Credit derivatives could provide the next threat to market stability, says Rathbone Unit Trust Management.
The warning comes as equity markets rallied on back of a cut in US interest rates by the Federal Reserve.
But Julian Chillingworth, chief investment officer at Rathbone, says investors should not relax as credit derivatives could suffer from downgrades.
He says: “There are still several unknowns out there, making even high quality credit derivatives vulnerable to severe downgrades.
“The problem has rested with the sub-prime market that then spilled over to the credit derivatives market.
"We’ve got an extended problem; the banks have been selling these instruments for some while and the amount they sold has priced up in the first quarter. They’ve been taking these on from the perspective the default was low.
“Now with a slowdown in the economy and the problem in sub-prime in the States, which spilled across credit markets globally, there’s likelihood we’ll see higher levels of defaults.
He says any continuing crisis could force companies to sell assets to cover loans, some of which are still linked to the sub-prime area.
He says: “This, in itself could spark defaults as economies slow, and credit default insurance on loans is called. The premiums that banks take in may no longer cover the insurance, so hedges on loan books would undoubtedly cause more pain.
“It could be pension funds as well could well have bought paper in form of derivatives in form of bonds and they discovered these bonds are not worth the price they paid.
“If you look at Northern Rock, the bonds have declined rapidly over the last few weeks. The problems you face as a bond holder is you buy something as a fixed coupon and you could find the value of the bond has dropped indeed.
“And from a hedge fund’s point of view, they might have done a lot of these on leverage as well, which compounds the problem.”
“Ultimately, this could instigate a pick-up in impairment charges for banks, and possibly more trouble for hedge funds who own unmarketable tranches of securitised paper.”
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