The Long-Awaited Arrival of Credit Derivatives
Credit derivatives are finally being used to manage the
last remaining dimension of financial risk
By Robert McDermott
The advance hype about credit derivatives has been unrelenting and high-pitched. For more than four years, dealers have predicted that their entrance into
the mainstream derivatives world was just a matter of months or even weeks.
And there's been no shortage of skeptics who, in the absence of any significant
volume, have dismissed credit derivatives as a financial engineering pipe
Now, at last, the skeptics have been proven wrong. There are now definitive signs that these revolutionary new instruments are actually being used in
the real world by real financial institutions. Though credit derivatives
have not developed into the commodity products that dominate the interest
rate and currency markets, credit derivatives are nevertheless reaching
It is a positive development. Credit was always the one piece that was
difficult to isolate in the risk equation. Credit derivatives allow issuers,
investors, banks and dealers a full panoply of options in managing risks.
By quantifying and pricing each risk component-interest rate, duration,
currency and credit-the whole can be unbundled. The risks can then, theoretically,
be parceled out to the holder able to handle them most efficiently. In the
ideal world the effect should be increased access to and decreased cost
of credit. Even falling short of this utopian vision of global capital market
efficiency, the benefits will still be enormous, as the relationship between
the supply and demand for credit is adjusted.
If you need more than theoretical evidence as to why credit derivatives
are important to watch, just take a look at the surging growth in contracts
over the past three years. Depending on who you believe, the notional volume
of contracts has jumped from an estimated $5 billion in 1993 to $40 billion,
according to CIBC Wood Gundy. "Volume is starting to grow exponentially,"
says John Tompkins, head of credit derivatives at Prebon Yamane. "We'll
see this soar over the next year." Prebon is one of the two broker-dealers,
with Garvin, Guy, Butler, that act as market-makers in credit derivatives.
Blythe Masters, global head of credit derivatives at JP Morgan, estimates that total outstandings, which were in the "low-digit billions"
as recently as last year, have mushroomed dramatically. "Sometime during
this year that number surpassed $50 billion, and it's possibly closer to
$100 billion than to $50 billion," she says. "Clearly we are on
some kind of exponential growth path."
Volume and liquidity have been helped by at least one very large benchmark transaction. In August JP Morgan structured and sole-managed a mammoth $594
million note linked to the credit of Wal-Mart Stores. The note was placed
globally with a broad range of investors in the U.S., Asian and European
capital markets, many of whom do not normally buy U.S. public debt.
"The product has clearly evolved beyond the interbank market," says Masters. "When you have broad distribution of a large transaction
like that, investors become significantly more familiar with the specifics
of how documentation works and what synthetic credit risk really means.
A lot of America's largest pension funds, banks and investment managers
can now say they've bought a credit derivative."
The JP Morgan transaction was followed a few weeks later by another mega-deal. In mid-September Chase revealed it arranged for the issuance of an investment-grade
security based on a $625 million managed portfolio of non-investment-grade
bank loans. The structure, which it calls a Chase Secured Loan Trust Note,
was issued by a trust and lets investors effectively purchase high-yield
bank loans on margin without the risk of a margin call. "This type
of structure allows a variety of investors including insurance companies,
hedge funds and money managers to get exposure to bank loans on a protected,
investment-grade basis," says Gregg Whittaker, global head of credit
derivatives at Chase Securities. "They can now get exposure to bank
loans in a security form with relatively little administrative burden at
a fraction of the capital ordinarily required."
Actual and perceived illiquidity has been a major hurdle since credit
derivatives first appeared as over-the-counter contracts in 1991. But today
that barrier appears to be falling. As recently as 1995 there were no two-way
prices on credit derivatives. Now inter-dealer brokers offer quotes on dozens
of U.S. credit swaps, options and indices, and active institutional traders
have begun to quote both sides of default and total return swaps, offering
both bid and ask prices.
Banks with big research and development efforts in fixed income and derivatives markets-Bankers Trust, Chase Manhattan and JP Morgan-dominated the nascent
credit derivatives markets. But the recent surges in volume have come from
the flurry of new entrants-banks and brokers as diverse as Citibank, Credit
Suisse Financial Products, CIBC Wood Gundy, Lehman Brothers, Merrill Lynch
and Bank of Montreal. And waiting not too cautiously on the sidelines are
the Japanese, German, U.K. and Swiss banks, which hope to play a major role
in the development of the business outside the U.S.
