There is a lot of hype globally about credit derivatives, perhaps undeserved. Curiously, the focus is on how banks are shifting their credit exposure around, either selling it to institutional investors or passing it off to other banks, in such a way as to ensure a win-win for both sides.

Oddly enough, not many experts are talking of how these derivatives are also proving advantageous to corporates, reducing the cost of funding through such instruments as total return swaps, structured notes and debt warrants. Total return swaps have already lured several million dollars worth of buying power from new investors to the high-yield loan market. Coming to the nitty-gritty of derivatives, in a total return swap, payments reflecting price appreciation and coupon on a debt instrument are offered as a quid pro quo for payments pegged to a fixed or floating interest rate. Enlarged availability of capital overall has led to improved terms for borrowers generally. One wonders why all this has failed to receive much attention but there it is. The last few years have seen a dramatic change in the scenario and a BB plus borrower who three years ago would have been accommodated at LIBOR plus 110 basis points can now enjoy access at LIBOR plus 60. This sums up the benefits floating from credit derivatives.

In a total return swap, an investor -- often a hedge fund -- receives from the holder of the loans the interest and any price appreciation from the loans -- calculated from prices in the secondary loan market -- and in return pays the floating rate LIBOR, a spread and any price depreciation on the loans. In the process, the investor receives all the economic exposure to the loans without having to go through the cumbersome qualification process that members of a loan syndication cannot generally avoid and, not only that, without having to put up cash -- that is never easy to come by — to buy the loans. But what benefits investors most is that loans -- in terms of the risk-adjusted rate of return -- enjoy a greater relative value than bonds. A loan does not have a greater credit risk than a bond from the same issuer, but pricing of loans generally does not reflect this and total return swaps exploit this factor. Companies are free also to exploit such swaps by using these as an alternative to repurchase of their bonds.

Ideally, corporates with a high-yield bond and a generally improving credit rating -- but still to get reflected in the pricing of the bond -- would find these swaps very useful, especially in the changed circumstances. Some years ago, the only recourse would have been to buy back all or part of the issue, financing the bond with a loan or issue of a new bond, with obvious consequences for the capital structure and less than optional financing cost.

These developments have little relevance in the Indian context. While there is a lot of semantic discussion among members of academia about derivatives, on the ground little is happening. Corporates are taking recourse to debt instruments and BHEL is planning to raise Rs 1,000 crore through short and long-term issues so as to be able to provide supplier's credit. But, how much of swapping is done? If corporates abroad can do a lot of return swaps without any of the parties burning their fingers, there would be no harm in using credit derivatives here and in a big way. But who is going to test the waters and without attracting adverse attention from regulators? When repos are still suspect, this is no joking matter. Maybe, it is not enough for corporates and their financial advisors to learn the new rope trick but the regulators should stop smelling a rat in any act of ingenuity.

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.