More Investors Turning to Credit Default Swaps

The $50 trillion market for credit default swaps is set to continue a five-year trend of breakneck growth and increasing sophistication after serving a vital role during the summer credit crisis.

Investors turned to CDS -- mostly using market indexes -- in July and August to hedge risk, taking advantage of CDS liquidity as spreads widened and they lost confidence in other more complex credit products.

"This was the first correction in the credit markets when investors could use credit default swap indexes to hedge themselves," said Marcus Schueler, head of credit product marketing at Deutsche Bank. "Without CDS indexes, there would not have been any transparency about where credit is priced."

The growth in CDS is providing investors with new ways to trade credit, while supporting the underlying bond and loan markets for corporate borrowers.

"There is no question that CDS afford investors the opportunity to adjust or tailor market exposure in a way that previously would have been impossible," said James Batterman, a senior director at Fitch Ratings.

"But it remains to be seen how the CDS market in its current size would respond to something approaching the 2001-2002 period, when there were massive defaults across the board," he said. "That would be the true test."

CDS Moving into The Mainstream

For now, the market is likely to mushroom this year after more than doubling in four of the past five years. In the first six months of 2007, it grew 75 percent year-on-year to reach $45.5 trillion in outstanding contracts by end-June, according to the International Swaps and Derivatives Association.

GFI, a leading CDS inter-dealer broker, has seen demand recently for its electronic screens from a few traders in other markets, such as interest rate options and even foreign exchange options, who want to keep an eye on CDS indexes as indicators.

"Before it was the Dow, the FTSE, the long bond. Now they also want to know where the Crossover is trading," Swain said. "It is being accepted as part of the mainstream today."

Many macro hedge funds ventured into the market for the first time in the summer to take advantage of its volatility. A number of insurers such as Aviva are starting to shift portfolios from bonds toward credit default swaps, said Barry Hadingham, senior manager of derivatives compliance for Morley Fund Management, the UK insurer's in-house asset manager.

"It's an issue of liquidity. The CDS market is a lot more liquid than the underlying bond market," he said.

Even so, the CDS market has not detracted from the bond and loan markets but has helped support their growth, Schueler said.

Using CDS, banks can hedge their exposures to reduce risk and so gain capacity to lend more to companies.

Also companies themselves can use CDS indexes as a way to lock in spreads. A corporate borrower that plans to issue a bond in several months and is concerned spreads may widen by then can buy protection on an index. If spreads widen, the gain from that trade will help offset its higher cost of borrowing.

"Companies have been using the interest-rate swap market for a long time to hedge against the risk of rising interest rates. Now a few are starting to use the CDS market as a way to hedge against widening spreads," Schueler said.

Drives Demand for Bonds

CDS bolster demand for bonds as well as supply.

Investors may be more likely to buy bonds or loans if they can hedge them in the CDS market. As a result, the increasing number of corporate names underlying CDS contracts means more borrowers may benefit.

CDS are written on about 3,400 names, up from 2,500 at the start of 2006, according to Markit. The figures include separate CDS on the senior and subordinated debt of some companies.

The CDS market is also evolving for investors.

"It has become much more than an insurance policy, and the indices have had a huge amount to do with that," said Julian Swain, GFI managing director for Europe. "They are an easy way to gain exposure based on a bullish or bearish view of credit."

The market's size, depth and lower transaction costs now allow for more sophisticated strategies.

For the past year and a half, people have been doing curve trades, said Ulf Erlandsson, a credit strategist at Barclays Capital.

These are based on changes in the shape and steepness of the curves that measure spreads at different maturities. Players use strategies such as butterfly trades, which take three or four positions across the curve, he said, while the bond market is not liquid enough to support this kind of trade.

Erlandsson recently advised investors that the time had come to employ trading techniques used in equity and foreign exchange markets.

"The market seems to be at a juncture now that more people can start doing momentum-based, intraday strategies that have not been used in the credit world before," he said. "It shows how far the market has come."