Oct. 27 (Bloomberg) -- Derivatives traders may be profiting from inside information on leveraged buyouts and other takeovers, a study by Credit Derivatives Research LLC suggests.

Credit-default swaps based on the bonds of 30 takeover targets, including four of the five biggest LBOs of 2006, rose before deals were announced or news reports said transactions were likely, according to the New York-based independent research firm.

The fluctuations in credit-default swaps based on the bonds of Austin, Texas-based Freescale Semiconductor Inc., Sara Lee Corp. of Chicago and San Jose, California-based Knight Ridder Inc. were highlighted by the report. The U.K.'s Financial Services Authority said in June it would monitor unusual trading on concern inside information is leaking from banks or securities firms privy to details about takeover talks.

``The evidence keeps building that there is a problem here,'' said Michael Greenberger, former director of trading at the Commodity Futures Trading Commission and now a professor at the University of Maryland School of Law in Baltimore. ``If there continues to be reports of this kind coming out, it's going to suggest that at least a hard look needs to be taken at what's going on.''

Credit Derivatives Research found the cost of contracts increased 30 basis points on average during the three months before reports of a transaction. During the same periods, indexes measuring the risk of owning bonds for benchmark companies declined 5 basis points, or $5,000 per $10 million of bonds. A basis point is 0.01 percentage point.

$350 Billion

``Evidence shows that CDS prices are widening before public rumor or news,'' said Tim Backshall, a strategist at Credit Derivatives Research in Walnut Creek, California, who conducted the study. ``Whether it's insider trading or more informed selling is unclear. That could simply be a reflection of smart players in the market buying protection.''

Credit-default swaps are financial instruments based on about $350 billion of bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default, and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.

The total face amount of contracts outstanding worldwide more than doubled in the past year to $26 trillion, outpacing the growth of all other derivatives markets since their creation less than a decade ago, according to the International Swaps and Derivatives Association, or ISDA.

There are contracts on more than 3,000 companies in the U.S., Europe and Asia as well as indexes that seek to replicate the risk of investing in everything from emerging markets to mortgage-backed securities.

Knight Ridder Speculation

For investors seeking to speculate on the creditworthiness of companies, the market is gradually replacing corporate bonds because the derivatives are less expensive and easier to buy and sell. They are created by banks such as JPMorgan Chase & Co. and Deutsche Bank AG, and do not depend on companies to be issued.

Contracts based on $1.6 billion of bonds sold by Knight Ridder began rising just before the company's largest shareholder in 2005 called for a sale in a Securities and Exchange Commission filing, according to the research report.

The cost of credit-default swaps on $10 million of Knight Ridder bonds surged 35 percent to $88,000 on Oct. 31, the day before the filing, from $65,000 six weeks earlier, according to data compiled by Credit Suisse Group. Prices increase in buyouts because the addition of debt will reduce the perception of credit quality. The company was bought by McClatchy Co. in June.

No Regulation

The SEC says it has no direct supervision of trading, while the CFTC says it isn't responsible. ISDA, a New York-based trade group whose members include the largest credit derivatives dealers, said this month that they aren't aware of any instances of investors using the market to exploit inside information.

The U.K.'s Financial Services Authority said in a June newsletter that the credit derivatives market ``is very difficult to police'' in part because participants are less likely ``to report suspicious behavior.''

A London Business School study last year of 79 North American companies from 2001 to 2004 found ``significant'' evidence that contracts were moving ahead of news that could affect credit quality.

ISDA this month issued a statement saying the industry has done an effective job policing itself, and that their ``understanding is that the regulators have been quite happy with the way things are.''

HCA, Georgia-Pacific

Credit-default swaps on $10 million of HCA Inc. bonds rose 48 percent in 2 1/2 months before the Wall Street Journal reported that the biggest U.S. hospital operator had been in talks for what would become the biggest leveraged-buyout, Backshall said.

The contracts rose to $177,000 on July 18, from $120,000 on May 1, he said. Kohlberg Kravis Roberts & Co., Bain Capital LLC, Merrill Lynch & Co. and HCA co-founder Thomas Frist are buying the Nashville, Tennessee-based hospital company for $33 billion.

The gap between five-year and 10-year contracts on Atlanta- based Georgia-Pacific Corp. widened to 40 basis points from 30 basis points in the days leading to its November 2004 announcement that closely held Koch Industries Inc. was acquiring it, Backshall said. The difference jumped to 65 basis points after the announcement, he said.

In the week before the New York Times reported on Sept. 11 that Freescale Semiconductor may be sold for $16 billion to an investor group, credit-default swaps based on the company's bonds rose 11 percent to $82,000, according to Bloomberg data.

Standing Out

What made Freescale's movement stand out was that it was one of a number of companies that ``did not appear as good candidates for an LBO prior to the event,'' according to Backshall.

Credit-default swaps have become so useful in predicting takeovers that will hurt bondholders that a growing number of debt analysts are now monitoring derivatives prices as a way to watch for potential deals.

``There is value in monitoring trading activity in these markets for potential `early warning' signals,'' Barclays Capital Inc. strategist Matthew Mish in New York wrote in a note to clients on Oct. 23.

Private-equity firms this year have raised a record $300 billion of acquisition funds, meaning the credit-default swap market is on ``a hair trigger now with LBO rumors,'' said Backshall. Almost any report of a company being a target of private-equity firms causes prices to ``blow out,'' he said.

To contact the reporter for this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net.

Last Updated: October 27, 2006 00:08 EDT