by Michael Peterson
When credit spreads narrowed sharply in early May, investors and issuers breathed a sigh of relief. But the rise in corporate bond prices was not driven by a rally in equities or an interest rate cut. A new and powerful force was at work in the credit markets. "That tightening of credit spreads was driven almost entirely by the credit derivatives market," says a senior credit derivatives trader. "Banks have been buying massive amounts of credit to cover short positions."
In the past, it was difficult to take a big short position in the credit markets. That has now changed with the arrival of bulk credit derivative trades known as portfolio swaps or synthetic CDOs (collateralized debt obligations). By combining credit derivative tools with the tranching techniques of securitization, banks can sell large pools of credit without the need to transfer the assets physically.
These trades were developed originally to shed credit risk from bank loan books. But they also allow firms to place large directional bets. In many recent cases, banks have sold portfolios without owning the underlying credits. They were betting they could buy the bonds at a lower price later.