Three years ago investment bankers began to talk about a new class of structured products – credit derivatives. But, despite the talk, almost the only deals done were for the investment banks themselves. Clients weren’t interested and hedging was next to impossible.
But, at last, the talking is over and a significant number of transactions are getting done.
The potential of credit derivatives is immense. There are hundreds of possible applications: for commercial banks which want to change the risk profile of their loan books; for investment banks managing huge bond and derivatives portfolios; for manufacturing companies over-exposed to a single customer; for equity investors in project finance deals with unacceptable sovereign risk; for institutional investors that have unusual risk appetites (or just want to speculate); even for employees worried about the safety of their deferred remuneration. The potential uses are so widespread that some market participants argue that credit derivatives could eventually outstrip all other derivative products in size and importance.
The first deals were done in 1993 when Bankers Trust and Credit Suisse Financial Products (csfp) in Japan began selling notes whose redemption value depended on specified default events. “When the business started, it was about credit protection for the bank,” says Philip Borg, a managing director at Bankers Trust. “We would sell a bt note whose payout was linked to a credit event and a reference asset. We also did basket notes which referenced several names. The investor receives a premium to all of them because if any one of them defaults then he has to make a payout to Bankers Trust.” This enabled Bankers Trust to free up its credit lines to the Japanese financial sector.
The main problem was to find investors willing to buy the notes. The incentive used was yield. “The market depends on two sets of counterparties – hedgers that wish to mitigate a particular credit risk and entities that want to assume that risk for a return,” says Martin Kannengieser, vice president, credit derivatives, at csfp. The bt notes paid a healthy spread over Libor of around 80bp to 100bp but investors faced coupon and principal losses if any of the institutions defaulted.
Sellers lead
This way of selling credit risk has continued, and it is driven largely by the needs of the providers of the notes, not the buyers. The providers are, largely, investment banks. Much more than the commercial banks, they need the credit derivatives market to develop rapidly to enable them to manage the credit limits in their huge bond and derivatives portfolios – particularly their riskier portfolios such as illiquid corporate and emerging market bonds.
They need to manage these portfolios on a much more dynamic basis than the commercial banks do their loan portfolios because they have smaller balance sheets, because their portfolios are marked to market daily and because they tend to move in and out of fashionable sectors more quickly than syndicated lenders. They need to off-load yesterday’s risks in order to free up lines to carry on today’s business.
But though investment banks will continue to exploit the potential of credit derivatives, the main users of the market – to begin with, at least – will be commercial banks. After three years of development, the market has come up with standardized, priceable credit derivatives that commercial banks can use.
The building-block of this category of credit derivatives is the credit default swap, a bilateral financial contract in which one counterparty (the protection buyer) pays a periodic fee – typically expressed in fixed basis points on the notional amount – in return for a floating payment contingent on the default of one or more third-party reference credits. This floating payment is designed to mirror the loss incurred by creditors of the reference credit in the event of its default. It is usually calculated as the fall in price of a reference security below par at some pre-designated interval after the reference credit has defaulted.
“Counterparties typically wait from one week to three months after default in order to give the price of the reference security time to settle at a new level,” explains Rob Reoch, vice president, credit derivatives, jp Morgan. “Since most securities become due and payable in the event of default, most plain-vanilla securities will trade at the price that reflects the market’s estimation of recovery following a default, irrespective of maturity or coupon.” This type of cash-settled transaction is the most common. But there are also structures in which there is physical delivery of the reference security.
One of the clearest applications of the default swap is the synthetic reallocation of credit risk between the loan and bond portfolios of banks. Providers of the swaps envisage a liquid market in which financial institutions will use credit swaps to free lines filled up with loan transactions and bond and derivative portfolios. By paying another financial institution to take over the default risk on a loan or bond, or on a swap or option exposure to a single counterparty, banks can manage their credit limits quickly and confidentially, without having to undergo complex assignment procedures.
This will enable banks, for the first time, to hedge the most difficult risks they face: concentration risk, correlation risk and the conflict between external regulatory and internal economic capital adequacy requirements.
