Changes in Corporate Bonds, Part 1

This column was originally published on RealMoney. It's being republished as a bonus for TheStreet.com readers.

Two changes have taken place in the corporate bond market in recent years. The first change deals with credit default swaps, which I'll discuss in today's column. In Part 2 I'll talk about how corporate bonds are analyzed differently now.

Surviving the Loss of a Major Class of Investor

There used to be a tendency for Wall Street to hold a supply of corporate bonds to sell to the buy side. That changed when credit default swaps were, or CDS, developed. A credit default swap is a transaction where one party buys protection against the default of a corporate credit from another party. The party selling protection receives a constant payment over the life of the transaction so long as the corporate credit does not default.

These swaps were developed in the mid-1990s, but they remained somewhat tangential to investment banks until the negative side of the credit cycle hit in 2000-2002. Many banks did a huge business in CDS, but they traded cash bonds and CDS separately. Typically, the cash bond side of the house was net long corporate bonds, and the CDS side was typically flat credit risk. From late 2001 through 2002, a major change rippled through the "bulge bracket" firms on Wall Street. They got the bright idea to trade cash bonds and CDS together as a group. This had several desirable outcomes:

• It enabled them to hold a larger inventory of corporate bonds with less risk.
• It enabled them to be flat the corporate bond market in a period of severe stress. (However, it must be noted that most of those that instituted programs like this had the trough of the corporate bond market.)
• It allowed them to trade more rationally. There were new trades that could be done by comparing the cash bond market and CDS market, going long one and short the other. (Note: Here's how to make money on corporate trading desks: You have more flow in the market than most people you trade with. When clients offer you mispriced trades in your favor, you trade with them and then buy or sell the offsetting positions in the intradealer market at a fair price. With CDS, you have more options for laying off the risk.)

This had the unfortunate effect of removing a seemingly natural buyer from the corporate bond market at a time when the corporate bond market could least afford it. It is my guess that that was part of the reason why the corporate bond market bottomed out in October of 2002, rather than July of 2002. Pressure on the corporate bond market from CDS-related selling did not abate until mid-November of 2002.

As a result, there is only one major buyer of long-term corporate credit risk left in the U.S. economy: life insurance companies. Pension funds play a role in this market, as do foreign institutional buyers. So when corporate bonds do badly or well, life insurance companies are disproportionately affected.