The credit derivatives market's amazing run of growth was thrown off course this year because protection buyers, such as KBC Bank, have scaled back, resulting in volumes falling from their first quarter peaks. There are no natural alternatives to replace these players, according to Chris Francis, head of international credit research at Merrill Lynch in London. The list of protection buyers that have pulled in their horns include loan houses and convertible bond arbitrageurs. In addition, funds' hedging models were telling them to warehouse credit risk rather than buy protection, he noted.
These factors will all keep spreads narrow over the medium term and have had a severe impact on the collateralized debt obligation industry. If the CDO market is going to stay alive, investors will have to either accept higher yielding underlying credits or investing further down the credit spectrum.
Loan houses, which account for around half of the market, are no longer concerned that credits they have exposure to are on the brink of imminent default and so have withdrawn, according to Robert McAdie, head of credit strategy at Lehman Brothers in London. He added, however, that a few of the largest loan houses are starting to return to the market to lock in profits because spreads have tightened so much. This, in addition to the development of the single-tranche CDO market, could bring back the volatility needed to encourage wider participation.