“Default swaps are the commonest credit derivatives,” says Lincoln Benet, excutive director in the derivatives product group at Morgan Stanley in London. “They were first done on high-quality credits and used for limit risk management and the elimination of risk on swap book exposures.
Here is an example of a how a five-year default swap would work in practice. Metro Bank, wishing to free up its credit lines to Italy at five years, enters into a five-year default swap with an Italian government bond as the reference security. Metro pays a premium to the counterparty of, say, 20 basis points (bp) a year. The counterparty makes a payment in exchange only if Italy defaults on its debts, in which case the payment might be par less the final price of the security, multiplied by the notional principal amount of the swap. In the simplest example, Metro Bank holds the same value of the underlying bond as the notional swap principal. So if Italy defaults, and the reference bond falls to 85%, Metro collects the 85% from the market and the remaining 15% from the swap counterparty.
Behind borrowers’ backs
The fee of 20bp is not necessarily arrived at scientifically (see box on pricing, page 30). Most likely it will have been determined by the spread to Libor that could be achieved by investing in comparable Italian securities. An arbitrage of sorts exists between the bond/asset swap market and the credit derivatives market. No counterparty is likely to accept 20bp for assuming the default risk of a credit if it can take the same risk, by buying securities in the bond or asset-swap markets, and receive Libor plus 30bp. Another price check is the underlying cash position: you can think of a credit swap as equivalent to going long the risky bond and short the relevant (theoretically risk-free) treasury.
However, if it can’t take a similar position with a bond or asset, the counterparty may be willing to accept less than 20bp for assuming the credit risk. There may be no other assets available from this credit; there may be assets available but not of the size and maturity the counterparty requires; or the counterparty assuming the credit risk may be an institution that could never have participated in the original bond issue or syndicated loan either for relationship reasons or because its own funding costs are too high. Indeed, so fierce is competition for lending relationships at the moment that banks are building up portfolios of exposures to the key credits in the secondary loan and bond markets, the asset swap markets and the credit swap markets so that they can then approach these borrowers and pitch for relationship business on the basis of a significant existing commitment.
One man’s meat
So transactions are often driven simply by their relative value to each counterparty. Says one banker: “A bank will simply pay at the offer if it has too much exposure and will receive at the bid if it doesn’t have enough. If the perceived market price for five-year Fiat is 25bp mid, then a counterparty over-exposed to Fiat is happy to pay 30bp in a default swap and a counterparty under-exposed to Fiat is happy to receive at 15bp.”
These types of synthetic asset-reallocation trade are just as likely to involve strong credits as weak. The hedging institutions are not so much buying protection as using credit swaps to free credit lines in their loan or derivatives portfolios and to reduce particular country exposures, so that they can do additional business. This is what stops the market from being completely one-sided. A market in which banks simply wanted to hedge against defaults would be characterized by long periods of inactivity and then frenzied one-way hedging as a credit or sector moved visibly into problems.
The credit default swap also enables banks to get credit risks off balance sheet where they might be obstructing higher margin business. For example, a key corporate client is looking for a large credit facility. He turns to his core relationship lenders, expecting them to take the bulk of the loan at razor-thin margins. With limits pressed, the banks’ relationship managers must persuade ever more sceptical credit officers that the client’s ancillary business will make up for the poor returns on the credit. At some point, no matter what the relationship, the concentration risk will be too great. On a risk-adjusted basis the loan is unprofitable and it is preventing other higher margin business from being done.
Selling the loan in the secondary market is of little use. Lesser institutions can use the secrecy of sub-participations or silent sub-participations to trade paper, but not the lead relationship banks.
A credit swap can solve the problem. The relationship bank subscribes to the loan but also enters a credit default swap agreement on the proportion of the loan it wishes to hedge. The borrower never knows that its relationship bank no longer holds the risk and so is happy to provide it with that additional high-margin business. If it’s lucky, the relationship bank may even have been able to exploit the current dearth of quality assets and make money on the default swap.
