In theory, derivatives are securities, such as options, futures, or mortgage-backed bonds, whose value depends on other securities, commodities, or "events." Contrary to proponents' longstanding reassurances, however, these synthetically-created, often complex instruments are increasingly the tails that wag the dogs in various markets, potentially leading to a wide range of unintended consequences.
In "CDO Surge Squeezes Deutsche Bank, Vanguard Bond Funds," Bloomberg reports that "credit derivatives, the fastest- growing business on Wall Street, are squeezing returns for bondholders to an all-time low."
Contracts that protect investors against defaults are being sold in record numbers and then bundled into securities known as collateralized debt obligations. CDOs are driving down the cost to protect against non-payment so much that even the government of Argentina, which reneged on $95 billion of debt five years ago, is paying less than ever to borrow.
"CDOs are changing the economics of investing in corporate bonds," said Lorenzo Isla, head of structured credit research at Barclays Capital in London. "By expanding the investor base for corporate credit risk, they compress the spreads available to corporate bond investors."
Bondholders have halved the amount they charge high-risk companies in the past four years to a record-low 2.6 percentage points on average over U.S. Treasury notes, according to data compiled by Merrill Lynch & Co. Investment-grade securities produced the worst returns since 2001 for fund managers from Deutsche Bank AG to Vanguard Group, Bloomberg data show.
CDOs that invest in derivatives of investment-grade bonds return as much as 12 percent a year, three times more than the yields on the underlying notes, according to data compiled by Barclays Capital.
The diminishing returns on bonds prompted WestLB Asset Management to add credit derivatives to some of its $6.5 billion of debt investments.
"Spread levels are very tight in the cash bond universe," said Christian Doppstadt at the Dusseldorf-based fund manager. "You can't really initiate nice trading strategies using only cash bonds."
Other reports even suggest that the imaginary constructs are more relevant to today's investors than the underlying assets.
According to Bloomerg, "Morgan Stanley, the world's second-biggest securities firm, will switch to using credit-default swaps instead of bonds in a model used to determine whether a company's debt is cheap or expensive."
The firm plans to identify credit-default swaps that are ripe for relative-value trades. The predictions will be made with a computer model that analyzes factors such as a company's rating, stock volatility and cash flow. For about six years, Morgan Stanley had used the model to forecast moves in the actual bonds of companies.
Morgan Stanley's switch to credit derivatives reflects the growing importance of the contracts in fixed-income investment portfolios. The face value of outstanding credit-default swaps, the fastest-growing derivatives market, surged to an estimated $26 trillion last year.
"It's a cleaner indication of the credit risk of a company and, from that perspective, the natural place to judge any credit-risk value," said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.
Morgan Stanley said its reasons for changing to credit swaps were mainly technical.
It just removes a lot of the challenges we had adjusting for duration and maturities, said Gregory Peters, Morgan Stanley's head of U.S. credit strategy in New York.
Because bonds come with varying maturities, the model had to make adjustments to compare a company's bonds with the broader market. Credit-default swaps, by contrast, typically trade with benchmark five-year maturities, making comparisons easier, according to Morgan Stanley.
So there you have it. When it comes to the fixed-income investing, at least, why bother with the real thing when the related derivatives are worth so much more.
Until, that is, the music stops.
(Note: for a more in-depth primer on derivatives and some of the risks they pose, check out my November 2005 article, "The Coming Disaster in the Derivatives Market.")
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