What next for credit?

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Views on the future of the credit markets tend to differ significantly. Credit traders see the past few months as just a brief pause in the inexorable rise of credit as an asset class. Equity derivatives specialists will, perhaps not surprisingly, paint a slightly less optimistic picture.

Nonetheless, a couple of predictions keep cropping up. First, there will be a flight to simplicity. The days of highly leveraged, whizz-bang products seem to be over, at least for the next few years. Second, there will be less reliance on ratings by investors. Indeed, the recent crisis highlighted that a worryingly large number of investors appeared to be basing their investment decisions on credit ratings alone without conducting any fundamental analysis on the underlying portfolios.

So, what does this mean? Some credit dealers suggest there will be more focus on investment-grade synthetic collateralised debt obligations (CDOs) and greater use of short buckets. Managers will be a must-have, with greater tiering between those firms with a good track record and those with little experience of managing synthetic portfolios.

That seems at first glance to tick all the boxes. Spreads on investment-grade credits are significantly wider than at the start of the year, so investors can achieve attractive returns without having to leverage up. Giving experienced managers the option of shorting credit in the current environment also seems to be a smart move.

But does this resolve the underlying issues? Investors that relied too heavily on credit ratings and did not understand the nitty-gritty of correlation, probability of default and recovery values are likely to face the same problems with any CDO. Only the largest investors have the resources to thoroughly analyse the 100 or so credits in a CDO portfolio. Those without sophisticated models and large in-house credit analysis teams will have little choice but to continue to rely on analysis and modelling expertise from arranger banks, and independent analysis of portfolios from rating agencies.

If the idea of a flight to simplicity is to ensure investors understand the risks, and are able to analyse the underlying credits and value the instrument in-house, the only real answer is the credit-linked note market. This is unlikely to happen. Dealers argue that investors don't necessarily need to understand the intricacies of correlation, so long as they understand the key risks - that if a certain number of blue-chip companies in a portfolio default, they will lose money. Provided there's sufficient liquidity in these products, the risks are fairly easy to comprehend, they argue.

This is a fair point, but the move to investment-grade CDOs does not answer all the questions posed by the credit crisis. It's unlikely to be the last time we hear reports of investors being surprised about the performance of their CDO investments.

Nick Sawyer, Editor.

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