But it isn’t only banks which can exploit the opportunities thrown up by credit derivatives. Now the mystery of their workings is starting to be unravelled, their scope is widening fast. Corporates, investors in projects and insurance companies all stand to benefit.
Many companies are heavily exposed to a small number of key customers. Take an engineering company all of whose heavy drilling equipment in the next three years will be sold to a particular customer. In some areas of mining, where highly specialized equipment can take years to build and where two or three companies dominate a particular field, this is not unusual. If the customer goes bust, the manufacturer is left out of pocket holding machinery that no-one else will buy. If the risk to its survival is serious enough it can now buy a credit swap on a notional principal that gives it either the value of the machinery or some break-even amount.
Then there is project finance. An equity sponsor to a large project may be happy with the operational and project risk but not with the sovereign risk on the guarantees. It may have protected itself against 70% of this risk via an export credit agency-backed facility. However it wants protection against the remaining 30%. It could enter into a credit default swap with a notional principal equal to the amount not covered by the sovereign guarantee and with the same maturity so that, if the sovereign defaulted, it would receive the cash. “The corporate sponsor might say, well we know the contracting company and are happy with the project risk but we are not happy about Indonesia. They will pay us a premium so that if Indonesia defaults, then we pay up,” says one banker.
Hedging project risk
The only problem is that the export credit agency (eca) business is heavily subsidized and often banks cannot compete. However, the eca guarantees are still modelled on matrices that have not changed to accommodate recent regional economic developments. The rates often reflect a time-warped view of the world.
At one time “all the Asian economies were dreadful, so they charged a lot for guarantees to those countries”, says one swapper. “By contrast the rates to eastern European countries were very low because they were a good risk as part of the Soviet empire. Now the economic situation has flipped, so we can’t do much in eastern Europe, but we can in Asia. Russia is ludicrously cheap but Thailand is ludicrously expensive.”
A company involved in a project that has a predictable payment stream can secure a more complex version of the project financing hedge. Credit swaps can be structured so that the company continues to receive the same payment stream in the event of default.
Another credit derivative structure has been used to protect employee remuneration. Where a group of employees is owed significant deferred compensation, they can pay a premium of a certain percentage of that future bonus pool to insure themselves against the bankruptcy of their company. It doesn’t take much imagination to see that such insurance is loaded with moral hazard. The employees can bet their firm, knowing that their maximum downside is to be fired with their bonus intact.
Attractive as they seem, these risk management applications need counterparties willing to accept the credit risk. This is not straightforward. Where it works best is in the commercial banking sector with, ideally, counterparties which are large banks looking to swap concentration and correlation risks with other banks, or to arbitrage between different regional views of credit risk. But even between banks such back-to-back trades are relatively rare. To find enough buyers to keep the market growing banks have had to create enticing new structures, breaking down the underlying assets into parcels of credit risk which alter the maturities and the leverage.
The most straightforward of these trades involve swaps used to create synthetic assets that do not exist in the markets. “The market can fail to supply investment opportunities in the required maturity, or the constraints on the maximum term of an investment fund may restrict investment in credits which only issue in longer maturities,” says jp Morgan’s Reoch.
Here is an example of how five-year risk becomes two-year. A bank might have a two-year line for a credit that issues only five-year debt; a credit swap can be tailored to create a synthetic two-year asset indexed to the default risk of the five-year cash asset. A bank might have a five-year line but be full out to the second year; a forward-start credit swap could be used to plug the gap in the credit curve. This structure could also enable an investor to benefit from wide forward credit spreads without having to go long one asset and short the other.
On the other side of these types of trade are hedgers wanting either to hedge just part of an exposure – rather than liquidate an entire position – or to hedge an exposure for a limited period. A credit swap’s notional principal and maturity can be tailored to provide exactly the amount and tenor of protection required.
