Rosenberg, credit market strategist at Bank of America, avers that CDS spreads (their margin over risk-free government debt yields) have been driven to record lows by heavy supplies of "synthetic" instruments, including the introduction of CDPOs.
In the process, those who bought credit protection in the CDS market are on the losing side of that game. So, now they're furiously trying to sell protection, like any squeezed short.
Of course, these new-fangled products aren't the sole reason for tight corporate spreads. The economy is growing amid "The Great Moderation," as Fed chairman Ben Bernanke has dubbed it, which implies no precipitous downturns. And so risk premiums have been squeezed down, from corporate credit to the stock market, as encapsulated by everybody's favorite fear gauge, the VIX.
One would have to be churlish indeed to wonder about what could go awry in this best of all possible worlds for credit derivatives. Just because mind-numbingly complex structures are traded by the billions in an unregulated market by hedge funds? It's not as if they're natural-gas futures, for goodness sake.
(c) Barron's Nov 7 06
A CLASSIC SHORT SQUEEZE is helping to send the cost of corporate credit tumbling.
The squeeze is taking place in the huge but opaque and arcane market for credit derivatives. One genus of the species, credit default swaps, is basically an insurance policy on whether a company won't make good on its debt.
With a credit default swap, an investor can buy protection against the default on a credit, just as a homeowner takes out a flood insurance policy. Or an investor can sell an insurance policy that the credit won't go bust, just as Allstate does on a home, to make a profit.
Investors who buy a CDS are buying the functional equivalent of a put option -- a negative bet -- on the company's credit. As the corporate bond market keeps strengthening, these put options are losing value. And so these investors -- or more accurately, traders -- are scrambling to cover by selling these instruments, just as a short seller who bets on a stock's decline is forced to buy back that stock if it rises, which push the price even higher.
Investors looking to take on credit risk can sell credit protection in the CDS market. Just as put sellers profit in a bull market, sellers of credit protection have made out well.
If all that sounds a bit complicated and convoluted, as they say on late-night infomercials -- Wait, there's more.
CDOs, for their part, also are eminently tradable; far more so, in fact, than corporate bonds, which require a company to be of the mind to issue a bond to the public. A CDO can be created by a derivative dealer to meet the desires of its customer, who can than take a position in that credit in the absence of a bond and without worrying about such nonsense as where interest rates are headed.
CDOs also can be assembled into indexes. The CDX is like the Dow of the credit derivative world, tracking major investment-grade issuers, while the iTraxx is the European equivalent. And, of course, those indices are dandy trading vehicles for anybody (hedge funds, especially) who has an opinion about corporate credit.
And those index products can be reassembled into new structures. The latest and greatest is the Constant Proportion Debt Obligation, or CPDO. Leaving out the details, which are comprehensible only to derivatives professionals, suffice it to say that, with the magic of 15-to-1 leverage, CPDOs provide the marvelous combination of upwards of 200 basis points (two percentage points) over Libor (the London interbank offered rate, the money-market benchmark) for a something deemed a triple-A credit. Real high-grade bonds, when you can find them, trade at only a handful of basis points over governments.
Not surprisingly, CPDOs have caught fire. And that's rippled through the credit derivatives market.
"When CPDOs are priced, index trades are executed," explains Lisa Watkinson, head of Global Structured Credit Business Development at Lehman Brothers. "The leverage in the trades could mean billions need to trade in the CDX and iTraxx indices. The daily volumes in the indices are anywhere from $30-50 billion per day."
"Billions would have to print in the CPDO market to be the sole catalyst behind significant spread tightening," she adds. But Jeffrey A. Rosenberg, credit market strategist at Bank of America, avers that CDS spreads (their margin over risk-free government debt yields) have been driven to record lows by heavy supplies of "synthetic" instruments, including the introduction of CDPOs.
In the process, those who bought credit protection in the CDS market are on the losing side of that game. So, now they're furiously trying to sell protection, like any squeezed short.
Of course, these new-fangled products aren't the sole reason for tight corporate spreads. The economy is growing amid "The Great Moderation," as Fed chairman Ben Bernanke has dubbed it, which implies no precipitous downturns. And so risk premiums have been squeezed down, from corporate credit to the stock market, as encapsulated by everybody's favorite fear gauge, the VIX.
One would have to be churlish indeed to wonder about what could go awry in this best of all possible worlds for credit derivatives. Just because mind-numbingly complex structures are traded by the billions in an unregulated market by hedge funds? It's not as if they're natural-gas futures, for goodness sake.
(c) Barron's Nov 7 06