The end of the insurer as investor?
Spreading the load of distribution
From direction to correlation
GMAM looks for more efficient risk exposure
A NEW KIND of investment tip is circulating in the City. "If you want to make money, buy a first-to-default note on a bank" was the advice overheard in a London restaurant last month. Where once investors were sold on the easy-to-understand virtues of cheap bonds or undervalued equity, these days it seems that conspiratorial figures hunched in urgent conversation over their lunch plates are just as likely to be discussing the latest collateralized swap obligation, first-to-default basket, or credit option.
Some of the smartest players in the financial markets – and perhaps many of the not so smart – are piling into structured credit. "We've seen new buyers coming into the market," says Marc Pantic, financial engineer in the structured credit team at SG CIB in London. "Structured credit volumes have increased significantly due to continued activity from traditional users of the product – principally banks – but also because of the arrival of new users."
Standard & Poor's estimates that the European CDO market nearly tripled in size last year. Synthetic CDO issuance totalled over e29 billion.
It's got to the point where, as one head of credit at an investment bank puts it: "It's very in right now to be a manager of all credit products. A lot more people are saying to me, for example, that they have a view on correlation." He rolls his eyes. The implication is that many investors are picking up the buzzwords but don't really know what they mean.
One of the main reasons for the increase in interest in structured products is that credit spreads have generally been tight and trading in a relatively narrow range since the end of 2003. That's very different to the previous three years. From 2001 until October 2002, spreads consistently widened. Between then and the end of 2003, they consistently tightened. "Investors needed to get the overall directional trade, the beta trade, right," says Guy Stear of SG CIB credit research.
Assuming investors did get that right, it was easy to hit their targets. Not in 2004. "The big theme this year has been the search for yield enhancement," says Mike Connor, managing director in structured credit derivatives at Merrill Lynch. And that has led a wide range of investors to look at a variety of structures they might not even have considered 18 months ago.
Other factors have helped considerably. The rapid growth of tradable credit derivative indices that are transparent and equally accessible to all dealers has made more products available to investors to manage credit risk. Three years ago, they were dependent on illiquid total-return swaps based on proprietary indices. Liquidity in the merged Dow Jones iTraxx and CDX and their predecessors has opened the flow credit markets to tactical investors who have, say, a six-week time horizon.
This has been the building block for structured credit products. These include nascent credit options and standardized, tranched CDOs of iTraxx, which provide an easy-to-follow benchmark priced by the market on a daily basis. Live two-way prices mean that for the first time investors have a neutral reference point for structured credit products. And that has made trading much easier.
The combination of transparency and liquidity is what many in the markets have been waiting for, and has spurred the growth of credit hedge funds over the past 18 months. "The market reached a beautiful inflection point in the first half of last year," says Andrew Feldstein, who left his job running structured credit at JPMorgan to set up Blue Mountain Capital Partners last July with several other former Wall Streeters. "For us to prosecute our strategies the credit markets needed on the one hand to be liquid, transparent and efficient. But on the other hand sufficient inefficiencies also need to persist. The latter has been and will be there for some time. Until last year we were lacking the first part." Blue Mountain Capital Partners joined with UK hedge fund BlueCrest Capital Management to establish BlueCrest North America, which manages two funds: the first, Blue Mountain Credit Alternatives, has about $1.9 billion in assets split among four strategies: credit long/short, intra-credit trading, volatility trading and correlation trading. The second is Blue Mountain Ultra Short fund, a dedicated short fund with about $100 million in assets.
Blue Mountain is not alone. Last year, by some reckonings, 70% of all new hedge funds setting up were credit funds.
Liquidity begets liquidity
Liquidity is begetting liquidity, which in turn has attracted yet more players into structured credit. "Exotic credit products got so liquid so quickly that more and more investors have been looking at them compared to a year ago because they know they can get out of a trade now," says Connor. "Custom tranche prices are more or less within a point to half a point of each other across the Street, and that includes on other brokers' deals."
The credit markets in general and the structured credit markets in particular might well have benefited from improving transparency and liquidity. But we've been in similar yield-hunting territory before. In 1997 and 1998 credit investors were patting themselves on the back for their sophistication and ability to distinguish between credit risks whether in regular Asian and east European bonds or the blossoming corporate high-yield cash CDOs. The flight to US treasuries when first Asian and then Russian financial markets collapsed put paid to the pretensions of those investing in emerging markets, while those buying high-yield CDOs discovered that investing in black box structures many of whose underlying assets were bought at very tight spreads offers no protection when credit markets tank, spreads widen and a few large credits go bankrupt.
Are investors setting themselves up again for a similar crash in the credit markets? "In certain respects people are getting ahead of themselves, looking at structured products because they are structured products, rather than focusing on the value that these products are adding," warns Jim Ballentine, global head of structured credit at Lehman Brothers.