TOP VIEW Some wealth advisors now recommend that their clients consider investing in structured notes linked to a basket of underlying credit default swaps. These products, more popular in Europe than in the U.S., offer risk-averse investors exposure to the credit markets and insurance against loss. Although some question whether these products—typically associated with the bond market—will appeal to American investors accustomed to the higher risks and returns of equities, those interested in credit exposure may ultimately find them hard to avoid.

For obvious reasons, these products are highly successful. According to the Bank for International Settlements, banker to the world’s central banks, volumes as measured by notional amounts outstanding on CDSs have increased from almost $6.5 trillion at the end of 2004 to more than $20 trillion by the middle of last year (see chart). Ten years ago, this market barely existed. Meanwhile, CDS indices have quickly usurped traditional bond indices to become the primary barometer by which the health of the credit market is measured.

Opportunities to trade credit derivatives have traditionally been limited to professional traders—until now. In 2006, the Chicago Mercantile Exchange filed an application with the Commodity Futures Trading Commission to list credit futures. Although no details have been forthcoming, observers excitedly speculate that this will ultimately lead to credit derivatives trading for a much wider pool, with brokers offering their retail clients opportunities to invest.

Until then, however, credit derivatives exposures are surfacing in the retail market in other forms. For example, some wealth advisors now recommend that their clients consider investing in structured notes linked to a basket of underlying credit default swaps. "You won’t see this type of thing as part of the Merrill Lynch ad during a football game," says Mark Adelson, a credit derivatives analyst with Nomura Securities in New York, "but the people who have big accounts with these firms will get a phone call saying, ‘There’s this area that you might want to look into; we can give you some basics on it and show you some deals.’"

Banks currently use structured notes—basically investment contracts—to offer investors exposure to many different CDS variables (see "Assembly Required," December 2005). These notes often come with a guarantee on an investor’s initial capital and, more often than not, will use derivatives to replicate the exposure, rather than forcing the individual to invest directly in the underlying market. In the vernacular of the financial industry, this is known as taking synthetic exposure.

Source: Bank for International Settlements

With structured notes, there are now many different types of derivatives—equities, commodities and interest rates, among others—from which investors can choose. A bank will wrap that investment up as a note and sell it to investors. An individual might decide, for example, to take exposure to a certain financial index. He could then choose how much capital to protect, how much leverage to include with the product and, finally, the terms of maturity.

This level of flexibility, says Nicole Montoya, a credit fund manager with AXA Investment Managers in Paris, appeals greatly to increasing numbers of investors. "It is no surprise that we are seeing a lot of demand from retail investors for the credit market," she says, adding that the lower volatility of the credit market will always entice safety-conscious investors.