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Step-Up Credit Protection Gets Premium Reducing Twist

A twist on credit portfolio step-up protection is being pitched which brings down the costs for portfolio managers.

A twist on credit portfolio step-up protection is being pitched which brings down the costs for portfolio managers. The hope among dealers is that the tweaked protection will attract more institutional portfolio managers looking to hedge, but also credit investors who focus on the riskier parts of the capital structure.

Dealers have been offering for some time a basic form of step-up protection that references managers' corporate credit holdings. While it is initially zero-cost, as defaults occur premiums ratchet up dramatically.Goldman Sachs,Morgan Stanley,Deutsche Bank andBarclays Capital, however, are all actively pitching a hedge which references the corporate credit portfolio in conjunction with the CDX and iTraxx indices. Adding the indices into the mix reduces the premium cost in the event of a default because the liquidity of the indices means portfolio managers and dealers are better able to manage the risk. The manager's portfolio is likely to include the bulk of the names in the index and while it may happen that the manager has to pay out for a default on an index name it does not hold, the cheaper cost of the premium compared with that in standard zero-cost protection outweighs this disadvantage, say proponents. Officials at all the firms declined comment.

The cost of the protection--free until the first default in the portfolio--steps up with each additional default and tends to exceed standard protection prices. The contracts usually unwind when around 3% of the portfolio has defaulted. Demand has come from bank-loan desks, insurance companies and asset managers in the U.S. Firms, however, are also marketing the protection to hedge funds that buy into equity tranches and are comfortable with first-loss risk.

On the dealer side, the premiums that kick in after defaults can be employed to balance out somewhat losses they chalk up if equity tranches on their balance sheet experience the same defaults. Including the indices in zero-cost protection structures increases the likelihood premium income from selling protection will make up for losses on balance sheet.

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