Credit houses, including Deutsche Bank , Bear Stearns and JPMorgan , have adapted the re-settable feature of constant-maturity interest rate swaps to create a credit-default swap with a re-settable coupon. The hybrid instrument allows end users to take a punt on credit spreads without taking default risk. The instruments are designed to lure hesitant protection sellers back into the market. "This should develop to become a major component of the CDS market," said Olivier Vigneron , exotic credit-default swap trader at Deutsche Bank in London.
Brad Poprik , co-head of North American structured credit trading at Deutsche Bank in New York, explained that some clients do not think credit spreads are wide enough to make selling protection an attractive proposition and are concerned about being burned by potential spread widening. The constant-maturity credit swap allows clients to take a short-term view on credits at the same time as taking a bearish view that spreads will widen, he said.
In a typical trade, an investor would sell protection on Allianz for 42.5 basis points, around 85% of the current 50bps spread. The credit spread would then be re-set every quarter and the investor would get 85% of the current five-year spread, according to Vigneron. The dealer hedges its position through the options and forwards market. This means that the lower volatility or the flatter the forward curve, the higher participation the seller can have in any spread change, explained Vigneron.
Credit derivative constant-maturity swaps make sense to investors who want to take views on spreads without taking a view on default risks, explained Alex Reyfman , head of credit derivatives research at Bear Stearns in New York. For example, investors who are bullish on both a name and the spread can buy a credit-default swap and sell a constant maturity swap, which cancels any exposure to default, but gives exposure to widening spreads. Many of the inquiries for credit constant-maturity swaps are from hedge funds looking for ways to take long credit positions, said Poprik. Loan portfolio managers also benefit from constant-maturity swaps, which reduce the volatility of marking to market swap positions, he said.
The reset can be made at various intervals, including quarterly and annually.
