risk premia

Credit derivatives, the fastest-growing business on Wall Street, are squeezing returns for bondholders to an all-time low.

Contracts that protect investors against defaults are being sold in record numbers and then bundled into securities known as collateralized debt obligations. CDOs are driving down the cost to protect against non-payment so much that even the government of Argentina, which reneged on $95 billion of debt five years ago, is paying less than ever to borrow.

CDOs, as with other marvels of financial engineering, allow risk-profiles of investors to be better tailored, but you should always be careful to be aware of exactly how much something you're getting for just how much nothing:

``It's like a free lunch,'' says Gorgeon. ``You're immune to default.''

Oh, you can't possibly say that without expecting it to send our spidey senses tingling.

CDOs make it easy, in particular, for more risk-tolerant types to leverage up in a diversified way that won't completely break them if the world goes against them; it still pays a small premium, in today's market, to the generally risk-averse investors to take the deep tail loss, which they at least think is worth the extra few basis points they can get for it. What this chopping and meting doesn't do is reduce the probability that the underlying credits will default. If a company has a default probability that, in a world without risk preferences, would justify a 200bp spread, financial engineering like this can conceivably help them cut their financing costs from 300bp to 225bp — and, to be clear, that may be all that's happened — but unless you've found someone who just likes risk, it can't justifiably get them below 200bp.
- posted by dWj @ 8:50 PM