The next credit tidal wave

Friday, 22 February 2008

The rocketing cost of protecting corporate bonds has shone a light on another arcane corner of the financial world – the $45trn (£23trn) market for credit default swaps (CDS).

The cost of insuring the debt of US and European companies against default surged to all-time highs so that buyers of protection in the market were paying €126,500 (£95,500) a year to insure €10m of debt over five years.

The markets eased a little yesterday but Wednesday’s surge to an all-time high was triggered by a panic that market experts are struggling to explain.

Credit-default swaps are financial instruments linked to bonds and loans that are used to bet on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower does not honour its debt. A rise in the cost of the instruments indicates greater fears about credit quality.

The troublesome part of the market is constant proportion debt obligations (CPDOs) – products that package indexes of credit-default swaps. The trouble is caused partly by fears about the corporate debt that underpins the products.

But “fundamentals” do not necessarily have to get worse to cause a widening of spreads – the difference in the cost of insuring a security compared with risk-free debt. Structured products have been set up with triggers to stop investors losing more than they put in, and it can take only a small fall in the value of the securities to hit these triggers which force the structured products to start to unwind.

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