A Credit Derivatives Primer

Blythe Masters, head of global credit derivatives for JP Morgan, explains how credit derivatives are simpler-and perhaps more useful-than you think.

For a portfolio manager, something nasty in the woodshed is owning paper in a company that files for chapter 11. For a CFO, it's the thought that the company's biggest customer goes bankrupt before paying the bill for that mega-order. Several years ago, when it was hard to open a newspaper without reading about another company going belly up, the only choice a CFO or portfolio manager had was to buy letters of credit or guarantees, or perhaps to attempt shorting corporate securities. Today, just as interest rate swaps isolate and restructure interest rate risk, new instruments are available that separate credit risk from market risk and provide insurance at a reasonable price. Just as the default cycle may be turning and with credit problems again in the air, credit derivatives offer particularly rich risk premiums to investors in the market for credit risk.

For an investor, the existence of credit derivatives provides an opportunity to sell off the credit risk without also selling the underlying loan or security. For a risk manager worried that too much of the company's business is conducted with one customer, credit derivatives can provide a version of business concentration insurance. And for arbitrageurs, credit derivatives increase the tools at their disposal, for instance, as they seek to exploit the differences in the pricing of credit risk between various markets and time horizons.

By definition a credit derivative allows an owner to isolate and transfer credit risk without in any way transferring the ownership of-or other risks inherent to-the underlying asset. If, for example, an investor owns a bond of a company that he thinks will undergo a rating change or a default within the next year, he may decide to purchase a credit derivative, thus providing himself with a measure of protection against the inevitable drop in value that would occur when the company's credit deteriorated. From an economic perspective credit derivatives and letters of credit (LCs) are similar; both can involve a contingent payment to a counterparty should a third party fail. Credit derivatives, however, are considerably more flexible.

The most basic credit derivative structure is the credit swap. In a credit swap the holder of credit risk pays a periodic fee. The other counterparty agrees to make a contingent payment of a contingent fee if an event such as a default occurs. Say the credit swap was written on the senior debt of a now-bankrupt company. When the bankruptcy is concluded, holders of this class of security may receive 60 cents on the dollar. The counterparty then is liable for a payment which will return the bond to par. In this case, the contingent payment would be 40 cents, or par minus the 60 cents recovered from the company. In general, the more junior the debt in the capital structure, the higher the contingent payment (because junior claims will never recover less in bankruptcy) and the higher the investor's periodic payment. It costs more to buy that which will pay out better.

Deceptive Appearances

Superficially, though the structure resembles a deep out-of-the-money put option, it is more realistically described as a swap. We believe it is more "swap-like" for the following reasons: the buyer makes a continuous stream of payments rather than handing over a premium up front. The seller's contingent payment is triggered only in response to an event that is statistically more extreme than most option triggers. The credit swap has a fixed leg, which represents the buyer's regular, fixed payments, and a floating leg, which represents the seller's potential contingent payment. Finally, credit swaps are usually documented under ISDA swap transactions.

Of course, there are many variations on this product. For example, rather than using just one security, a credit swap can be engineered on a portfolio of securities. Or if the issue is business concentration, a CFO may choose a basket of his suppliers as the reference point for the credit derivative. The reference credits can be almost any sort of entity that both sides of the swap can agree upon. Furthermore, the contingent payment is equally flexible. In a bankruptcy it need not simply cover the difference between par and the recovery rate on a physical security; flat payments or a formula linked to the market valuation of defaulted securities are often used.

Simple Models

Credit swaps can be priced without complex mathematical models. As an example, imagine an investor who bought a bond that pays a fixed rate of treasuries plus 50 basis points, or the equivalent when it is asset swapped, which would be LIBOR plus 20 basis points. To finance this purchase the investor repos the bond and pays the going repo rate, typically close to LIBOR. The net income for this transaction, then, will be 20 basis points, whether originally bought on a fixed or a floating rate basis.

A credit swap offers similar economics to a financed purchase of a bond-no net initial outlay of cash and a stream of income as compensation for a default-contingent risk. Clearly, then, a benchmark for the fair pricing of a credit swap, ignoring counterparty credit risk, illiquidity and balance sheet issues, will be the asset swap spread on a comparable bond. If asset swap spreads were wider than credit swap spreads, you would profit by owning the asset swap and shorting the credit swap, and vice versa.

Though credit swaps are the basic building block in the credit derivatives universe, there are already many other derivative products available to buyers and sellers of credit risk alike. These include options and forwards on credit spreads, total return swaps on debt instruments, options to exchange one asset for another ("substitution" options) and downgrade-triggered credit swaps.

