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Credit Derivatives Jump, Corporate Bonds Decline (June 16, 2006)

Location: New York
Author: Ellen J. Silverman
Date: Friday, June 16, 2006

The cost of protecting against bond defaults rose 32 percent in the past six weeks, as investors grew more concerned rising interest rates will slow the economy and cause bankruptcies to increase.

Corporate bond yields are rising compared with Treasuries as investors pay more for derivatives to protect against defaults. "Investors are becoming a bit more risk averse,'' said John Tierney, credit strategist at Deutsche Bank AG in New York. "Most of the widening is being led by' credit default swaps indexes."

The credit derivatives market has grown to $17 trillion from almost nothing in eight years, as investors used the contracts to bet on a company's creditworthiness or protect against non-payment. Like insurance, buyers pay a premium to protect debt for a specified number of years. Credit default swaps are the fastest growing part of the market for derivatives. Credit default swaps have led corporate bonds in the past. Credit default swaps showed investors were growing more bullish on the ability of companies to pay debt at the end of November. Corporate bond spreads didn't begin narrowing until January.

Investors in corporate debt are growing more concerned because Federal Reserve officials indicated they are prepared to continue a two-year effort to curb inflation by raising rates even if it slows economic growth. Moody's Investors Service said last month the percentage of global borrowers defaulting on obligations hit a five-month high and would almost double by the end of May 2007.

The threat that U.S. growth could slow to less than 2 percent from 5.3 percent last quarter raises significant risk of defaults, Banc of America Securities LLC said in a June 12 report. "It is this concern in turn that likely is contributing to the increase of spreads,'' wrote strategist Jeffrey Rosenberg. Rosenberg said a growth rate of 2 percent would cause defaults to surge to 6 percent. The extra yield, or spread, investors demand to own investment-grade bonds reached 94 basis points, its widest point of the year this week, according to indexes compiled by Merrill Lynch & Co. The yield premium on junk bonds which is debt rated below BBB- at Standard & Poor's and Baa3 at Moody's has risen to 3.25 percentage points, up from the low this year of 2.88 percentage points on May 12, according to Merrill indexes.

The increasing availability of credit default swaps makes it easier to bet on wider corporate bond spreads and contributes to price declines, said Andrew Feldstein, chief executive officer of Blue Mountain Capital Management. Credit derivative indexes tend to lead corporate bonds because they are cheaper and easier to buy, he said. "People who previously couldn't use credit to speculate on the market selling off or to hedge their positions against a market sell off now have a much easier way of doing so,'' said Feldstein.

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