Corporate Bond Risk Soars to Record on CDO Loss Speculation

The cost of protecting corporate bonds from default soared to a record as investors purchased credit-default swaps to hedge against mounting losses in the $2 trillion market for collateralized debt obligations.

The market is full of rumors of unwinding of CDOs, and the price action suggests that people believe the rumors, said Peter Duenas-Brckovitch, head of European credit trading at Lehman Brothers Holdings Inc. in London. It sort of has that Armageddon feel, and the market is feeding on itself.

Securities known as constant proportion debt obligations that package indexes of credit-default swaps may be forced to unwind about $44 billion of assets because of a decline in the value of their holdings, UniCredit SpA analyst Tim Brunne in Munich said today. The value of the so-called CPDOs has fallen to as low as 40 percent of face value, according to Morgan Stanley.

Credit-default swaps on the Markit CDX North America Investment-Grade Index of 125 companies with investment-grade ratings jumped 13 basis points to 167.25 at 8:31 a.m. in New York, according to Deutsche Bank AG.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.

The CDX index of credit-default swaps doubled this year as bank losses and writedowns on debt investments soared above $145 billion worldwide. The equivalent iTraxx index in Europe rose 16.5 basis points today to a record 134.5, according to JPMorgan Chase & Co., the biggest one-day move since the index started in 2004. The index was at 51 basis points on Jan. 2.

Bank Losses

CDOs package assets and use the income to pay investors. Securities made up of credit-default swaps are known as synthetic CDOs. The notes are losing money as the cost of credit-default swaps rises. CPDOs are based on the CDX and ITraxx indexes.

Moody's Investors Service downgraded 1.1 billion euros ($1.62 billion) of CPDOs arranged by ABN Amro Holding NV, Lehman Brothers Holdings Inc. and BNP Paribas SA last week as asset values fell. CPDOs arranged in 2006 by banks including Amsterdam-based ABN Amro may be forced to unwind if the iTraxx Europe index rises another 5.5 basis points to 140, according to UniCredit's Brunne.

Different CPDOs have different trigger levels, but once one is triggered the negative technical pressure that is created may well cause other triggers to be hit, Willem Sels, a credit analyst at Dresdner Kleinwort in London, said in note to investors today.

CPDO Unwinds

Banks would seek to unwind CPDOs by buying credit-default swap indexes to offset their bets.

What seems to be clear in both Europe and the U.S. is that the continued unwind of leverage and structured products has continued to lead to underperformance in investment grade, Nick Burns, a London-based credit strategist at Deutsche Bank, wrote in a note today.

Contracts on U.K. mortgage lender Alliance & Leicester Plc jumped 40 basis points to 245 after the bank slashed its profit target for this year and next, citing rising borrowing costs and declining valuations on asset-backed securities because of the U.S. subprime mortgage slump.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Contracts on Standard Chartered Plc rose 3 basis points to 112 after the London-based bank abandoned a plan to refinance its $7.15 billion Whistlejacket Capital Ltd. structured investment vehicle, the largest SIV run by a bank to collapse.

KKR Financial

KKR Financial Holdings LLC, the $18 billion publicly traded credit fund run by Kohlberg Kravis Roberts & Co., delayed repaying some of its asset-backed commercial paper and started restructuring talks with its creditors, according to a regulatory filing yesterday.

Contracts on the Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings jumped 26 basis points to 611, according to JPMorgan prices. Contracts on the benchmark Markit iTraxx Asia Ex-Japan index rose by 24 basis points to 295, according to ICAP Plc.

The risk of defaults on European LBO loans is the highest recorded by the benchmark Markit iTraxx LevX Senior Index of loan credit-default swaps. The index fell to 90, according to Bank of America Corp. prices, the lowest since it started in October 2006. A level below 100 indicates loans are valued below par.