By Caroline Salas May 31 (Bloomberg) -- When Mark Kiesel, who manages $50 billion at Pacific Investment Management Co., decided this month that corporate bonds were about to slump, he bought credit default swaps.

Louise Herrle, treasurer of mortgage lender Residential Capital Corp., measures investor demand for debt by looking at credit default swap prices before she decides to sell a bond.

Gery Sampere, who helps oversee $2.5 billion at hedge fund BlueMountain Capital Management, trades credit default swaps almost exclusively because his bets are easier to complete.

Such derivatives, contracts that insure investors against defaults, are displacing trading of corporate debt as the surest way to gauge a company's health. The market totals $17 trillion, more than three times the amount of U.S. company bonds.

``The credit default swap market is now the dog as opposed to the tail that wags the dog,'' said John Burger, managing director and head of investment-grade credit trading at Merrill Lynch & Co.'s Plainsboro, New Jersey-based investment management unit. The change to credit derivatives happened in the last 18 months, he said.

Two Weeks Behind

The Dow Jones CDX North American Investment Grade Index, which tracks the derivatives on 125 company bonds, rose almost 15 percent in the first two weeks of May. The next week, corporate bonds posted their worst performance in a year.

``We strongly believe that today, the credit derivatives market is fast becoming a precursor to the cash market,'' Jayesh Bhansali, head of derivatives strategy and trading at TIAA-CREF, said in an interview from his New York office last week. ``This market is a very sensitive barometer.'' TIAA-CREF, the largest U.S. manager of retirement funds for university and college employees, manages $380 billion.

Derivatives related to corporate debt are the fastest- growing part of the $270 trillion market for financial obligations that are based on the performance of assets such as stocks, currencies and commodities, or on the outcome of events including defaults or changes in weather patterns. The credit derivatives market has grown from almost nothing in eight years. It more than doubled in 2005.

In a credit default swap, buyers pay a premium to protect an amount of debt for a specified time against a company's failure to pay. If a borrower defaults, those holding the swap hand over the bond in exchange for full payment of the face amount of the debt.

Greenspan Endorsement

``Credit default swaps are becoming the most important instrument I've seen in decades,'' Former Federal Reserve Chairman Alan Greenspan said May 18 at a Bond Market Association conference in New York. ``For decades we used to have monetary crises because banks'' would periodically ``freeze up.'' Credit default swaps ``lay off all of these loans.''

The Dow Jones investment grade index, which shows the average cost of insuring debt sold by borrowers including AT&T Inc. and Wal-Mart Stores Inc., rose almost 5 points to 39 between May 2 and May 12, Bloomberg data show. A level of 39 means it costs an investor $39,000 to insure $10 million of debt for five years.

The extra yield investors demand to own investment-grade corporate bonds rather than Treasuries, or spread, didn't widen until the week ending May 19. Then it rose 3 basis points to an average of 90 basis points, according to Merrill indexes that measure corporate bond performance.

No Stress Test

The CDX index reached 43.58 last week, the highest since Feb. 22, and has traded between 63.19 in June last year and 34 this month. Spreads on company bonds closed last week at 91 basis points, down from about 105 basis points a year ago. A basis point is 0.01 percentage point.

Though the credit default market has surged, the derivatives haven't been measured in a period of increasing corporate bankruptcies.

``Given that credit derivatives allow for a leveraging of credit risk, a down cycle in credit will surely result in large investor losses,'' Merrill's Burger said.

When Delphi Corp. filed for bankruptcy on Oct. 8, there were $20 billion of credit default swaps related to its $2 billion of bonds. The imbalance drove up prices of the bonds and forced banks to hold an auction to determine a price to settle the derivatives. It took Moody's Investors Service four months to figure out the impact of the Delphi default on the market for credit default swaps and securities that contain the derivatives.

ResCap's Indicator

Securities firms were unprepared to handle the growth of credit default swaps. The Federal Reserve Bank of New York demanded last September that 14 firms, including Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., improve their handling of credit derivatives after discovering 150,000 unconfirmed or unsigned transactions.

