Investors dine on fresh menu of credit derivatives

In March of last year, Kyle Bass, founder of the hedge fund Hayman Capital Management, made a startling proclamation: aggressive young bankers in Japan were pushing complex over-the-counter derivatives similar to those that rapidly soured during the financial crisis of 2008.

Mr Bass warned of the return of the spectre of AIG, the giant insurer that required a huge bailout during the depths of the crisis, after selling billions worth of credit default swaps (CDS) that offered payouts to investors in defaulted mortgage bonds.

That warning appears sagacious, with investors once more chasing levered returns via certain types of US credit derivatives that Wall Street is willingly providing in the current climate of low interest rates and moribund volatility.

Some market participants say the rise of these derivatives raises questions about the effectiveness of financial reform undertaken since 2008. While standardised derivatives such as interest rate swaps are now transacted in exchange-type venues and centrally cleared, the flourishing area of opaque products are not, and moreover there are few records of activity that regulators can monitor.

"We've reformed nothing," says Janet Tavakoli, president of Tavakoli Structured Finance. "We have more leverage and more derivatives risk than we've ever had."

Proponents say bespoke instruments are playing a prime role in allowing investors to "hedge", or offset, increasingly large positions in the debt markets. But in the current environment of low volatility and meagre returns, the risk is that the strong growth in the use of complex derivatives may compound the next major market reversal.

The danger, as demonstrated vividly during the financial crisis when Lehman Brothers collapsed, is how complex credit bets can unravel and prove enormously costly for investors once market volatility erupts.

"The markets don't really need a Lehman or even Lehman-lite event for a credit dislocation," says Manish Kapoor, managing principal at hedge fund West Wheelock Capital. "You just need spreads to widen out or rates to go up for a significant impact on collateral movement for derivatives."

The renewed boom in credit derivatives is being powered by yield-hungry investors and Wall Street banks looking for new revenues. The two instruments helping investors play booming corporate credit markets at this juncture include total return swaps (TRS) and options on indices comprised of credit default swaps.

A total return swap enables an investor to receive a payment based on the performance of an underlying basket of assets. Such a strategy in this case enables an investor to leverage their exposure to the performance of credit, without owning an actual asset. The downside is that any sharp deterioration in the value of credit means an investor would need to compensate the other party in this transaction, usually a bank that arranged the deal.

"The new TRS product is really, really interesting in that you do now have a number of TRS products referencing credit indices," says Andrew Jackson, chief investment officer at Cairn Capital. "We're even starting to see options on TRS."

Markit, the financial services and data company, started licensing its bond indices to be made into TRS about two years ago. Analysts at Morgan Stanley estimate that the volume of TRS tied to these indices will be about $10bn this year, and new TRS tied to its leveraged loan indices will boost trading further.

The use of options tied to CDS indices, known as "swaptions", has grown sharply, buoyed in part because the instruments are not required to be centrally cleared. Such swaptions allow investors to protect their portfolios from large movements in markets, known as "tail risk".

More than $60bn of CDS index options currently exchange hands each week - up from just $2bn traded per month back in 2005, according to Citigroup analysts.

Bob Douglass, head of credit electronic trading at Barclays, says the bank is excited about the future of these swaptions: "It's one of the really bright spots in the world of credit derivatives insofar as growth goes. We're ramping up our capacity for this."

Meanwhile, in the retail market, ProShares this month began offering an exchange traded fund that uses only swaps tied to CDS indices that allow investors to go long or short credit in a fresh way. Many ETFs already use TRS, options and other derivatives to juice up their returns or hedge portfolios.

Mr Douglass describes large asset managers, financial institutions and hedge funds as the "three pillars" of swaptions clients.

That leaves the possibility that in fighting the vanguard of the last financial crisis, regulators have missed new areas of danger in the system.

Says Ms Tavakoli: "There's always a blind spot in terms of risk when an activity is not attracting much capital."

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