Demand for collateralised debt obligations, the focus of the recent sell-off in the credit markets, has evaporated in recent days, but investors are keeping faith with derivatives as they try to turn market losses into profits, say bankers in London. As credit spreads track wider, products that allow investors to express a negative view are finding favour. These include credit default swaps, constant maturity default swaps and credit index options, which can generate higher returns as corporate bonds decline. "The CDO market is obviously going to face a period of consolidation," said Charles Longden, head of credit marketing at ABN AMRO. "But the last few weeks have shown the value of derivative products that can be used to hedge exposure or take a two-way view."
Sales of tranched structured products such as CDOs have slowed to a trickle after the now infamous long-equity short mezzanine strategy exploded earlier this month, reportedly losing some investors over a $1 billion within hours.
The bet allowed investors to buy the riskiest slices, or tranches, of CDOs, and sell the safest. Both sides of the wager lost after Standard & Poor's moved Ford and GM to junk. The risky tranches dropped as much as five percent in a day.
A CDO packages together a portfolio of credit default swaps, or insurance policies against default, which are sliced into tranches of risk that offer scaled returns according to their exposure to bad news. So-called equity tranches are most risky while mezzanine tranches less so.
In response to Ford and GM, as well as a rise in leveraged buyouts, faster inflation and slower economic growth, the credit markets have this month seen the biggest sell-off since the end of the dot-com bubble in 2002. In a few days the Iboxx index of European corporate bonds has given up over 20 months of gains.
Banks with big structured finance businesses, such JP Morgan and Deutsche Bank, are likely to be most hurt by the slowdown in the CDO business, analysts say, but debt originators have been quick to promote other ways to take a view.
Credit default swaps are probably the easiest way for investors to hedge spread widening as their value rises on increased perceptions that companies are in trouble.
They have soared in recent days, with the iTraxx crossover index of default swaps rising over 100 basis points since the automaker downgrades, with trading volumes at three-times average levels of up to 8 billion euros.
Another product which can be used to hedge spread-widening is the constant maturity default swap (CMCDS). Already popular in the interest rate world, the CMCDS attracts a lower-than-average premium if the corporate spread stays below a specified level and a higher coupon if it exceeds that level.
In that way the seller hedges himself against widening, while the buyer is able to express an opposite view.
Options on credit default swaps, introduced with much fanfare last year but habitually marooned on the sidelines, are also increasingly popular. As in any futures market, investors are given the chance to profit whichever direction the market is heading. Meanwhile, as correlation traders lick their wounds, some investors in CDOs remain quietly satisfied. As correlation fell in the past weeks, and equity tranches got hammered, the mezzanine tranches staged a mini-rally of some 60 basis points.
The higher idiosyncratic risk (company-specific rather than economic or systemic) implicit in the downgrades of Ford and GM was good news for those tranches, analysts say.
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