Balance sheets to rent
The more complex credit swaps take into account the basis risk between the payout formula of the swap and the actual loss incurred by the hedger. In a credit swap on a bond, the payment to the hedger on default is based on a bid for the reference bond. If that bid does not accurately reflect its exposure – perhaps because the swap valuation is made one month after default but subsequent events push the final recovery value much lower – then swaps can be created that pay out a fixed percentage of par which the hedger believes will mirror its loss. This in turn is usually based on historical data for that maturity, rating and security type. It is generally difficult for intermediaries to place risk based on this kind of formula and so it tends to be expensive and time-consuming.
In these cases counterparties must take particular views of likely recovery rates. Any counterparty asked to take fixed recovery must judge whether that percentage is fair, given any available data and also given the market pricing of any outstanding debt. More complex adjustments to the payout on default can create first loss/second loss restructuring of a credit and plays on the actual recovery of the credit.
In the more complex credit derivative structures, an increasing amount of credit responsibility is adopted by the counterparty. In some structures even the new counterparty risk arising from the credit derivative is laid off.
The total-return credit swap, first seen about three years ago, not only pays a premium to the counterparty assuming the default risk, it also periodically marks to market the underlying loan or bond. The simplest structure works like this: the holder of a loan with positive carry pays all cashflows from the loan – Libor plus a spread and all fees – to the swap counterparty. In exchange, the counterparty pays Libor back to the bank. Periodically the swap is settled on the market value of the loan. Any positive change in value is paid by the premium payer (the bank) to the default risk holder (the swap counterparty). Any negative change is paid by the default risk holder to the premium payer.
The bank paying the premium in this kind of swap is effectively warehousing a loan, renting out its balance sheet while transferring the economic value of the loan to a third party. The motivation behind this type of transaction is a need to get rid of an asset without entering a physical transaction that might upset the borrower.
But what if the receiving counterparty is as risky as the loan being warehoused. There is little point in, say, Lehman Brothers off-loading an exposure to a strong single-a rated sovereign credit if the swap counterparty is weak single-a. Even if the risk being sold is double-b, the effect of the sale is seriously diluted by the counterparty risk.
Worse still, there is a correlation issue. If an investment bank wishes to lay off Belgian sovereign risk, then the effect on its own overall credit risk portfolio will be different depending on whether it sells that risk to a counterparty whose fortunes are linked to those of the Belgian economy or to one whose are not. Sell to a Belgian bank and the probability is that a sovereign default will cause problems in the banking sector. Better to sell to an Asian bank unlikely to be affected by a European economic crisis. The problem is, first, to evaluate the exact probability of joint default so that the net post-swap credit exposure can be worked out and, second, to find enough uncorrelated counterparties interested in or knowledgeable about the credit risk that has to be sold.
Working out the net credit effect of a swap and examining every counterparty in turn is not practical. One solution is a credit-linked note. By selling a note whose principal and coupon are linked to default events, the seller of the risk has no exposure to the institution that assumes the default risk. In the event of default, the buyer of the notes simply gets less principal back or a lower coupon.
High yield, high risk
Structured notes are always more expensive and less liquid than the underlying components. This is all the more true of credit-linked notes where the lack of standardized documentation – the International Swaps & Derivatives Association is negotiating what one banker terms “a bid/offer spread in the language” – and the attendant risks might result in a legal nightmare. Also, most structured note buyers tend to be credit neutral: they are prepared to take very significant market risk as long as there is a triple-a or double-a note underlying the trade. Traditional fixed-income investors are neither volume buyers of structured notes nor are they easy to persuade to take credit risk.
Finding investors for this paper is therefore a question of very high yield, a singular view of the risks involved and a sales approach that emphasizes the ability to take sophisticated views difficult or impossible to express in the cash markets.
“Transactions will be driven by people looking at spreads,” says csfp’s Kannengieser, “people looking at relative perceptions of credit, people looking to strip credit risk from other instruments so as to play it and people wishing to take views on credit that cannot be expressed with existing instruments. For example, at the moment, there is very little weaker single-a paper available and any that there is, is quickly snapped up in the asset swap market. Using credit swaps enables us to provide investors with exposure to this sector.”