In the U.S. the dominant share of credit derivatives trading involves
a universe of perhaps 500 names-financial institutions and corporations
with large, liquid debt issues outstanding. Still, a recent list of swaps
quoted offered a fair selection of relatively obscure names, and contract
amounts as low as $10 million.
On the buy side the major banks are joined by hedge funds and insurers
which play increasingly prominent roles in the market, typically seeking
incremental yield from buying credit risk. For the roughly 25 major U.S.
insurance companies seen regularly in the market, taking on credit risk
is a natural extension of their core business and capabilities. "We
see insurers actively doing total return swaps and default puts to pick
up an extra spread of 10 basis points, as well as trading bond indices to
hedge against price changes in the underlying issues," says one trader.
Hedge funds, which are key players in the high-yield bank loan sector, have
also helped push up volume.
In Europe the lack of two-way prices is one factor still hampering market growth, according to Paul Hattori, vice president at The Chase Manhattan
Bank in London. Bank loans play almost no role in the market; in Europe
it is all about bonds. Some dealers, however, say they are seeing new activity
in credit structures on secondary European and Asian currencies.
Attempts to peel off credit risk have been around for decades in the
form of credit enhancements and default guarantees such as bond insurance.
But the neater package known as a credit derivative is generally dated from
Bankers Trust's 1991 introduction of collateralized loan obligations. By
repoing a commercial loan portfolio and breaking the package into tranches,
BT held the loans and sold the default risk-essentially creating the first
One indication of the speedy development of the credit derivatives market is how far it has moved from the original BT collateralized loan obligation
structure. "Since 1993," says Robert Reoch, director of special
financial products at Nomura Capital International in London, "when
credit derivatives really emerged, buyers of credit risk were solely interested
in yield enhancement. Today, by contrast, they are using credit derivatives
to tailor the terms of transactions to meet their needs precisely in regard
to currency, duration and setting caps on maximum exposure."
At the heart of every credit derivative is the recognition of a credit
risk premium. The capital markets charge for varying degrees of default
risk by setting a price spread between corporate bonds with different ratings.
This premium not only makes it possible to isolate and price the credit
risk component, but is itself a variable that fluctuates over time. Credit
risk, then, is more than the risk of potential default. It's also the risk
that credit risk premiums will change, affecting the par value of the underlying
Credit derivatives are typically priced off of instruments that permit
some type of price discovery. The reference asset for a credit derivative
used to hedge the credit risk of bank loans, for example, is often a publicly
traded bond issued by the same borrower, or less commonly a widely syndicated
loan or loan portfolio. "The challenge is to build an integrated business
marrying derivatives and corporate bonds, not just to create new structures,"
says Nicholas Mumford, global head of credit derivatives at Citibank in
New York, whose team interacts continuously with the bond and loan sales
Although most credit derivatives deals are highly customized, they consist primarily of two core building blocks: default swaps or puts and total return
swaps. In a default swap contract, a credit risk seller pays a counterparty
for the right to receive payment in the event an agreed change takes place
in the credit status of reference credit, typically a corporate bond. These
types of changes are usually triggered by default or debt repackaging, not
by a downgrade. Default swaps normally contain a "materiality"
clause requiring that the change in credit status be significant and be
validated by third-party evidence-typically the plummeting of the bond's
price in the market. The payment is sometimes fixed by agreement, but a
more common practice is to set it at par minus the recovery rate, a figure
determined by the market price of the defaulted bonds some months after
the actual default.
Total return swaps, by contrast, allows the credit risk seller to retain the asset and receive returns that fluctuate as the credit risk changes.
The seller pays the total rate of return on a reference asset, typically
a bond, including any price appreciation, in return for periodic floating
rate payments plus any price depreciation.
From these two building blocks, bankers have churned out a bewildering
variety of synthetic credit instruments to meet investor demand. Buyers
of credit derivatives are often hedge funds or insurance companies looking
either to pick up incremental yield or to diversify their portfolios.
