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.

Below investment grade and unrated derivatives made up about 24% of the surveyed market in 2004, compared with 18% in 2003, and that percentage is likely to have increased further in 2005, and could shoot up again next year, analysts and investors said. (Fitch will not begin surveying 2005's derivatives market until next year, Fitch officials said.)

A main reason for the spike in lower-rated derivatives growth is that given the current low default environment and relatively tight credit spreads across the board, investors with riskier appetites - not only hedge funds, but even some investment banks - are growing dissatisfied with top quality derivatives. In the survey, Fitch found that AAA and other top-ranked issues dropped to 14% of derivatives sold in 2004, compared with 17% in 2003. By contrast, BBB rated derivatives exposures increased to 32% from 29%, Fitch found.

That trend could pose some challenges for high yield traders and investors in 2006, as an increase in lower-rated derivatives creates a greater potential for market volatility if issuers hit turbulence. For example, the bankruptcy of auto supplier Delphi Corp. in October could have massive implications for high yield - Fitch says it has rated CDOs that reference more than $2 billion in Delphi obligations, and the total exposure to Delphi from all credit derivatives is likely to be "multiples of this figure."

James Batterman, a senior director at Fitch, said that in the first weeks following Delphi's bankruptcy filing, its bond trading volume and prices continued to rise, in contrast to bonds of most other issuers that filed for bankruptcy this year. The difference was that the other issuers had far less derivatives exposure than Delphi did. That turn of events is prompting junk officials to wonder just how much faith investors are placing in the use of credit derivatives to remove some of the risk of outstanding Delphi bonds.

Fitch found that this year's explosive growth in credit derivatives was dominated by single-name credit derivatives, which accounted for two-thirds of all the gross sold positions. Yet things are changing: Analysts found that the fastest growth rate among derivatives products lies in newer, more complex products like index-related derivatives. Nontraditional credit derivatives increased by more than 425% in the survey period, compared with a mere 48% in growth by more traditional "portfolio" derivatives.

And much of the sector's growth is owed to Wall Street - banks have been increasingly using credit derivatives as a protective hedge on their balance sheets for several years now, and indeed, some banking analysts have credited the Street's use of derivatives as a key way that banks have avoided getting burned by the recent recession and stock market downturns.

Fitch found global banks had a roughly $427 billion net position in various credit derivatives at the end of 2004, compared with $260 billion in the previous year. Basically, this means that banks had managed to transfer $427 billion of credit risk off their balance sheets and into the willing arms of insurance companies, financial guarantors, hedge funds and asset managers. Global insurers had an approximately $319 billion exposure to various derivatives, a whopping amount of that held by one company - AIG Financial Products, which had a net sold position in derivatives of roughly $268 billion as of the end of the survey period.

In the survey, Fitch included results from 120 financial institutions, including 73 banks and broker/dealers, 39 insurance companies, and the remainder comprised financial guarantors.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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