Providing yields high enough after structuring costs to entice investors has tested the ingenuity of note sellers even though the risks they want to lay off are already high-yield. The structured credit note market has concentrated on weaker, particularly emerging market credits and complex range and spread trades. “Our focus has been on finding buyers for difficult credits so that we can offer our clients – one of whom is our own internal credit risk management system – protection against them,” says Kannengieser.
Morgan Stanley’s Benet agrees: “Our focus is on weaker credits. We structure these credits to allow financial institutions to buy what would otherwise be unacceptable credit risk or maturities. Though we can warehouse the risk of a small transaction, the way we lay off risk in general is by creating structured notes and then finding investors who want exposure to that risk.”
Worrying trends
The investment banks cannot warehouse anything like the volume that commercial banks can. “We could warehouse smaller transactions, say $25 million to $50 million, in the same way we would take on that kind of bond position,” says one swapper. “However, for larger deals, we have to find a buyer for the risk and so we depend on our distribution network.”
The simplest credit-linked note embeds a credit swap in a fixed-income instrument. In return for an enhanced yield – the premium paid under the swap less the investment bank’s cut – the investor accepts a redemption formula with the potential for loss of principal or coupon should a particular borrower default. This loss mirrors that on the underlying swap, which is the difference between par and the price of a reference security. Assuming that some recovery will take place, the loss will be limited.
But there is one note structure which worries even those who provide it, and some banks refuse to sell it at all. To increase yields further, some banks market a product known as the zero-one structure. Here, instead of some coupon and principal loss, investors lose all their principal if there is a default.
“We don’t get involved in that kind of trade,” says one swapper. “It doesn’t matter how many times you explain it to the client there just aren’t that many fixed-income assets that become worthless on one trigger event. It’s a headache waiting to happen – when somebody loses, which they haven’t yet.”
According to lawyers that have worked on these deals, even the banks that sell them – which include csfp and Morgan Stanley – devote extra time to the legal documents to ensure there can be no misunderstanding of the terms. Paranoia is too strong a word, but the banks realize that even one client able to claim it didn’t realize it could lose everything would lead to costly litigation.
The kind of yields available depend on the assumed recovery rate of the reference asset. If an investor could receive a premium of 100bp on an assumed recovery rate of 50%, then a zero-one structure would double that.
Betting on bankruptcy
“The problem with the structure is that you have to be absolutely certain that the reference asset will not default,” says one swapper. “But you can’t be absolutely certain – that’s like saying the reference credit is risk free, so why is the market demanding a premium to lend to it? What is happening here is that people whose own default is highly correlated with that of the reference asset are buying these things: for example a small Korean bank is happy to take this trade on Korea Development Bank (kdb) because if kdb is bust, then so are they. So a loss on the note is irrelevant.”
Basket trades have also become popular. Instead of the swap being referenced to just one credit, it is referenced to a basket. If any one of the credits in the basket defaults, the swap counterparty must pay the specified default amount.
Nick Burge, head of swaps at Nomura Securities, in London notes that this basket concept has been used in the asset swap market: “You can buy an asset swap and sell someone else – usually the dealer – the right to put you into any one of, say, three other credits on specified dates.” The dealer will only exercise that right if it can substitute a cheap bond for an expensive one. Such an option is not priced theoretically but, as Burge says, according to “what it’s worth to you”. The dealer may have a view on a particular bond and the investor, if it does not have to mark to market, may be indifferent as to which of the bonds it holds as long as none are downgraded below a particular floor.
The next step is to tailor notes more precisely to the investor’s requirements by designing a credit swap whose maturity or other terms do not match those of an underlying security. Emerging market sovereign plays have been popular.
Credit spread plays
An investor may wish to take six-month exposure to Brazil when the shortest maturity paper available is twice that. A note can be structured with a six-month credit swap embedded so that the investor is exposed to Brazil’s default risk only for the six-month period required. On the other side of the trade, the investment bank, or an end client, is looking to hedge Brazilian risk for just six months, perhaps in anticipation of a particular event or just to reduce pressure on the Brazil country limit.
