One of the most important contributions of credit derivatives is that they have made it possible to effectively hedge credit risk. Consider the following applications:
Cash market credit portfolio.
A high yield fund can hedge the fund's exposure to a macro market credit spread widening by entering into an index swap where the fund pays the total return on the Merrill High Yield Master Index and receives the Merrill Government Master Index. The swap allows the manager to get "short" high yield credit spreads without altering the duration of his portfolio.
Hedging counterparty exposures.
The growth of interest rate derivatives has lead financial institutions and corporations to manage their exposure to derivative counterparties. A firm can enter into a contingent default swap under which the default swap is only in effect during those scenarios when the exposure is significant, thereby gaining credit protection for adverse scenarios at a lower cost than normal default protection.
Business risks
. Manufacturers that sell to retailers have concentrated credit exposure to a single industry. Many utilize "factors", credit intermediaries that provide a guarantee of payment on each shipment. Because of limited capital and lack of business diversification in the factoring industry, pricing of receivables credit insurance, when available, is often significantly higher than capital markets credit pricing. As an alternative, manufacturers can purchase first loss credit protection against an entire portfolio of receivables in the form of default options linked to more liquid corporate bonds.
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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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This is the most common application for cash-style corporate bond investors. For example, a fund manager can achieve yield enhancement through structuring synthetic corporate bonds with credit default swaps. Specifically, credit default swaps can be combined with high quality asset-backed securities to create a cheap corporate bond with negligible additional risks
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