By all accounts, the rapid growth in credit derivatives will continue unabated into 2007 following another year of growth in 2006. Behind the growth in demand has been new participants entering the market, continued structured credit issuance and the emergence of the indices (iTraxx).

While today credit derivatives are dominated by contracts referencing corporate credit, the first credit derivatives were designed to exchange sovereign risk. However, through a deteriorating credit cycle in the late-1990s and through to today, credit derivatives have evolved to be the easiest way to exchange corporate risk. Throughout this period, the credit derivative market was challenged with defaults, corporate restructuring and documentation disputes. Each time the product was challenged, the International Swaps and Derivative Association (ISDA) assisted in the creation of working groups to address standardisation of documentation and any inefficiencies. The original definitions contained in credit derivative documentation were highlighted as being somewhat inefficient by key events over this period. These events included Russia and Conseco (restructuring), Armstrong (highlighting the importance of the detail as to the reference entity), and Railtrack (concerns over the deliverability of convertible bonds). With standardisation came a more universal acceptance of the product and today most credit investors in one way or another will be active and or interested in the credit derivative product.

Banks dominate the use of credit derivatives as an effective tool for the management of credit risk, but in recent years there has been an emergence of the managers of insurance money, third-party asset managers and hedge funds. In the UK, asset managers (when compared to their European counterparts) have been slow to take up the use of credit derivatives. European asset managers have been very active throughout the growth period of the product. However, it has only been in the last two to three years that UK asset managers have shown an appetite for the product.

The bond market as a whole has seen significant growth over a similar period. Particularly in the UK, asset allocation out of equity and into fixed income are prominent as fixed income is often better placed to match the liabilities for pension funds than equity. In addition, the emergence of hedge funds has meant the competition for fixed income products is intense. While traditional corporate bond issues are constrained by the amount of bonds on issue, credit derivatives are not (as with all over-the-counter products) and this, when coupled with the demand for fixed income product goes someway to explain why the volume of growth has been as fast. Credit derivatives are a flexible way of expressing opinions on credit and can be transacted more efficiently than cash bonds.

The main advantages for users

There are six main advantages in using credit derivatives when compared to cash bonds. The product allows the credit risk to be assessed more precisely. When considering a cash bond, interest rate risk, currency and credit risk require consideration. Credit derivatives allow these risks to be managed independently from each other and the investor to make a more accurate bet on a corporate name. If that bet is based on a negative view, an investment manager can ‘go short’ the name in anticipation of a deterioration of the credit fundamentals. This type of investment style is very difficult for asset managers (particularly) to transact in the cash bond market due to the costs involved.

Credit derivatives allow a greater level of tailoring as users can opt for a variety of currencies, maturities and risk profiles in their investment to suit their needs. The prior discussion on the volume growth highlights a major advantage for users. The liquidity for users is deep and remains deep even during times of distress. There are numerous examples of corporate names in distress where credit derivative activity has remained high. Especially in times of distress, credit investors may have a real need or desire to be able to undertake an investment strategy and having a market that allows for the dispersion of credit risk assists that. And this ability to disperse credit risk is an advantage of the product, but advantageous to the credit market in general. Finally, credit derivative transactions, much like secondary bond trading, are not required to be disclosed to the underlying corporate entity. This allows (where required) the transfer of credit discreetly without any impact on business relationships.

Strategies for asset managers

The starting point for strategy discussions are single name corporate entities. Credit derivative transactions allow asset managers to take a positive view (sell protection) or a negative view (buy protection) on a corporate. The advantage of the negative view has been discussed prior but the relevance is worth noting. For UK asset managers who are assessed against sterling denominated benchmarks the traditional method undertaken when expressing a negative view would be not to hold the bond. However, the typically used sterling denominated benchmarks are diverse and the allocation to an individual entity is usually small. If an asset manager simply chooses not to hold the bond and that is proven to be the correct strategy it does not have a major impact on performance. However, by taking that strategy and enhancing it by buying protection on the corporate name, the asset manager can derive real performance if the view is proven correct.

An asset manager can also construct strategies with credit derivatives, which take a view on the shape of the curve of the underlying corporate issuer. These trades are often implemented between the five and 10-year part of the curve. For example, should the investment strategy expect that the differential between the five-year credit derivative and the 10-year credit derivative in the same name to change, an investment could be undertaken to take advantage of this. This is often a difficult strategy to do through corporate bonds, as you may not have the variety of bonds on issue at varying maturities to create a curve.

Indices have emerged as one of the most important part of the credit derivative market. Indices such as the various iTraxx products group together corporate risk (by using credit derivatives) and are managed according to specific rules. The market makers who trade the product and assist in the ongoing maintenance of the indices must comply with the rules as set down by iTraxx. The indices facilitate the ability to express very specific market views, not individual entity views. Examples of important iTraxx indices are Euro Main (European corporate names), Euro High Vol (European names with the widest spread) and Euro Crossover (non financial European names that have a credit rating in danger of crossing over to high yield). Asset managers can buy or sell these indices much like individual credit derivatives.

The problem with credit derivatives is that by market standards, it is a relatively new product that has been dominated by the banks. The dispersion of knowledge from out of the banks and into the asset management community has been slow. This is seen not only in front office people (i.e. fund managers) but also in middle and back office functions. To add to this, traditional systems used for fixed income businesses have not been easily adaptable to the nuances of credit derivatives. Asset management firms are having to spend significant resources on systems to allow the incorporation of credit derivatives into their processes but often, the greatest challenge is expecting the people in the support roles (risk management and compliance) to be able to be versed in the product as quickly as is required.

The future of credit derivatives

Credit derivatives will continue to grow in importance for asset managers just as they have grown into an important part of the fixed income market. It is in an investment bank’s interest to assist asset managers to get ready to use the product and this flow of information is an important part of the development of asset managers skills. The use of credit derivatives can successfully complement a fixed income mandate to allow the manager every chance of achieving his return objectives.

In association with AXA Investment Managers.

^{AXA Investment Managers (AXA IM)is a multi-expert asset management company within the AXA Group, a global leader in financial protection and wealth management. AXA IM is one of the largest European-based asset managers with approximately €441bn in assets under management as of the end of June 2006. AXA IM employs over 2,500 people around the world and serves customers in 18 countries.}

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