The yield pickup on credit derivatives can be substantial. With five-year single-A corporate bonds going for LIBOR plus 15 basis points, it's increasingly
difficult for corporate bond investors to make any serious money.
Credit derivatives can be particularly attractive for fund managers benchmarked to the major bond indices. Bond managers can use total return swaps to hedge
part of their portfolio to an index. Building a hedged position in the cash
market would not only be difficult to accomplish, but certain to influence
The derivatives alternative is also likely to be considerably cheaper.
Total return swap quotes are readily available, especially for short-term
hedges. The repo market for high-yield bonds, by contrast, is so thin that
it is difficult to finance the bonds themselves.
Credit derivatives were first called into service to hedge bank loans.
The early growth of credit derivative instruments, in fact, was helped along
by a key secular trend: More and more financial institutions were becoming
originators, rather than long-term holders, of credit. The explosive growth
of securitized instruments was the most successful outgrowth of this trend.
On the theory that anything can be bundled up into a security, banks found
that their balance sheets would benefit from selling off their loan portfolios.
Selling loans, however, can put banks in a difficult situation. A bank
needs to maintain the relationship with the company to which it made the
loan, and selling off the loan can threaten a carefully nurtured banking
relationship. On the other hand, each commercial loan exposes a bank's balance
sheet to a very specific kind of credit risk. Credit derivatives have become
popular because they enabled banks to retain the asset-and the relationship
with the customer-while segmenting and laying off a part of the risk.
For commercial banks, credit derivatives represent a dramatically different way to approach balance sheet risk management. "The inherent nature
of commercial bank loan portfolios is to concentrate credit risk geographically
and by industry," says Shaun Rai, head of credit derivatives at CIBC
Wood Gundy. Loans are originated locally, and banks tend to build depth
and expertise in particular industries. This balance sheet inflexibility
has helped fuel a steady stream of bank lending disasters. By using credit
derivatives, banks can potentially diversify these risks globally, separating
the funding decision from the credit decision.
In practice, this means that a bank can free up lines of credit and continue to lend to a valued customer, even when exceeding its credit exposure limits
to the company or industry, by laying of all or part of the credit risk
through a total return or default swap. And it can focus on lending to the
sectors where it has a strong franchise and depth of expertise without worrying
about excessive risk concentration. Less credit-worthy banks whose lending
margins are squeezed by a higher cost of funds could potentially get higher
returns and exposure to better credit risks from credit derivatives than
from direct lending.
Corporate issuers have their own uses for the products. One basic strategy is to hedge credit risk exposures to key customers and suppliers, either
directly through default swaps or via the proxy of derivatives based on
a basket of comparable risks. Since all the suppliers whose business is
heavily dependent on major customers such as Boeing or DuPont share common
credit risk characteristics, access to liquid public debt issues becomes
a key factor.
Corporate treasurers who have secured financing through a complex capital structure often find that the market prices different tranches of debt unpredictably,
based on differences in both seniority and term. Credit derivatives allow
them to arbitrage out the spreads. "Going long zeros and shorting coupons
is almost always a good trade for corporate treasurers to narrow the spread,"
according to Philip Borg, managing director of global credit derivatives
at Bankers Trust. "There is always a premium paid on zeros."
Corporate bond issuers can also use credit options to hedge the credit
risk premium component of future borrowing costs. Since the spread paid
by borrowers in different rating tiers against Treasuries or comparable
assets tends to widen during economic downturns, the purchase of call options
on the spread protects against an overall rise in the risk premium. Should
the premium rise-which historically it has done both quickly and sharply
at times in the economic cycle-the payoff on the option offsets some or
all of the increased funding costs.
Derivatives can also be used to alter the tenor of debt issues. They
can shorten maturities though puts, effectively converting an eight-year
note into five years, for example. And credit spread forwards can be used
to strip out the near term while retaining the out years.
Valuation and pricing
While a number of major money center banks are continuously developing
models to quantify and price credit risk, the market currently functions
largely by referencing the cash market. "You essentially reference
the underlying cash market and the spread of the credit over a comparable
asset of Treasury of like duration," explains one trader. The bulk
of activity is in the two-to-four-year range. If XYZ bond trades at Libor
plus 100 basis points, a two-year credit default swap can be expected to
trade somewhere around 100 basis points or tighter.
