Idiosyncratic risk poses greatest threat to credit derivatives market

Idiosyncratic risk poses a greater threat than a systematic widening in the credit markets during the next six months, according to John Tierney, head of credit derivatives research at Deutsche Bank.

Tierney said the wider picture for credit markets remains “benign” because of strong underlying credit fundamentals and a steady US economic outlook for 2006.

But Tierney told delegates attending a GFI-hosted event last week in New York that credit short funds are focusing on single named companies and the activity at the single-name level means greater exposure to risk associated with a company-specific event. The trend coincides with a rise in company debt.

Because of this, Deutsche Bank projects total volume in the credit derivatives market will grow to about $13 trillion by the end of 2006, or about a 20% year-on-year increase compared with this year's growth of about 50%.

The explosive growth of the derivatives market has had a significant impact on the overall credit market, noted Tierney. “Previously credit spreads widened over a period of months or quarters when the credit cycle turned,” he said. “In the future when the credit cycle turns, the spread widening process could be much more rapid, due to the growth of credit derivatives and hedge fund involvement in the credit markets.”