Credit-default swaps grab attention

NEW YORK — Institutional investors are recognizing the importance of protecting fixed-income bets, and the money that can be made off that protection.

General Motors Corp., General Electric Co. and Verizon Communications Inc. are among the pension plans that either have or are considering writing or buying single-name or asset-backed credit default swaps to beef up returns and provide downside protection and lower volatility in their fixed-income portfolios.

Additionally, recent credit-rating downgrades in the auto manufacturing sector, which affected both GM and Ford Motor Co., have prompted heavier use of single-name credit default swaps.

Credit default swaps allow an investor, through a counterparty, to either buy or sell protection against default on a portfolio of debt obligations, such as high-yield bonds or asset-backed securities, or a single debt obligation, such as a high-risk loan or bond. Investors can also buy baskets of credit default swaps through the Dow Jones' North American Investment Grade and High Yield Indexes.

Buyers of such protection pay a periodic premium, usually quarterly, to another party for the life of the protection agreement. In return, the seller of the protection agrees to make a specified payment to the buyer if a specified default occurs.

If the default does not occur, the seller earns a premium on its own portfolio of assets, much as the seller of a put option earns a premium.

"I would say in general, we have been working increasingly with our fixed-income managers and looking at ways to enhance returns without adding a lot of risk," said William Heitmann, chief executive officer of Stamford, Conn.-based Verizon Investment Management, which oversees Verizon's $39 billion cash balance plan. "We're looking at a broad number of strategies right now and we're always open to hear new strategies from our managers, and credit default swaps are among them," he said.

He declined to elaborate on whether the firm is seeking to write or buy credit default swaps in its roughly $1.2 billion fixed-income portfolio.

Jerry Dubrowski, a General Motors Asset Management spokesman, said the firm has tapped in to the credit default swap market on a limited basis, but declined to give details. GMAM manages $160 billion in assets for GM.

According to the British Bankers Association, London, pension funds comprised 3% of all buyers of credit protection in 2004, up from just 1% a year earlier. Pension funds also comprised 2% of all writers of CDS contracts in 2004, up from less then 1% a year earlier.

The entire credit default swap market has become more popular in the past five years, as CDS contracts, including notional amounts, are expected to grow to $15 trillion in 2006, according to GFI Group Inc., New York, a broker-dealer in various over-the-counter derivatives markets. According to GFI, CDS contracts totaled about $12.4 trillion as of Nov. 30, and about $8.4 trillion after the first six months of 2005.

"The trend is going in the direction of credit default swaps," said Peter Wilson, senior fixed-income portfolio manager and strategist at Barclays Global Investors, San Francisco, which is one of the bond managers used by Verizon. "Foundations and endowments and some of the larger corporate pension plans are looking at the CDS market."

Mr. Wilson said his firm has been authorized by some institutional clients to write single-name CDS contracts as a way to beef up returns. "Most of the plans that are doing it are the ones you would associate with large, sophisticated institutional investors," he said, although he declined to identify any clients.

BGI manages $400 billion in fixed-income assets, with about $50 billion overall in corporate bonds, he said. Additionally, about 10% of BGI's long-short high-yield bond strategy is earmarked to single-name credit default swaps.

According to a recent paper from BGI written by Fred Dopfel, senior strategist, the use of single-name credit default swaps in a long-short bond portfolio could lower the cost of shorting, as bond managers can take short positions by buying single-name CDS contracts. The typical cost of shorting a single credit name is 30 to 40 basis points, according to the paper, "Efficiency Gains of Long/Short Credit Strategies." However, the cost of buying a single-name CDS contract typically is less.

The price of buying a CDS contract is a percentage of the spread between the yield of the contract and the interest rate swap curve. The formula for determining the price of a CDS contract is the notional amount multiplied by the spread and then multiplied by the number of payments per year.

According to a white paper from General Electric Asset Management, Stamford, Conn., "Using CDS to achieve Incremental Returns," the cost of a five-year protection on a $10 million notional amount for a credit issuer with a spread of 200 basis points with quarterly payments would be $50,000 per quarter, or about 20 basis points per year of the notional amount.

The GE Asset Management paper, written by Craig Varrelman, fixed-income product portfolio manager, and Lewis Tatananni, senior fixed-income derivatives trader, said: "The ability for managers to short credit risk and take advantage of market dislocations between the cash and default swap markets adds to their opportunity set to add value and improve the information ratio. It is likely that investors who are reluctant to utilize these instruments will be at a disadvantage to those investors who do."

GE Asset Management handles about $180 billion for parent General Electric.

"Credit default swaps are being viewed as almost an essential tool by pension funds and money managers," said Peter Chiappinelli, senior vice president and head of investment strategy at Putnam Investments, Boston. "Any pension fund or manager has to be viewing CDS as vital tools in gaining additional alpha."