Derivatives distortions in the credit market
* Low nominal interest rates have forced bond investors to chase higher yields anyplace they can get them.
* Many are buying up collateralized debt obligations, or CDOs. CDOs are securities comprised of credit default swaps (CDS) on underlying bonds. CDS are contracts that (in theory) protect bondholders against the risk of credit losses. If the company whose debt you own gets into financial trouble and defaults, the seller of the CDS contract you purchased is obligated to make you whole.
* Instead of buying cash bonds, many fixed income investors are buying CDOs because they pay higher yields. Hedge funds typically snap up the riskiest "tranches," or portions, of these CDO deals, while insurance companies and other conservative investors buy the highest-rated stuff.
So what's the problem?
Well, the market for credit derivatives is growing at an exponential rate -- so much so that it's dwarfing the size of the underlying bond market. As Bloomberg notes, CDS contracts provide protection on $26 trillion in debt ... five times the $5 trillion outstanding in global corporate bonds. In other words, credit derivatives are the tail wagging the bond market dog.
Because so much money is flooding into the CDO market, CDS sellers are being forced to accept less and less money for the protection they're providing. An example: European bondholders can now protect 10 million euros of bonds for five years at a record-low cost of 189,000 euros. That's down 58% from the 450,000 euros that protection cost in 2005.
This raises the whole issue of counterparty risk. A CDS contract isn't worth the paper it's printed on if the guy who sold you the protection gets vaporized in a credit crisis. You have to wonder: Are CDS sellers REALLY collecting enough money to put them in a position to make bondholders whole in the event of a default?
Then there's the distorting effect the CDO market is having on traditional market signals. Historically, when a corporate borrower starts getting into financial trouble, the spread between the yield on its bonds and the yield on risk-free Treasuries widens out. That's an important market signal to bond and stock investors -- a yellow warning flag, if you will. But because so much money is flooding into the CDO market ... and that money is artificially suppressing corporate spreads ... those market signals are being drowned out.
In the short-term, everything looks hunky dory. The corporate debt default rate is close to an all-time low, so the CDS system is not being stress-tested. But some serious imbalances are building up, and that raises the risk of a big blowup down the road.