CDS may be the financial innovation that will reduce credit spreads permanently

Credit default swaps are fast becoming a cost-effective means of transferring credit risk as well as leveraged financing hedging strategy.

Loan Credit-Default Swaps May Exceed Loan Trades (Update2)
By Patricia Kuo and Junko Fujita

June 20 (Bloomberg) -- Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc., the largest U.S. bank.

Trading of loan credit-default swaps now accounts for 50 percent of the volume of loan trades handled by Citigroup, New York-based Jonathan Calder, head of the U.S. bank's loan sales and trading, told a conference yesterday in Tokyo.

``It's an easy bet that over next year, loan credit-default swaps will exceed cash loan trades volume by at least two times,'' Calder said at the conference organized by New York- based Loan Syndications and Trading Association.

Credit-default swaps on loans, used to speculate on the ability of companies to repay the debt, are luring investors such as hedge funds and fund managers as a lower-cost alternative to investing in loans. They also provide arbitragers with opportunities to profit from the gap in risk premium between loans, derivatives and bonds.

The amount of loan credit-default swaps outstanding has ballooned to more than $85 billion from $31.6 billion last year and $6.3 billion in 2005, according to estimates from Goldman Sachs Group Inc. and Markit Group Ltd., administrator of the LCDX index, the first tradeable index contract tied to the loan market.

The amount traded on the LCDX index, based on the loans of 100 companies, reached $25 billion in its first two weeks, according to Markit. Goldman estimates that about $60 billion in credit swaps tied to individual companies were outstanding before the index started trading.

First Data
Arrangers of the non-investment grade loans that Kohlberg Kravis Roberts & Co. is seeking for its takeover of First Data Corp., the world's largest card payment processor, may start selling the debt in the next few weeks. Credit-default swaps on the loans, which haven't yet been sold, are already actively traded, Calder said.

Greenwood Village, Colorado-based First Data said in a regulatory filing in May that New York-based KKR will seek $16 billion of loans to fund the acquisition.

``This is not just an evolution. This is something that will significantly change the way we do business,'' Calder said.

$40 Billion Trade
Traders have bought an estimated $40 billion of loan credit- default swaps as part of what is called a negative basis trade, Calder said. In such a trade, investors can profit from holding both a loan and its protection against default when the cost of the derivative contract is less than the interest income they get from the loan.

The loan's yield premium over the cost of protection -- which ranged between 30 basis points and 120 basis points in the U.S. this year -- will probably disappear once the commercial lending departments of banks start purchasing credit-default swaps based on loans they've made, he said. A basis point is 0.01 percentage point.

The funds might leave the U.S. loan market should investors reverse these trades, Calder said.

``At the moment, cash is flowing into loans to do the negative basis trade,'' Calder said. ``At some point in the future, cash may flow out of loans.''

`Move the Market'
Even loan investors who don't use credit derivatives should learn about this trade because it is big enough to affect the loan market, Calder said.

``The size associated with that potential flow is enough to move the market,'' he said.

Credit-default swaps tied to corporate bonds, which were conceived about a decade ago, more than doubled in 2006 to cover $34.5 trillion in securities, according to the International Swaps and Derivatives Association. That's almost 10 times the amount of senior unsecured bonds outstanding. Credit swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

The record amount of money sought to finance buyouts may cause borrowers in the U.S. to pay more for non-investment grade loans by the end of the year, Calder said. Standard & Poor's Leveraged Commentary & Data unit estimates that companies will seek about $197 billion of junk-rated loans in the next 12 months.

That concern is reflected in the LCDX index. The index fell for a seventh day, declining 0.30 to 99.74 at 4:03 p.m. in New York. The index is below 100 for the first time since May 22, according to Markit Group. A decline in the index signals deteriorating perceptions of creditworthiness.

Leveraged Loans
Leveraged loans in the U.S. grew 85 percent to $550 billion this year compared with the same period of 2006, Bloomberg data show.

``With the large size of individual deals and large aggregate calendar, we expect there will be some backup in the rates in the U.S. leveraged loan market as we go through the summer,'' Calder said. ``We're going to have the busiest summer and I will be very surprised if we don't see coupons expand a little bit.''