LBO Crystal Ball

There's more evidence that the fast-growing credit derivatives market can be a shareholder's best friend in predicting leveraged buyouts.

A new study by Credit Derivatives Research points to increased trading activity in the market for so-called credit default swaps on buyout targets. The New York-based firm looked at the swaps trading in advance of 30 takeover announcements.

A credit default swap is a contract under which a Wall Street bank or other so-called counterparty agrees to pay a bondholder in the event of a default.

Rising prices in the swap market imply investors see a greater likelihood that a company won't be able to pay back its lenders. By adding debt to a company's balance sheet, a leveraged buyout tends to raise the risk of default. So issuers of credit default insurance demand higher premiums, or swap prices.

The analysis found that in days and weeks leading up to the announcement of an LBO, the price of swaps written against possible default on target-company bonds often rose. The finding is notable because common sense dictates that the swap prices in an LBO should rise -- but only after public announcement of the deal.

Still, the study stops short of suggesting that insider trading is behind the moves. Some observers point instead to a herd mentality at Wall Street firms.