Credit market participants are expressing concern about the amount of financial leverage that has crept into the fixed-income market in recent years and say the explosion of credit derivatives has led to a false sense of security. While most participants expect a benign environment this year, credit players at last week's Euromoney Bond Congress in London said they are anxious liquidity may suddenly evaporate if the situation turns, particularly with relatively untested structured products playing an increasing role in credit portfolios.
Duncan Sankey, head of credit research at Cheyne Capital, said the rise in the number of new investors using credit default swaps could result in a liquidity crunch and stampede for the exits if just one credit defaults. "There's a possibility, not necessarily a probability, that liquidity would disappear very quickly," he said, adding banks have huge correlation books that have not been tested. And just one credit default could destroy a manager's performance for an entire year because there are no opportunities to make it up, cautioned Karl Bergqwist, head of research at Gartmore Investment Managers.
Joe Biernat, director and head of research at European Credit Management, said tight spreads are masking increasing leverage and there is a general sense the market is not adequately prepared for a downturn. He projects spreads will back up sharply if the tide turns and finds the recent stream of payment-in-kind deals worrisome because bond investors could be left in poor stead.
And it's not just investors who are at risk. Simon Adamson¸ senior analyst in European financial services at CreditSights, expressed concern about the credit exposure of dealers because prop trading desks are playing an increasingly larger part of their generated revenues. The recent period of low volatility has prompted banks to take on bigger bets and more risk in their relationships with hedge funds, which could spell trouble in the event of a downturn.
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