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Watch out for restructuring

For all its increased transparency, standardization, and liquidity, investors should treat the credit derivatives market with caution in 2005.

In a November report that focused on the high-yield credit default swap market in the US, Fitch Ratings looked at some of the issues surrounding restructuring as a credit event. Restructuring through a distressed debt exchange could be particularly problematic.

Using a sample of 16 high-yield bonds, Fitch found that investors who bought at or close to par could lose between 40% and 60% of their investment by the time a distressed exchange has occurred. But buying protection in the CDS market might not fully make up for the shortfall because most high-yield CDS don't cover the protection buyer specifically in the event of a loan restructuring or distressed bond exchange.

Beware lack of protection

?The fact that most high-yield loan restructurings and distressed exchanges effectively are not credit events triggering payment is something the market should remember,? says James Batterman, analyst at Fitch Ratings in New York. ?Were language in place to protect the CDS buyer, the cost to the seller would increase, which would make sellers less likely to offer protection, or sell it at higher cost.

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