Portfolio Insurance
November 20, 2006; Page C1
The world is awash in credit. For the sake of investors, it had better be awash in good credit analysis, too.
So far this year, a record $2.3 trillion in investment-grade bonds have hit been issued globally, according to Thomson Financial. This already tops last year's $2.1 trillion.
The rise in bond issuance is a trifle compared with what is happening in credit-derivative markets. The issuance of credit-default swaps, which are basically insurance contracts written against debt default, is soaring. As of the end of June, such contracts had been written against a total value of $26 trillion in debt, according to the International Swaps and Derivatives Association. That was up from $17.1 trillion at the end of 2005 and $8.4 trillion at the end of 2004.
Banks and other debt holders can buy credit-default swaps to limit risk. If a borrower goes into default, debt holders will lose money on the debt, but the default swaps they hold will rise in value, helping to mitigate the loss.
On the other side of the trade, sellers of credit-default swaps have a nice source of income, as long as the issuer whose debt they are backing doesn't go belly up.
The boom in credit-default swaps, as well as other derivative instruments that allow creditors to mitigate risk, and the run-up in bond issuance may not be unrelated. The decision to buy or underwrite a bond is easier to make if you can offload some of the risk associated with it. By diffusing risk, the chances for financial blowups seems to be diminished.
But in the process of spending so much brain power slicing and dicing risk and passing it around, Wall Street might miss more fundamental questions about the underlying health of companies issuing bonds.
Frank Partnoy, of the University of San Diego, and David Skeel Jr. of the University of Pennsylvania Law School illustrated this point in a recent paper by pointing out that the banks that financed Enron's debt used massive amounts of credit derivatives to limit their own risk of the company going into default. That is one reason they might have fallen asleep at the switch.
The real test for credit derivatives might not come until the next recession, when the chances of corporate debt defaults will rise. Nobody can say when that downturn will come, but when it does, it will be a nail-biting time.
Write to Justin Lahart at justin.lahart@wsj.com1
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Derivatives Tails Are Wagging Corporate Bond Dogs: Mark Gilbert
By Mark Gilbert
Nov. 23 (Bloomberg) -- The bond vigilantes may have retired; the derivatives vigilantes are saddling up.
Last week, London-based hedge fund Cairn Capital persuaded Experian Group Ltd. to change the terms of a bond issue to safeguard derivatives holders. In October, New York-based hedge fund Blue Mountain Capital told cable-television operator Liberty Global Inc. that the company could have won cheaper borrowing by consulting with derivatives owners before selling new bonds.
Bond prices for Delphi Corp. and Dura Automotive Systems Inc. whipsawed as owners of debt insurance on the two bankrupt U.S. auto-parts makers raced to buy securities to resolve the contracts. And for weeks, European indexes that track credit derivatives have bounced around as traders try to second-guess whether new securities are about to flood the market.
All of which is evidence that the credit-derivatives tail is starting to wag the corporate bond market, altering the behavior of borrowers and directly influencing the value of the securities that derivatives such as credit-default swaps are based on.
Suppose you signed up for a five-year auto-insurance policy, only for your car to disappear in a way not covered by the insurer (zapped by aliens, say). You would still owe the annual premium even though the policy had become worthless.
That's one of the risks facing credit-default swap holders. They may have bought derivatives insurance to safeguard their corporate debt investment, only for the bonds to disappear because the company decided to repay them early, which often happens when a borrower gets taken over.
Reconciling Needs
To get paid on a credit swap, the holder has to hand over the defaulted securities, just like a driver claiming for an unsalvageable car has to deliver the crashed vehicle to the insurer. The swaps become worthless if the bonds disappear.
The deal brokered by Cairn Capital with Experian is designed to avoid that situation. It introduces a new flavor of investor protection to the debt markets, reconciling the credit-checking company's funding needs with those of investors who had augmented their fixed-income investments with derivatives.
In the event of a takeover trashing Experian's credit rating to non-investment grade, bondholders can choose either full repayment or a higher interest rate -- the latter option crafted for investors who don't want to unravel their derivatives strategies by handing back their bonds.
``The technique of offering bondholders a coupon step-up as an alternative to the more traditional put at par is an important innovation,'' said Deniz Akgul, an analyst at Cairn. ``We hope and expect coupon step-ups will be used more widely to ensure stability in the credit-swap market.''
Chasing Debt
Default swaps on Rentokil Initial Plc, a London-based pest- control and washroom facilities company, lost 80 percent of their value earlier this year after a change in its capital structure erased the debt linked to those contracts. Delphi bonds were trading at about 57 percent of face value before the Troy, Michigan-based company filed for bankruptcy in October 2005. With $20 billion of credit swaps and only $2 billion of bonds, prices soared to about 70 percent as derivatives traders fought over the scarce securities.
``Corporate events can have unexpected effects on bonds, with the opposite happening to credit-default swaps,'' says Andrew Sutherland, who oversees about 13 billion pounds ($25 billion) of corporate bond investments at Standard Life Plc in Edinburgh. ``Treasurers have got to be aware of it.''
Unintended Consequences
Last month, default swaps on Englewood, Colorado-based Liberty doubled in 20 minutes after the company decided to replace an existing bond issue with new debt that could be transferred to its Dutch unit, rather than retiring the old notes. That prompted an offer from Blue Mountain Chief Executive Officer Andrew Feldstein, who manages the $3.6 billion hedge fund, to buy new bonds at a lower yield provided the obligations couldn't be switched.
``Advising a corporate client on a bond buyback that will extinguish the reference obligation on which credit derivatives are based generates market-sensitive information just as advising a client on a takeover does,'' Thomas Huertas, the banking- industry supervisor at the Financial Services Authority, which regulates U.K. financial markets, said in a Sept. 19 speech.
At the beginning of the month, an index that tracks the 30 most-volatile European default swaps jumped 6.5 basis points higher in a week, climbing to about 49 basis points after declining for six consecutive weeks.
Feedback Cycle
The moves were driven by speculation about a new strain of credit derivative called a constant proportion debt obligation, invented by ABN Amro Holding NV. Traders tried to anticipate whether ABN had found additional buyers for the new securities, which would have shifted the balance of buyers and sellers in the default-swap market. That sets up a feedback cycle; lower default-swap values make it harder to engineer derivative products at attractive yields for investors.
The credit-derivatives market is too big to ignore. It doubled in a year, surging to more than $20 trillion by the middle of this year, according to figures released last week by the Basel, Switzerland-based Bank for International Settlements.
Companies are typically fixated on their shareholders, reluctant to even acknowledge their bondholders. They are about to discover a whole new constituency of investors clamoring for attention -- the derivatives crowd.
(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net . |
