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Derivatives

Step-Up Portfolio Protection Finds Favor

Bank loan desks, insurance companies and asset managers are turning to portfolio protection strategies where the cost of protection steps up as losses occur.

Bank loan desks, insurance companies and asset managers are turning to portfolio protection strategies where the cost of protection steps up as losses occur. The trades are being fueled by the belief solid credit fundamentals will prolong a near all-time low in defaults but not all-time tight spreads. The step-up protection provides a mark-to-market hedge against spread widening for less than the cost of standard portfolio protection, so long as default rates remain low.

"It is an attractive trade for people who are bullish on near-term defaults and bearish on spreads," said Oliver Dunsche, head of credit derivatives structuring at Barclays Capital in New York. "It is a cost-effective way to get short the market, which we have seen is something investors are looking for as an overlay strategy."

Step-up protection is structured as a credit-default swap on any portfolio of corporate exposure, where the price of protection starts at zero and rises with each successive default. If defaults remain low, the feature provides investors the same protection as standard default swaps for less money. After a certain level of default, however--typically after 2%--the cost approaches or exceeds static protection premiums.

Step-ups can be modified based on an investor's portfolio to express more finely a certain type of spread-widening or default-timing view, structurers said. Dealers are beginning to customize step-up variations for investors to express nuanced views about the timing and magnitude of corporate defaults in their portfolios. These can be structured with more or less steep step-up premiums and caps around 3% loss. Most dealers either have started offering these products or are actively looking at structuring them.

"We are seeing a lot of interest in these trades," Dunsche said. "There is a need for efficient hedges that are very cost-effective, and this is a solution structured around that."

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