Schroder Investment Management is canvassing opinion among clients about setting up its first fund to use credit derivatives to take positions rather than to hedge exposure. John McLaughlin, head of the structured investment team in London, said the fund manager, with USD172 billion under management, is pitching the idea as an alternative to buying yield-enhancing structures. Instead, Schroder wants to create its own structures since liquidity in the synthetic market has improved to a point where Schroder can actively manage a portfolio of single-name default swaps. "We need to know that we're not bound to go back to the original trader to unwind a trade," he noted, adding the market has also become more standardized.
Another factor is Financial Reporting Standard 17, which comes into effect in 2003 and could force Schroder and other U.K. fund managers to avoid lower-rated, more-volatile bonds at the expense of generating higher returns for their pension fund clients.
The fund manager wants to run a cash corporate bond portfolio that it will overlay with credit derivatives by purchasing and selling single-name default swaps to boost yield, which is particularly attractive given the low interest rate environment. Each fund would be several hundred million euros, McLaughlin said, although he stressed any such initiative is unlikely until next year. The fund manager already uses foreign exchange and interest-rate derivatives extensively.
Credit derivatives professionals said such an initiative makes sense, both to boost yield and take advantage of arbitrage opportunities between the cash and synthetic markets. For example, "there was a huge demand for default swaps in the summer because of synthetic securitizations and they were trading well through cash bond levels, but since Sept. 11 we saw a big shift and names were hit badly and widened out a lot further than cash bonds," said one London-based head of credit derivatives. He added, "it's an attractive strategy and we're going to see more and more funds getting involved." However, another trader added the risks in the synthetic market are different than in the cash market.