This makes perfect sense to Chase's Hattori. "The principles and
goals of managing credit risk remain the same as they have for centuries.
The tools available to do the job are just becoming more refined and flexible,"
The direct reference pricing to the cash market makes credit swap pricing fairly straightforward and transparent for investors and corporate end-users
to understand and evaluate. Synthetic credit instruments such as first-to-default
baskets are another story. The pricing in the more complex instruments is
based on the ability to analyze and value not simply the default or expected
loss risk, but the correlation risk among different credits in the swap.
Building bases of historical data to quantify and price loss probabilities
is also critical.
Not everyone agrees that pricing is such an efficient process. "Six months ago it tended to be fairly primitive," says Prebon Yamane's
Tompkins. "It wasn't unusual to see prices 100 basis points apart.
Since then, however, it has become more efficient, with dealers making two-sided
prices; a 50-point spread would be considered very wide." Other dealers
also perceive that prices are converging and spreads tightening.
Regulatory capital requirements remain a formidable barrier for many
potential bank participants. Current bank regulations require that banks
hedging loans via credit swaps reserve capital against both the loan and
the derivative contract, rather than netting the position. Recent statements
by the Federal Reserve Bank and the Office of the Comptroller of the Currency
express what most view as a positive attitude toward the development of
the credit derivatives market, and a commitment not to place unnecessary
hurdles in its path. Explicit in the regulators' views are an intent to
review capital requirements as the market develops. The Bank for International
Settlements (BIS) has also begun to indicate the direction, generally received
as positive, that its guidelines for credit derivatives will take.
Documentation is another head-ache. Every credit swap references a specific rather than a generic risk, making standardization of swaps documents an
elusive goal. The lack of standardized documentation for credit swaps, in
fact, could become a major brake on market expansion.
To smooth out the process, the International Swaps and Derivatives Association is advocating simplified, "menu-like" contractual frameworks for
the transactions. ISDA began circulating draft forms of documentation for
comment in January of this year, and issued a draft model for a credit default
swap confirmation in August.
For some, standardization can't come too soon. "For this market
to prosper, standardization of documentation is pivotal," says Patrick
Gallaway of Nomura Capital. "Documentation is a high priority for a
lot of firms in this market," adds an attorney who is a member of the
ISDA credit derivatives working group. "There is wide participation
in developing documentation standards, and a consensus is within reach.
We might see something from ISDA by the end of this year."
Virtually everyone in this market expects substantially increasing volumes of supply from both financial institutions and corporations in the next
few years. "Last year we saw $1 billion or more in bank loan capital,
leveraged 10 to 20 times, enter the credit derivatives market, largely through
loan swaps," says Citibank's Mumford, who adds that the sharpest rise
in activity was in non-investment-grade loans. "Revenue streams from
credit derivatives should parallel those of equity derivatives within two
years." The reasoning: The credit universe is not only much larger,
but more liquid. And more capital means more players and more flexibility.
Dealers predict that the new supply of product will come from stricter
and more aggressive loan portfolio management by commercial banks. "We
are getting several queries a week from banks who are newly interested in
looking at opportunities in the market, chiefly from Europe," says
Prebon's Tompkins. "Demand is such that you're starting to see bank
portfolio managers arranging one-off swaps with other banks, with no intermediary
dealers involved," says Barry Campbell, manager of the loan portfolio
department at Bank of Montreal.
Dealers also see increasing demand as investors perceive bank loans as
an attractive asset from which attractive comparative value can be won.
Many investors have come to believe that bank loans offer risk-adjusted
rates of return superior to bonds, since recovery rates in defaults have
tended to be higher historically and interest rates are commonly reset monthly
CIBC's Rai believes credit derivatives will profoundly change the bank
loan markets on a global scale. By giving investors access to bank loan
portfolios, credit risk will be more widely and efficiently traded among
an expanding universe of players. He envisions massive diversification of
credit risk in loan portfolios that will lead ultimately toward greater
liquidity in the credit markets. The more efficiently credit risk can be
diversified, hedged and traded, the more rationalized its pricing will become.
The ultimate result will be to lower the costs of credit.