Buyers market

The credit derivatives market offers potential end-users the ability both to buy and sell risk. Participants include banks, insurance companies, corporations, institutional investors, money managers, reinsurance firms and anyone else who has concentrations of illiquid credit exposure (risk sellers) or who seeks to be paid for taking on credit risk buyers. Each group of users has its own agenda and its own specific needs, although the current environment is often characterized as a "buyer's" market because those willing to buy risk through relatively novel means are often well compensated.

Credit derivatives can help banks free up credit lines to important clients. Corporations find it easier to do as much business as possible with a few key banks. For the banks, too much business from one client can breach internal guidelines. For example, if Bank X gives The Widget Company a $400 million dollar loan and then, three weeks later, the company calls to do a large interest rate swap, Bank X will need some way of freeing up credit lines so it can do the lucrative swap.

One way of laying off counterparty risk is to syndicate the loan, or to sell it to another bank. However, these methods lack an important feature: confidentiality. Credit derivatives make it possible to lay off excess exposure discreetly and free up additional lines of credit to make further business possible.

Insurance companies are often faced with a sticky regulatory dilemma that forces them to hold onto investments that they would rather sell. In held-to-maturity accounts assets are, not surprisingly, required to be held to maturity and are difficult to sell unless a severe credit deterioration has occurred. Clearly, an astute portfolio manager might prefer to reduce credit risk prior to such an occurrence. Credit derivatives allow these firms to lay off the credit risk associated with instruments lurking within held-to-maturity accounts without actually selling them off. Regulators, to date, have had no objections to this use of credit derivatives.

Credit derivatives can also help insurance companies to lock in profits without incurring an onerous tax bill. Say a portfolio has appreciated for reasons other than credit changes, perhaps because interest rates have dropped. The insurer can offload the credit risk while locking in the interest rate gains.

Credit swaps can be a boon to companies that wish to hedge against a loss of business from a key client. For example, if the Widget Company sells two thirds of its widgets to General Motors, and if GM goes bankrupt the Widget Company is likely to follow its dominant customer to financial oblivion. Buying a credit derivative can provide the Widget Company with an insurance policy that will pay out if GM defaults.

On the other side of these transactions is the intrepid buyer of risk. Because the credit market is now relatively young, investors are rewarded handsomely for taking on credit risk, which is often costly and difficult to get rid of once acquired. Furthermore, credit derivatives allow an intrepid investor to take advantage of arbitrage opportunities in the price of credit between markets, ratings brackets and term structures.

For example, if an investor can buy a bond for LIBOR plus 50 basis points and then enter into a credit swap for a fixed payment of 30 basis points, then he earns a positive 20 basis points per annum for what is effectively a triple-A asset. And consider the case of the eight-year bond. Typically, the first five years are relatively cheap to the issuer and expensive to the investor; during the last three years, the situation is reversed. The investor demand for five years is greater than that for eight years. With credit derivatives an investor can actually sell the risk associated with the first five years of the bond, and take on only the final, most profitable, three years of risk.

Fertile Adaptation

As with other species of derivatives, as credit derivatives become more accepted they also become more adaptable. The requirements between two counterparties need not match exactly. Consider the following example: Bank X will accept credit exposure at the senior, unsecured level or a spread of 40 basis points; Bank Y wants to sell this exposure at the same spread. However, Bank X feels the recovery rate for this debt is about 50 percent while Bank Y feels that the recovery rate is more like 70 percent. Given these two banks' differing views, how can they build a credit swap structure that works for them both?

One solution is for the two institutions to enter into a credit swap wherein the contingent payment is fixed at 50 percent rather than at the floating recovery rate as determined by a dealer poll. Since the formula "par minus recovery rate" means that Bank Y will receive a higher level of protection than that specified by the 70 percent recovery rate, Bank Y might be amenable to paying a bit more for the additional protection.

While I cannot speak for other banks, JP Morgan has taken a very active approach towards the developing credit derivatives market, not only because we are a large derivatives market maker, but also because Morgan's commercial banking business, which includes corporate lending, providing guarantees and other activities which generate illiquid credit risk, is an avid consumer of credit derivative products. Indeed, Morgan's portfolio managers, who are responsible for managing our "warehouse" of long-term credit risk, have contributed greatly to the product development process, and they have purchased literally billions of dollars in credit as risk management tools. Thus, JP Morgan is extremely serious about credit derivatives, and we look at this area as a business rather than a series of products.