NEW YORK: Wall Street is marketing derivatives last seen before credit markets froze in 2007, as the record bond rally prompts investors to take more risks to boost returns.

Bank of America Corp. and Morgan Stanley are encouraging clients to buy swaps that pay higher yields for speculating on the extent of losses in corporate defaults. Trading in credit- default swap indexes rose in the fourth quarter for the first time since 2008, according to Depository Trust & Clearing Corp. data. Federal Reserve data show leverage, or borrowed money, is rising in capital markets.

Investors who retreated to the safety of government debt during the financial crisis are returning to the simplest forms of so-called synthetic collateralized debt obligations after last year's record 57.5% rally in junk bonds left money managers with fewer options. While President Barack Obama's adviser Paul Volcker has blamed credit swaps and CDOs for taking the financial system "to the brink of disaster," bankers say the instruments help companies raise capital.

"In a flight to quality you see investors fly away from anything exotic," said Moorad Choudhry, author of "Structured Credit Products: Credit Derivatives and Synthetic Securitisation" and head of treasury in London at Europe Arab Bank Plc. "It's now very slowly reversing, and if the recovery continues we will see it come back."

Betting on Indexes

Bets using credit-default swap indexes that speculate on bonds without buying them have jumped 13% in the past three months to $1.2 trillion, DTCC data show. The amount includes index tranches, which may offer higher returns than indexes, according to Morgan Stanley and BlueMountain Capital Management LLC.

Derivatives, contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather, may boost yields for managers as if they were borrowing to purchase debt securities.

Bank of America strategists led by Suraj Tanna in London recommended that investors "rethink" so-called first-to- default baskets that pay investors for the risk that any one of four to 10 companies default. The trades "can provide an attractive premium relative to the total default risk the investor is taking," the analysts said last month.

Morgan Stanley strategists suggested clients sell protection on a so-called mezzanine tranche of the Markit CDX North America Investment Grade Series 9 Index that would pay 3.8%age points annually for about five years. That's more than triple the payments for a trade on the index, which is linked to 125 companies and used to speculate on corporate creditworthiness or to hedge against losses.

'More Leverage'

In the mezzanine trade, holders start losing money after 7% of the investment's value has been eliminated and lose everything after 10%.

As yields over benchmarks tighten, "investors are using more leverage to achieve return expectations," said Bryce Markus, a money manager at New York-based BlueMountain, whose founders helped pioneer credit swaps. "These are very thin slices and a very junior part of the capital structure. If there is a misstep, the whole tranche could be wiped out."

Speculative-grade bond yields have narrowed 15.4%age points relative to benchmarks since Dec. 15, 2008, when spreads were at a record 21.8%age points, according to the Bank of America Merrill Lynch U.S. High Yield Master II Index. The index has gained 1.45% this year, after the record rally in 2009.

Debt rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's is considered high yield, or below investment grade.

'Easier to Understand'

CreditSights Inc., a New York debt research firm, predicts investors will initially return to first-to-default baskets and other "simpler structures" including credit-linked notes, or floating-rate securities created by selling a credit-default swap on an individual company.

Such trades are "significantly easier to understand compared to more complex, portfolio-based structures like bespoke tranches," CreditSights strategist Atish Kakodkar wrote in a Dec. 9 note to clients.

One obstacle to the return of riskier derivatives is the dearth of experts after financial institutions fired more than 340,000 employees, including mathematicians who created these instruments.

"These are very complex and exotic products," said Sasha Rozenberg, global head of credit products at SuperDerivatives Inc. in New York. "It's going to take time to build up teams," said Rozenberg, who joined the pricing provider in 2007 from Morgan Stanley, where he worked in the credit derivatives structuring group.

Lehman, Washington Mutual

UBS AG hired more than 200 people for its debt unit last year, including traders specializing in credit structures, to rebuild the fixed-income business after $57.5 billion in writedowns and losses at the Zurich-based bank, Switzerland's largest. UBS spokesman Doug Morris in New York declined to comment.

While banks are recommending these trades, investors aren't seeking out the riskiest derivatives that led to losses of as much as 90% after Lehman Brothers Holdings Inc. failed, said Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York.

The investments included customized synthetic CDOs that during 2006 and 2007 loaded their holdings with credit swaps linked to the debt of financial companies such as Lehman, Washington Mutual Inc. and bond insurers MBIA Inc. and Ambac Financial Group Inc.

$62 Trillion

Insurance companies, hedge funds and money managers seeking investments with the highest ratings and bigger returns than corporate bonds pushed the amount of credit protection sold through such synthetic CDOs in that period to about $1 trillion, according to a Morgan Stanley estimate in February 2008. Credit- default swaps rose to more than $62 trillion at the end of 2007, a 100-fold increase in seven years, surveys by the New York- based International Swaps and Derivatives Association show.

As Wall Street recommends more complex trades, investors are also augmenting bets with borrowed money. Some banks are offering as much as 10-to-1 leverage on securities backed by prime-jumbo home loans, said Scott Eichel, global co-head of asset- and mortgage-backed securities at RBS Securities Inc. in Stamford, Connecticut, a Royal Bank of Scotland Group Plc unit.

Fed data show that as of Jan. 6, the 18 primary dealers required to bid at Treasury auctions held $32.7 billion of securities aside from government, agency and agency mortgage bonds as collateral for financings lasting more than one day. On May 6, the amount was $15.8 billion and in 2007 the figure reached as high as $113.9 billion.

Obama Proposal

"There is added liquidity and greater price transparency than 12 months ago," said Ashish Shah, a credit strategist at Barclays Capital in New York. "Leverage is coming back into the system, and that's a good thing."

Former Fed Chairman Volcker said last month there's no clear link between financial innovations to limit risk, such as credit-default swaps, and increased economic productivity. Obama called for limiting the size and trading activities of banks to reduce risk-taking and avert another financial crisis.

"We intend to close loopholes that allowed big financial firms to trade risky financial products like credit-default swaps and other derivatives without oversight," Obama said Jan. 21 in Washington.

Legislation is being debated in Congress designed to prevent the type of derivatives bets that pushed American International Group Inc. to the brink of bankruptcy in September 2008, threatening the global financial system. The proposed rules would require dealers and major market participants to process trades through a clearinghouse designed to contain losses if a firm fails. More capital would also need to be set aside for derivatives that aren't cleared.

New rules may prevent a return to the riskiest bets in structured credit, said Kakodkar at CreditSights.

"Regulatory changes are likely to increase capital charges for bespoke or customized tranche trades," he wrote in a report last month. That will force investors to focus on less risky versions of the swaps, he said.