(Reuters) -Credit derivative dealers are considering changes in the way some are traded to require larger upfront payments, as concerns about corporate credit risk rises.
Dealers are in talks about changing contracts that insure the debt of individual companies so that they are more similar to or credit derivative indexes, by requiring larger upfront payments and a set coupon, instead of only making payments on a quarterly basis, analysts said.
This would reduce the risk of protection sellers not receiving payments from the contracts as the risk of companies defaulting on their debt rises, and would make it easier for dealers to manage a myriad of positions they have on corporate debt.
The move may also impact the liquidity of the market, helping high yield trading though potentially scaring away some investment grade protection buyers.
"There are several problems to trading everything on an on-market spread basis," said Brian Yelvington, analyst at credit research company CreditSights.
At present, buyers of protection against a single company defaulting on its debt pay a quarterly coupon for the life of the contract, which is most commonly for five years. This coupon is set by the spread the swap is trading at when the contract is entered into, and is referred to as the on-market spread.
For example, to protect against a default by New York Times Co, one of the widest trading names in the U.S. investment grade index, a buyer would pay an annual rate of 3.95 percent of the sum insured, based 's prices, or 0.98 percent per quarter.
Contracts on individual companies only require upfront payments when their spreads near the 10 percent mark, a level generally considered as distressed.
As the economy weakens and credit spreads widen, however, protection sellers want to be paid more for the default risk at the outset of a greater number of contracts.
"This wasn't a problem when spreads were benign but now that spreads are wider, this indicates a higher degree of risk in the market, meaning those future cash flows are more in doubt," Yelvington said.
"Moving to a standard coupon would make pricing a lot more transparent and should improve the speed of trading," he added.
Also, "when you have to exchange cash, mistakes are found earlier since if the mistakes were material to the calculation, they will impact it and the money delivered will not be correct per one counterparty or the other," Yelvington said.
In spite of these benefits, the challenges over changing the terms of the contracts could be significant.
"I think it is a step forward in simplifying the entry and exit of positions but brings up as many problems as it solves," said Tim Backshall, chief derivatives strategist at Credit Derivatives Research in Walnut Creek, California.
Some dealers have floated the idea that the coupon for investment grade credits be based on the spread of benchmark credit derivative index, with prices then adjusted for a company being weaker or stronger than the index.
However, as a new series of the index is introduced every six months, credit default swaps on a single company could have various coupons, and some may risk being less liquid than others.
Also, spreads on individual companies can be wider, and more volatile than on the indexes.
"The big difference is that the single-names can be considerably more volatile than the indexes and so upfronts can become very large and potentially negate any liquidity improvements," Backshall said.
Large upfront payments may make some protection buyers more hesitant to put on a trade than if they were only required to make quarterly coupon payments.
"High yield investors are more likely to favor coupon payments because the spreads of high yield companies are so wide, though some investment grade investors may be worried about losing liquidity depending on standard coupon assumptions," CreditSights' Yelvington said.