One popular emerging market trade involves the most liquid securities. “There is a misconception that you can use credit derivatives to strip out the sovereign risk from emerging market bonds,” says one banker. “There is no value in doing that unless you can find investors with wildly different views on the credit. Much more popular have been trades that restructure the cashflows on emerging market securities or which strip out the us treasury risk from Brady bonds.”
The most complex trades focus on the yield differential between credit-sensitive instruments and reference government bonds. Assuming that fixed-income instruments of the same duration move together in price as interest rates change, then the main reason for any change in spread is a changed perception of credit risk. So options on the credit spread allow investors to isolate credit risk from interest-rate risk.
The purchaser of a credit spread call will profit if spreads tighten; the purchaser of a put will profit if spreads widen. Sell a credit spread put and, as long as spreads do not widen to the strike, the premium is profit. Sell a call and, as long as they do not tighten to the strike, the premium is profit. As with any option, buying and selling credit spread options means taking a view on credit spread volatility. This is generally much higher than yield volatility, because lags between moves in the treasury market and in the non-government bond markets mean that there is an imperfect correlation between the two.
“These spread options are priced off the credit spread curve, off expected volatility and expected recovery. That tells you what probability of default is implied in the option price. Default probability does not drive pricing,” explains Benet.
As with credit swaps, these options allow investors to take credit views whose duration is different from that of the underlying reference instrument. These views can be leveraged – a 1bp move in the underlying spread produces a 2bp, 3bp or even 5bp move in the value of the option – to further customize the spread risk of any note in which the option is embedded. Also, as with swaps, the options do not need to be cash-settled. The holder of a physically settled put would have the right to deliver an underlying bond to the option counterparty at a predetermined price if its spread rose to a particular level.
Stripping Bradys
Bradys (rescheduled sovereign debt packaged into bonds whose principal is backed by long-dated us treasury zero-coupon bonds) are the most popular instrument for investing in emerging markets because of their liquidity and because their long maturities give better potential for profiting from the improvement of the sovereign credit. However, the us treasury collateral gives investors a double exposure – to the emerging country’s sovereign risk and to us dollar interest-rate risk. So any rise in the price of a Brady bond due to improved credit perceptions may be offset by rising us interest rates.
Despite the fact that traders often quote Bradys in terms of stripped yield – that is, the yield on the non-us dollar portion of the bond – constructing the appropriate interest rate hedge to gain exposure only to the sovereign risk component is complex. Even the experts disagree on the best methodology.
Credit spread options are the answer. Investors can now buy options on the credit spread of the liquid Brady bonds over us treasuries, leaving bank traders to create the Brady bond/us treasuries position that hedges such options. A call on the Brazil spread over treasuries would profit if spreads tighten (Brazil’s credit improves) and a put would profit if spreads widen.
This trade gives investors easy access to the stripped yield spread over treasuries which is the best measurement of the sovereign’s credit quality and which should move independently of us interest rates in a way that Bradys themselves do not.
A similar concept, that of stripping one risk from another, has been applied to corporate debt. Investors have been offered options on the spread between a corporate security and the debt of the country in which the corporate is domiciled. The investor gains exposure to the corporate credit risk but not the underlying sovereign. Banks have even offered options on the spread between a company’s senior and subordinated debt.
Getting round guidelines
Credit options can be used to take views on the volatility of credit spreads. If a particular issuer’s bonds are trading at a high historical credit spread, investors can buy calls on the spread, or notes that pay an above-market return as long as the spread stays within the bands implied by the recent spread volatility that has pushed the spreads so high.
As with many other highly structured notes, assets with these types of options embedded can be used by asset managers to circumvent restrictions on their portfolios. A one-year floating-rate note could be constructed for a money market fund manager that incorporated the purchase of a call on the credit spread of a five-year bond and the sale of a put on that spread. The investor believes that spreads will tighten and so buys the call at the present spread of 150bp over treasuries and sells the put out-of-the-money at say 200bp over. Though he is not normally allowed to buy five-year bonds, he benefits from any tightening of five-year credit spreads (and loses if spreads widen significantly). Since the note is below his duration barrier he has not broken the rules governing his portfolio.
