Credit derivatives provide market assess in the form of new products and leverage that would otherwise be inaccessible. Example applications include:
Synthetic lending.
A bank with unused and available credit lines can enter into a variety of credit derivatives to profitably use these lines, including putable, callable or step-up asset swaps and default options.
Maturity shortening.
Money market funds require assets with tenors of 13 months or less. A fund can buy asset backed securities of an issuer that only has longer tenor bonds through Merrill Lynch's Asset Backed Trust (ABT) program. ABTs provide attractively priced assets like credit card securities, while maintaining the guidelines of "Rule 2a-7" money market funds.
Duration extension. Insurance companies can manage the interest rate risk of long-dated liabilities by purchasing high duration assets not offered in the cash market. Specifically, through a Public STEERS® special purpose vehicle, Merrill Lynch can offer investment grade deferred coupon certificates, which have a duration two to three times that of 100-year bonds.
Tranche credit risk by seniority.
Total return investors can increase expected returns by purchasing equity tranches of CBOs or CLOs. CBOs and CLOs tranche the credit risk in a portfolio of bonds or loans, offering investors the opportunity to own the excess return on a portfolio, while reducing up front investment and limiting exposure.
Provide efficient leverage. A hedge fund or insurance company may gain exposure to senior secured corporate bank loans through the purchase of the equity tranche of a CLO, through a total return swap (receive) on the underlying loans or by writing options on corporate spreads or default.
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