Credit derivative volumes are growing fast and they are increasingly a reference point for pricing other products. Natasha de Teran asks if the tail is beginning to wag the dog...

With risk management coming under more scrutiny and the accelerating increase of corporate debt issuance, credit derivatives, which were recently considered newfangled tools, will soon become as commonplace as interest rate derivatives.

That is good news for the banks that have built up expert franchises to deal in the products but may be less welcome news for the companies whose names are being bartered around in the market without so much as a by-your-leave. Investors and banks increasingly use the credit default swap (CDS) market, the fastest growing and largest sector of the credit derivative market, to buy and sell protection on issuer’s names. They can thereby enhance returns on a simple bond investment or insure themselves against a downturn in the issuer’s credit quality.

Early warning system

The default swap market has increasingly become the early warning signal for credit problems, indicating well ahead of the debt and equity markets that trouble lies in store for an issuer and its investor. Thus, credit derivative evangelists will argue, it is becoming increasingly ill-advised to ignore their market.

But the loan business segment of the banking market is turning to these instruments to an ever-greater degree, which is causing some concern. Loan officers can use credit derivatives for two purposes: to estimate the price at which they can extend the loan to a borrower, and to hedge out the loan. Neither of these will come as welcome intelligence to borrowers.

European borrowers have long enjoyed advantageous borrowing rates from relationship banks and others willing to subsidise these funds to gain other, more lucrative business. The high number of banks competing in the loan markets has kept prices low, despite the growing concerns about credit quality and the focus on reducing balance sheet exposures. With the advent of credit derivatives, however, loan officers have a method of pricing more accurately where loans should be made.

Pricing danger

Jonathan Davies: loans may become more expensive if CDS prices are referenced

Jonathan Davies, a credit derivatives expert at PricewaterhouseCoopers, says: “What may happen is that loans, which historically have been underpriced for banks to develop relationships, become more expensive as CDS prices are more commonly referenced.”

Even so, loan specialists maintain that they look at credit derivative pricing at present only to gain an indicative idea. Antonio Di Flumeri, head of European credit derivatives trading (non-emerging markets) at Deutsche Bank, says credit derivatives enable loan officers to quantify what, if any, the benefit or subsidy is when they are extending loans. “Basically, it is a data point that is referenced but which does not necessarily determine the pricing. The only impact credit derivative pricing has on the loan or bond market is in making it more transparent – so it is a mistake for borrowers to consider it adverse to their interests. Loans are not necessarily priced at the CDS level anyway but pricing is still specific to every borrower, its lending banks and the embedded relationship.”

Kristian Orssten: CDS and bond trading levels are useful guides to public securities market

Kristian Orssten, managing director, co-head of loan capital markets at JP Morgan, says the bank always looks at credit default swap and bond trading levels before pricing a loan. “They can provide useful guides to where the public securities market is or should be. But loans tend to price independently and more cheaply than both bonds and default swaps because they are more relationship-based and also often tend to offer more structural and covenant protection.”

Richard Munn: CDS pricing will become more relevant on relationship-driven deals

Richard Munn, head of loan capital markets at Deutsche Bank, concedes that on event-driven deals, which require broad syndication, CDS and bond levels do become more relevant in pricing-decisions. In these deals, loan officers need to attract the bank market, which makes its investment decisions based on relative value rather than relationships. And he has worse news still for borrowers: “Over time, CDS pricing will become more relevant on relationship-driven deals as well, as more banks seek to manage their exposures actively. This process has already started in the US.”

However, it is not all bad news. Because banks are also increasingly using credit derivatives to hedge out the loans they extend, they argue they are able to extend more loans, even to the more troubled borrowers. Deutsche’s Mr Di Flumeri points out that if these risk management tools were not available, credit allocations would fill quicker, big concentrations of risk would build up and banks would not be able to extend further loans. “They enable loan officers to be a lot more nimble and provide more help in more difficult times. The overall impact of the credit derivative market is therefore undeniably good – not only for lenders but also for borrowers,” he says.

Antonio di Flumeri: credit derivative pricing makes the loan market more transparent

Benefits at a cost

Even so, at least one banker concedes that those benefits come at a price. Niall Cameron, global head of credit markets at ABN AMRO, says: “The use of credit derivatives in this way does give corporates better access to money. But it is a more expensive market generically than the loan market, so it does have some negative implications for them. From one perspective this will affect corporates positively, as they will be able to access more loans because their risks will be distributed more widely. But, on the other hand, the higher-rated corporates could be worse off: they will not benefit by getting any more access to loans and yet their loans may be priced higher because they are being priced off the CDS market.”

Niall Cameron: the credit derivatives market is more expensive generically than the loan market

Borrowers might have an equally legitimate concern about banks hedging out their loans. If a corporate goes to a bank or syndicate of banks to take out a bridging loan ahead of a bond issue and the bank or banks use the CDS market to buy protection on that loan, there could be a significant rise in the corporate’s CDS price. When the time comes to price the bond, investors may reference the CDS price and demand a higher yield on the bond.

Mr Orssten says: “There is plenty of evidence of corporates being upset about the use of credit derivatives by banks during a primary syndication phase. There have been a number of recent occasions on which suddenly there has been some volatile movement in the CDS level, just at the time of a company undertaking a financing exercise. Corporates are quite clearly – and rightly – upset on these occasions. However, the problem becomes more difficult to resolve if a syndicate of banks has been involved.”

Bankers insist there are ways around this problem. Mr Munn maintains that it is relatively common for corporates to request banks not to hedge with CDSs, particularly when they have taken out short-term loans as bridges to the bond market. “This is understandable as we have seen evidence of other lending banks buying large amounts of protection on borrowers’ names and subsequently big swings occurring in the default swap market, which obviously pushes up the price at which the borrower can sell the bonds.”

However, not all corporates will be able to command such kid-gloved treatment. “Corporates often tell us that they do not want us to use credit derivatives to hedge their loans during the primary phase of syndication. For the most part we would agree. However, in instances where we were unhappy with this, we would not extend the loan,” says Mr Orssten.

Mr Cameron says that corporates might insist that banks do not use credit derivatives in this way but it could have negative repercussions for them. “Banks could either refuse to do so and thus be reluctant to extend the loan, or they might comply and subsequently charge a higher price for the loan which they had been unable to hedge.”

Safety devices

According to Mr Orssten, additional safety devices can be put into place to protect the better-rated corporates against CDS price movements when lenders sell on the loan. “To protect corporates from swings like that we would typically stipulate in the front-running language that any banks to which we sell on the loan would not buy protection on the name until the primary market syndication has been completed,” he says.

It is clear that it is not just Warren Buffet and his followers who are troubled by the popularity of these instruments. Forbes Elworthy, chairman of Credit Market Analysis, agrees that it is understandable that borrowers often get irritated with the wide rates they see in the CDS markets and their impact on loan pricing. But he also says that because of the peculiar regulatory status of loans (which unlike most bonds are not marked to market by banks), banks still have an incentive to lend at tighter rates on loans than they would accept on traded instruments like bonds and CDSs. “Because of this and the cross-subsidisation of products at underwriting banks, there are still distortions in the credit market of which issuers should continue to take advantage,” says Mr Elworthy. “They should always borrow tighter than the market if they can.”

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter