The credit derivatives market has grown so exponentially (by 86% in 2005 alone) that its notional value of $5.3 trillion now tops the $5.0 trillion of the entire US corporate bond market, according to a Fitch Ratings survey released recently. In the process, it has thrown an occasional scare into the capital markets and raised more than a few eyebrows, especially among regulators. That situation will likely intensify in 2006, as credit derivatives look to get even riskier, and have an even larger and potentially more volatile impact on the high yield bond market.

Hedge funds are now showing a growing taste for junk-rated derivatives, whether traditional single-issuer credit derivatives or structured products like collateralized debt obligations (CDOs). "The increasing focus of hedge funds on the high yield credit derivatives market, which offers higher yields and volatility, has been an important factor in the high yield credit derivative market's growth," Fitch analysts said in the survey.

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