He also believes credit derivatives will create new bridges between separate capital markets in the coming decade, just as currency and interest rate
products did in the previous decade. "Globally, the credit markets
are immense and highly fragmented," Rai says. "Most holders of
credit risk have overwhelmingly domestic exposures and resulting high concentrations
of risk." In practice this may allow banks to diversify credit risk
exposures in a loan portfolio globally, across economies with differing
cycles and characteristics.
Few of these grand scenarios are likely to materialize before the millennium. But if the financial logic holds, credit derivatives could transform the
financial world in the coming decade as profoundly as interest rate and
currency derivatives did in the previous decade.
Credit Derivatives in Emerging Markets
Emerging-market credit derivatives account today for the largest share
of the outstanding volume. But their function is less to diversify and rationalize
credit risk than to create access to markets by synthesizing assets that
are difficult or impossible to purchase directly. "Emerging markets
are a very different sector," according to BT's Borg. "The focus
is primarily on sovereign rather than corporate risk and on creating customized
risk parameters. And there is more speculative play."
Credit derivative structures are frequently used to create long or short exposure to the behavior of an overall debt market, as well as to customize
duration. Brady bonds, for example, can provide an attractive vehicle for
participation in the Argentine or Brazilian debt markets, since their principal
is guaranteed. But 30-year maturities, local regulations, reservations about
transparency in trading markets and nondollar settlement issues can make
holding the bonds themselves far less efficient than customized synthetic
instruments structured around credit derivatives. "Derivative structures
can separate out the sovereign risk of default, convertibility risk and
currency risk for both investors and issuers," says ING Barings' American
derivatives head Robert Hedges. "More emerging-market debt issues can
be now be cleared through Euroclear and paid in dollars."
There are also some signs that a few U.S. banks are using the instruments to get out of risk associated with foreign loans. Hal Holappa, head of credit
derivatives marketing at CIBC Wood Gundy, tells of one U.S. bank that recently
found itself uncomfortable with the credit risk inherent in a loan to a
Chinese borrower in the face of tense relations between the countries. The
bank decided to transfer the its default risk to an Asian investor. The
bank retained the asset, while paying an acceptable premium to shed its
A growing share of activity in emerging market credit derivatives is
being driven by corporations seeking to hedge capital exposures and receivables.
For U.S. corporations with substantial Argentine receivables, a default
option on Argentine government bonds can provide an imperfect but still
effective hedge. "For a U.S. company looking to hedge one-to-two-year
receivables in Brazil, we'd look first at the credit market's pricing of
Brazilian bonds, and then at the specific characteristics of the receivables
to determine whether they are in fact more or less risky than bonds,"
says Holappa. "There are no formula solutions. Depending on the tenor
of the bond market, it might make sense to create a default risk hedge structure
by shorting Brazilian bonds, or conversely by creating a structure that
synthesizes a long position in two-year Brazilian debt." The core issue,
as in all credit derivatives, is to quantify the risk of loss.
Analyzing Multicredit Baskets
An investor is most likely to find satisfaction in the credit derivatives market by doing his or her homework-and that means looking at the offerings
from every available angle. First-to-default baskets, for example, offer
an alternative whose attractions are difficult to discern at first glance.
These notes are issued commonly on a package of four single-A credits. They
offer investors incremental yield of 75 basis points or more, but the tradeoff
is that the investor takes the loss should any one of the credits default.
At first glance the package doesn't sound wildly attractive because a
package of four single-A credits produces a triple-B instrument, not a single-A
instrument. The reason: While the expected default rate on a 10-year single-A
credit is 3.9 percent, the probability on a basket of four rises notionally
to 15.6 percent.
But look again. "Despite a triple-B rating, a basket of four single-A credits will outperform a triple-B bond," says Citibank's Mumford.
"Bond investors are already loaded up on triple-Bs, because it's the
only part of the market where you can get a current spread. But on an historic
basis, the triple-B default rate over five years or more will result in
a negative return."
Dealers have used a total return swap on a high-yield bond or loan to
create a synthetic bond instrument, or clustered several into a basket and
placed in a trust. The result is a kind of indexed derivative product offering
investors diversified exposure to the U.S. high-yield market-where credit
risk is the key variant in valuation-without risk of principal.
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