Credit Traders Restless to Make a Buck Turn to Leveraged Swaps

Credit traders smell blood in the water.

More companies are running into financial trouble, and fund managers want to make magnified bets on which ones will be the next to suffer difficulty paying their bills.

To do so, investors are using complicated, leveraged credit derivatives called index tranches -- the very same structures that surged in popularity in the run-up to the worst financial crisis since the Great Depression.

“People want to take credit risk,” said Peter Tchir, head of macro strategy at Brean Capital LLC in New York. “I’m definitely having more people asking questions about tranches.”

The growing temptation to take credit risk with derivatives is easy to understand. It’s gotten harder to trade actual bonds. And at a time when the winds keep changing the way they’re blowing in Greece and China, it’s appealing to bet on companies that are already struggling to make ends meet as the Federal Reserve prepares to tighten its ultra-accommodative policies.

Plunging commodity prices are posing serious problems for energy companies such as Walter Energy Inc., which filed for bankruptcy this month, and KKR & Co.’s Samson Resources Corp., whose creditors are racing to line up cash to fund its restructuring.

When companies fail, that means there’s money to be made betting for or against them. And some credit traders are looking to hit a jackpot in structured, synthetic credit.

Betting Big

Here’s how this brand of fun works: In most credit derivatives transactions, traders bet on the chance of default for a big, diverse pool of companies. In a tranche trade, they can concentrate those bets on the riskiest of the bunch. That means they stand to win big -- or lose big -- if just a handful of those companies fail to meet their obligations.

Such activity in U.S. high-yield credit indexes has swelled to more than $10 billion, according to Bloomberg data compiled from the Depository Trust & Clearing Corp. That amount has steadily increased this year.

The popularity isn’t just in the U.S. -- Europe’s getting in on the game, too. There’s more interest in trading contracts heavily linked to the fate of companies including Norwegian paper manufacturer Norske Skogindustrier ASA and Spanish construction company Grupo Isolux Corsan S.A., according to Bank of America Corp. credit strategists in a July 20 report.

Adding Beta

The appeal of the trade goes both ways, with some investors keen to bet that companies teetering on the brink of default will make it. Investors in Europe have been selling protection against losses, “looking to add beta in their portfolios in a world dominated by” the European Central Bank’s quantitative easing program, Bank of America analysts wrote in the report.

While credit markets aren’t nearly as leveraged as they used to be, and trading in these tranches aren’t as massive as the once were, it’s clear that traders are getting restless about making some real money. The middling (at best) returns of 2.3 percent in U.S. high-yield bonds this year and a 0.6 percent decline in dollar-denominated investment-grade securities aren’t exactly the stuff that gets investors excited.

Credit derivatives sliced and leveraged up? Now we’re talking.