Credit derivatives were one of the financial markets’ biggest success stories of 2005, and the explosive growth, which topped 100% annually, is expected to continue through at least next year, as more and more market participants get involved. Pension funds, which have not played a huge role in the market of yet, could, by virtue of their enormous size, play a big role in that future growth.
“There are definitely pension funds in Europe which have been involved in the structured credit market for a long time,” says Terri Duhon, managing partner and founder of London-based B&B Structured Finance, and a former derivatives trader and structurer at JPMorgan. “At the same time, there are tons and tons of pensions who are seriously exploring the structured credit market today and have been for the last six months in particular.”
Among the European names involved in credit derivatives are Dutch government pension fund ABP and pension advisers AXA Investment Management, BNP Paribas, CDC Ixis Investment Management, Crédit Agricole Investment Management, Deutsche Asset Management, Morley Fund Management and Robeco, according to a list compiled last year by Michael Fuhrman, head of electronic trading at inter-dealer derivatives broker GFI Group. The fund managers either did not return calls or declined to comment for this article.
People familiar with the industry say things are heating up on this side of the pond, as well. “People are talking about it,” says James Batterman, a senior director at Fitch Ratings’ credit policy group.
Others say pension funds, wracked with solvency issues, are desperate to find alternative sources of return at low risk. The general market environment has not been terrifically helpful. A number of companies, including United Airlines, face looming pension-funding problems, while many others, such as IBM and Alcoa have closed their plans to new investors in an effort to avoid a similar fate.
“The fact of the matter is, [credit derivatives] provide an opportunity that you can’t necessarily get elsewhere,” Duhon says, “and, frankly, a lot of these pension funds really need to think about diversifying.”
The market itself has finally reached a point where credit derivatives make sense for most institutional investors, adds Duhon, who started B&B in 2004 to help institutions navigate the structured credit markets.
Faced with flat equity returns and low interest rates, pension funds in need of returns have had little choice but to consider something new and credit derivatives offers that sort of diversification. Opportunity, however, has not been enough to shake most institutions off of their conservative laurels.
“In the past, there was enough negative media that, although [structured credit] looked interesting, it also looked a little messy, and maybe still a little bit unproven,” Duhon says. To attract cautious institutional money, the relatively young, impetuous credit derivative market needed to grow up. That’s exactly what has happened in the last several years.
It was only in late 2003 that a standardized documentation was agreed upon, helping to increase liquidity and raise clients’ comfort level. Then, in 2004 came standardized index products, one of the main reasons for the market’s robust growth in 2005. In 2006, a more mature, highly liquid structured credit market is more ready than the pre-2003 nascent market to go after big institutional dollars.
“There’s certainly a wide range of options available, from single-name CDS, which allow you to take a position on a single entity, to portfolio products, like the traded indices or CDOs, which allow you to get broad market exposure,” explains Batterman. “Further, the liquidity in the credit derivatives market is often quite good, though not for all structures and specific reference entities.”
“It’s clearly now seen as a long-term, viable, real element of the financial markets,” Duhon says. “The growth of the structured credit market has received so much press recently, and is perceived to hold a lot of opportunity. What we’re seeing is a lot of different institutional investors who had not previously been in this market before looking at it with significant interest.”
As with any new product, education is the key. And the more investors learn about the products, the more they look like the first half of their name, credit, rather than the second, the risk-indicating derivatives, says Duhon, who spends much of her time educating clients on how these products work.
“Depending on how they’re employed, [funds] can tailor their risk profile more precisely than with cash market instruments,” Batterman says. “Through tranched products, they can more precisely choose the level of exposure or risk desired.”
While pension funds are getting their feet wet in the market, learning about the products and how they fit into their portfolio, Duhon cautions that they are not a “big driving force, not yet.”
Hedge funds, on the other hand, have already made their splash in the structured credit market, on both sides of the trade. Fitch analyst Roger Merritt says “they’ve become the dominant force in the market in terms of trading activity.” Most experts credit hedge funds for the increased liquidity in, and size of the market, and as pension funds put more and more money into alternative investments, they may well be getting into credit derivatives through the back door.
Duhon believes that, of the upwards of 8,000 hedge funds around the world, there are perhaps a dozen dedicated structured credit funds, with another 60 to 80 heavily using the products. But don’t be fooled by the small number: Though Duhon declined to name names, she says, “they’re well-known, respected names, and if they have devoted a portion of their money to credit, that means it’s probably more traditional places than you would expect.”
