HUNTINGTON BEACH, Calif. — For fixed-income investors, few words cause more fear in the over-the-counter-credit-derivatives market and its whopping $26 trillion notional value than “default” and “bankruptcy.”
And investors were reminded of the notion of risk by the Feb. 27 stock market sell-off, which was tied to worries over U.S. economic growth, subprime lending and emerging markets.
The return of risk awareness has widened yields and resulted in some bond issues’ being canceled or higher premiums for subsequent bond offerings.
The Chicago Mercantile Exchange and the Chicago Board Options Exchange each is coming up with new contracts that will help asset managers buy insurance against such events’ affecting their fixed-income holdings.
James Grady, senior portfolio manager for structured-finance securities at Deutsche Asset Management in New York, thinks that a reassessment of risk is a healthy development for bond investors. Deutsche Asset Management has a fixed-income portfolio of more than $100 billion across investment grades.
“Corporate-credit spreads had been very tight, close to all-time tight, and have given a little back,” he said, noting that there are many long positions in the investment-grade sector.
“We have seen a reversal of that. Ultimately, it is healthy for the market,” Mr. Grady said.
“We are at a point where the pricing of risk is richer than the fundamentals warranted, and this has reminded people that these assets are risky,” he said.
The new contracts are yes-or-no binary offerings, betting on the view that a credit event will occur or not. They are based on securities at the CBOE and on futures at the Chicago Merc. They allow investors to buy insurance against an event’s negatively affecting a bond, while sellers of the contract collect a fee for the insurance they extend.
“Bankruptcy and failure to pay are two primary risks in the credit derivatives market. We will be launching a credit event index contract in the second quarter,” CME managing director Robin Ross said in an interview at the annual risk management conference held March 4-7 by the Chicago exchanges in Huntington Beach.
The CME has filed with the Washington-based
Commodity Futures Trading Commission its plan to launch credit index event contracts “to extend to the credit derivatives industry the benefits of exchange-traded products, which had only been available on an OTC basis,” Ms. Ross said.
Pending regulatory approval, the CME North American Investment Grade High-Volatility contract is tentatively set for an April 23 launch. It will track 32 corporate issuers, such as Time Warner Inc. and Viacom Inc. The CME will reconstitute this and other upcoming indexes every March and September.
The offering is part of the CME’s long-term strategy to expand its presence in the OTC markets and migrate some OTC trading to an exchange-listed environment, given the sheer size of the OTC markets and their mature nature.
The CME last summer bought London-based Swapstream, an electronic trading platform for euro- and Swiss-franc-denominated interest rate swaps. It is readying the launch of FXMarketSpace, a joint venture with London-based Reuters Group PLC to trade foreign exchange in a listed environment with the benefit of centralized counterparty clearing.
“We are going to add U.S. dollars to Swapstream early in the second quarter. It will be a soft launch in Europe, and we will introduce that platform in the U.S. before the end of the year. We also have plans to add sterling,” Ms. Ross said, adding that the CME intends to broaden participation in Swapstream, including hedge funds, beyond its dealers’ constituency.
“Basically, we are taking things that we are very good at — the transaction process and clearing — and taking those efficiencies to the OTC market,” she said.
The CBOE also wants to move into a market mature enough to benefit from exchange-traded products.
On Feb. 7, it filed with the Securities and Exchange Commission “for the listing and trading of cash-settled binary options based on credit events in one or more debt securities of an issuer,” according to the filing. CBOE default options are binary call options that cover payment default or a restructuring of the debt.
For Jose Marquez, senior vice president,
portfolio management, at Deerfield Capital Management LLC in Rosemont, Ill., liquidity will be the key factor in whether the contracts take off as exchanges attempt to capture some of the huge liquidity available in the OTC market.
