Pre-Crisis Exotica Makes Comeback in Credit Amid Hunt for Yield

Complicated, opaque derivative deals are making a comeback in the shadows of the U.S. credit market.

As much as $20 billion of collateralized swap obligations - - which bundle credit derivatives into new derivatives -- were issued last year, up from less than $5 billion the year before, according to BNP Paribas SA. The French bank predicts even more will be done in 2015.

Demand for such deals dried up in the aftermath of the 2008 financial crisis, yet more than six years of near-zero interest rates from the Federal Reserve has investors hankering for ways to earn some extra yield. The synthetic investments are just another bet on whether companies will repay their debt while allowing fund managers to magnify their wagers.

One reason some investors are interested in increasing their risks within corporate credit is they aren’t as comfortable betting on all the geopolitcal unknowns out there, such as Russia’s complicated relationship with Ukraine and Greece’s potential exit from the euro-region’s shared currency. Never mind what the more than 50 percent decline in oil prices since June means.

“People tend to stay close to their knitting,” said Adnan Zuberi, head of credit structuring in the Americas for BNP Paribas in New York. Using structured, synthetic securities “is an effective way of expressing a leveraged view.”

Leveraged Bets

Banks including Citigroup Inc. and BNP Paribas have jockeyed to assemble the deals. Credit derivatives that are traded over the counter, off exchanges, tend to provide bigger fees to the arranging banks than more-frequently traded assets, like plain vanilla corporate bonds.

These transactions are similar to the derivatives that exacerbated the financial crisis by amplifying the pain tied to losses on mortgage debt.

Today’s CSOs are pegged to high-yield and investment-grade companies and allow investment firms to put down less money than they may stand to gain or lose. Money managers select the companies they want to bet on, then collect a bundle of credit-default swaps tied to those specific borrowers. They slice the pool into pieces with varying yields and risk, and decide which one they want to buy.

This creativity may result in juiced returns -- or another round of losses that will ripple through credit markets.

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