Bankers argue that the exact duration of the underlying security is not important since the recovery rate on a defaulted two-year note is the same as that on a 10-year bond – a two-year swap on 10-year paper is two-year credit risk. It is not clear that plan sponsors have the sophistication to evaluate the risk, nor is it clear how many investors’ internal guidelines will cope with notes whose performance is linked to forward credit spreads. The rating agencies provide some guidance but the scope for abuse remains.
Binary structures have also been created. Investors can purchase notes that pay a very significantly enhanced yield as long as the credit spread does not trade outside a specified range at any time. If it does, the yield is substantially below prevailing market rates. Generally the boundaries specified are the minimum and maximum levels at which the bond has traded in a predetermined period.
Other trades have seen investors sell another counterparty the right to swap them from one security into one of a specified group of different securities, if a particular credit spread level is breached.
Investor a, the holder of a sovereign bond believes the bond’s spread to a reference treasury will remain stable at 55bp. a decides to enhance its return by selling an option; the holders of the option can swap a into another security of the same rating, either specified or chosen from a specified basket, if the spread tightens below 40bp. If this does happen, the option holders will obviously swap a into a cheaper bond and take the expensive security, pocketing the difference.
One large credit derivative market of the future will be the provision of instruments that are hedges not against default risk, but against ratings changes. New ratings-based derivatives, and instruments based on credit and loan indices will help bond-holders hedge against credit migration. “You might expect derivatives based on ratings to be the most popular,” says one swapper, “But right now we might see one trade a year.”
These instruments break down the transition from today to default into a series of movements or notches – the credit ratings. The difficulty in creating them is pricing the credit migration that will take place in a year or other period.
One problem is that there is no stable relationship between rating and spread – securities with the same rating trade differently. So a derivative that protects an investor against the drop from single-a to triple-b cannot be expressed either as a simple credit spread option or as an option to switch from one security to another – both would normally be priced off the credit spread curve. “It is very hard to model a subjective event rather than an economic event,” says one swapper. “Though the agencies would disagree, ratings still depend on the mood of an analyst at a particular time. We cannot price something that depends on the action of one guy or a small number of people.”
Another difficulty is that most of the investors who would want this trade would be fund managers protecting themselves against a drop in ratings that would take a security below their ratings floor. “It’s hard to see who would be on the other side of this trade,” says the swapper.
This difficulty is compounded by the fact that credit has traditionally been priced off default. Because loans have not traditionally been marked to market, there is little data on the sensitivity of portfolios to changes in the credit quality of individual assets within them; and so there is no way for individual lenders or investors to put a value on an instrument that hedges them against downgrades. In any case, this value would depend almost entirely on the concentration and correlation risk in their portfolios. So even if loan officers were sensitive to downgrades, it’s unlikely that a bank would take the other side of the trade because it wouldn’t be able to price the risk to its portfolio of the trade.
Just the beginning
The majority of fixed-income fund managers buy only investment-grade bonds and maintain a credit buffer between the weakest bond in their portfolio and the level at which they must sell. This is why in Europe strong single-a tends to be the minimum acceptable rating: a credit warning doesn’t force an immediate fire sale. That makes fund managers very unlikely to take a trade that puts them into a security below their floor. One possibility is a transatlantic arbitrage: the floor for many us fund managers is triple-b. They might accept a trade in which they were paid for the risk of being put into a weak single-a or strong triple-b security.
Scarcity of data means that trends in ratings changes are difficult to analyze. For example, it’s clear that there are more credit downgrades than upgrades and that prices fall more when an entity is downgraded than they rise if it is upgraded. But much more data and analysis is needed to formulate rules that could help price these types of instrument.
Hedges against rating changes and options on the credit spread between similar fixed-income instruments lie at the more esoteric end of the product spectrum. Their widespread usage is still in the future, but it is a future that is approaching rapidly and with plain-vanilla products has already arrived.
