Credit default swaps (CSD) are increasingly being used in the loan market to determine pricing, as derivatives provide pure prices on credit. In a session on how credit portfolio management is changing the loan market, panelists cited credit default swaps as a key agent of change on the market. "Banks are now able to mark loans and bonds to the CDS market and there are new index products that will allow us to manage our portfolios better," explained Steve Bennett, senior v.p. at CIBC World Markets.
But banks are still struggling with the issue of how to price revolvers as relationship issues prevent more realistic market pricing, Bennett added. "One of the most significant contributions of loan portfolio management to the market was persuading our bank that unfunded revolvers were not profitable," Bennett said. "It's like buying a new car. The value goes down as soon as you drive it off the lot. How do we correct the revolver?" he asked. "At first I thought prices would rise as banks used realistic parameters in their pricing models. However, since banks look at the profitability of the customer as a whole, those that have significant sources of other revenue can afford to under price them," he added.
The default swap market has other benefits to the loan market. "Without the CDS market, lending would have been more restrictive in this last downturn," noted Hetty Harlan, managing director, portfolio analysis trading and execution at Bank of America. "The ability to lay off risk through the credit derivatives market allowed banks to continue to support corporate clients without increasing and, in some cases, even decreasing their hold sizes," Harlan added. She expressed surprise though that loans spreads have not widened more because premiums to hedge in the CDS market are significantly higher than loan spreads. "You would expect the need to hedge to have pushed loan spreads higher," she said.
Participants noted that CDS have been used less by leveraged loan managers. Harlan said the CDS market has been less useful in the leveraged loan market as there is less pressure to hold size in leveraged loans. A better tactic for yield loan asset managers has been to sell the loan outright rather than buy derivatives because of the expenses, she said. However, the demand for the high-yield CDS market is growing as there is more demand for spread from hedge funds with higher risk tolerances, she added.