Delays in documenting trades meant buyers and sellers may have been unaware of who owed money to whom in the event of a default. The 10 biggest firms reduced the time that trades go unsigned and pledged to create an electronic marketplace for swaps transactions. The firms also cut down on the delays at a point when the amount of swaps traded was growing.

``We pay very close attention'' to the credit default swap market ``because it can reflect investor views on the direction of credit spreads as well as specifically our own name,'' Minneapolis-based Residential Capital's Herrle said in an interview last week.

Pimco's Team

ResCap, as the company is known, is part of automaker General Motors Corp. The company produces a daily report of how credit default swaps, or CDS, on their bonds performed, which Herrle said can show her when it is a good time to borrow.

``When we announced we were coming to market to sell bonds, a credit default swap market developed in the ResCap name before the bonds were sold,'' Herrle said.

Credit default swaps showed investors were growing more bullish on the ability of companies to pay debt at the end of November as the CDX index fell to 46 on Dec. 30 from 51 on Nov. 17. Corporate bonds spreads, by contrast, widened almost 4 basis points to 99 basis points during the same period before narrowing 9 basis points in January.

Pimco has a team devoted to analyzing corporate bond and credit default swap spreads for such ``dislocations,'' Kiesel, an executive vice president, said in an interview from his Newport Beach, California, office last week.

Hedge Fund Favorite

``I went out and bought protection on the market using the CDS indices'' at the start of May, Kiesel said. ``I don't think the market has priced in the fact that the default rate is clearly going to be picking up over the next two years. We're basically priced to perfection.''

Pimco expects the U.S. housing market and economy to cool through 2006, spurring defaults in coming years, he said. High- yield bond defaults fell to 1.08 percent in April, the lowest in 20 years, according to Standard & Poor's.

Investors are increasing their use of credit derivatives to protect against the prospect of defaults in Latin America. The cost of default insurance on Latin American bonds started rising in March, two months before yield spreads on bonds in the region started widening, according to data compiled by Bloomberg.

Credit derivatives are gaining popularity among hedge funds in part because they are cheaper and faster to use than company bonds.

BlueMountain, a hedge fund started in 2003 that focuses on credit markets, has the bulk of its $2.5 billion in derivatives, said Sampere, the portfolio manager.

Easier to Sell

``You tend to have a dislocation when you have some kind of credit event and then CDS tends to react more'' quickly than bonds, Sampere said in an interview last week from his New York office. The opportunity ``window is relatively limited,'' he said. ``You have maybe a few minutes to a couple of hours to react.''

BlueMountain will take positions for as short as a few hours to as long as a few years, Sampere said.

Investors who want to bet that bond prices and credit quality will decline can use the CDX index more easily than individual bonds. To bet on a drop in the cash market, investors have to borrow bonds and sell them in the hope they can repurchase the securities at a lower cost later. That trade incurs commissions and financing costs.

With derivatives, they don't have to worry about coming up with the actual bond because dealers and investors can create as many credit default swaps as they want.

Trading in credit derivatives doubled in the last two years to $10 billion a day, according to Nishul Saperia, an associate director in New York at derivatives data company Markit Group Ltd. By contrast, an average $21.6 billion of company bonds changes hands daily at Wall Street's biggest firms, about the same as two years ago, Fed data show.

--With reporting by Hamish Risk in London and John Dooley in New York. Editor: Burgess (dfr)

Story illustration: For the NASD-Bloomberg corporate bond indexes, see {NABI }. For average weekly corporate bond trading among primary dealers, see {PDPLCP1P GP }. To graph the Dow Jones North American Investment Grade Index of credit default swaps, see {DJCDXNI GP }.

To contact the reporter on this story: Caroline Salas in New York at (1) (212) 617-2314 or csalas1@bloomberg.net

To contact the editor responsible for this story: Robert Burgess at (1) (212) 617-2945 or bburgess@bloomberg.net