Many investors already use CDS to take tactical positions in high yield, but Swiss private bank UBP says the market has evolved to such a degree that a structural allocation to CDS indices might be warranted.
Investors are increasingly making use of credit default swaps (CDS) on high-yield bonds to express their views on credit markets. But often these positions are only used tactically to gain exposure to a perceived dislocation in the market or to protect against the risk of a negative credit event.
But high-yield CDS indices deserve a structural allocation in fixed income portfolios as they tend to provide better liquidity over cash bonds and even exchange-traded funds (ETF), Mohammed Kazmi, Chief Strategist, Fixed Income and Senior Portfolio Manager at Swiss private bank Union Bancaire Privée (UBP), says.
“What we’ve really seen in times of crisis or times of risk off is that CDS in general significantly outperform not only the benchmark, but ETFs as well,” Kazmi says.
“One of the reasons is liquidity, that’s really the key element. During these crisis moments, liquidity dries up in the market. Within ETFs, within cash bonds, it becomes a one-way market, whilst the CDS remains two-way and orderly.
“And the second [reason] is because it’s at those crisis moments when companies decide to extend their bonds and not call them.”
During these crisis moments, liquidity dries up in the market. Within ETFs, within cash bonds, it becomes a one-way market, whilst the CDS remains two-way and orderly
Many fund managers have realised the benefits of CDS indices as the derivatives industry has continued to evolve over the past decade. Yet, Kazmi says there are still relatively few investors who have structural allocations.
“For a client who’s already quite heavily focused on fixed income, what they will see is that actually a lot of their managers are already using CDS indices, just to tactically add risk or reduce risk,” he says.
“But we say that investors should be structurally invested in CDS indices, over the cash bond market, over ETFs. An ETF or a cash bond fund is often the natural place for investors to look at, but it should be looked at the other way around: one should be invested where the liquidity is.”
ETFs tend to work well in equity markets, but in fixed income markets they tend to run into trouble, he says.
“ETFs in fixed income do not as easily replicate the benchmarks and underlying [assets] as it would be in the equity space, because with bonds you have new supply that’s coming to the market,” he says.
“You have extension risks because high-yield bonds have call options in them. But actually, within CDS, you don’t have that extension risk. You have a known maturity and, therefore, you know exactly what you’re working with.
“What it means is that over time the ETF can be a weaker replication of the cash bond benchmark than you might have thought initially.”
He argues that an ETF works well for a sovereign bond benchmark, but not so well when moving up the risk curve.
“It gets a lot more complicated and it becomes less of a useful proxy,” he says.
Evolution of CDS
Today, the CDS market is worth around US$3.8 trillion, according to recent figures from the International Swaps and Derivatives Association. Not quite the same as during its heyday in 2008 when the market reached US$33 trillion, but the industry has become a lot more robust since then.
CDS played a key role in the turmoil during the global financial crisis of 2008 as investment banks had issued many of these derivatives over a broad range of assets.
Cracks started to appear when CDS issued on mortgage-backed securities (MBS) by investment banks, including Bear Stearns and Lehman Brothers, led to hefty payouts to investors as large-scale defaults on mortgage payments rendered many of these MBS worthless, triggering a global crisis.
Yet today, CDS are used more selectively for a narrower range of assets. CDS indices also cover a broad spectrum of the high-yield bond market, while in the past CDS were often applied to single names.
In addition, CDS indices are cleared these days, while previously transactions were largely over the counter. Clearing takes away counterparty risk and, therefore, any uncertainty about settlement, Kazmi says.
“It used to be bilateral trading with your counterparty. But since about 10 to 12 years ago, everything goes through the clearing house. So there’s no counterparty risk in trading the CDS indices, which is crucial for clients and which is why it has really allowed this part of the market to grow,” he says.
The COVID-19 pandemic provided a serious test case for CDS indices, but once again they proved to not only remain liquid, but also become more so.
What does liquidity really mean? It's being able to trade in and out at a reasonable price.
“What does liquidity really mean? It’s being able to trade in and out at a reasonable price. And what we’ve learned from CDS indices is that throughout the cycle, no matter what the environment is, it’s always been an orderly market where you’re able to trade in and out very efficiently,” Kazmi says.
“If we talk about the pandemic, the average daily trading volumes in CDS indices are just under US$10 billion a day, but during the height of the pandemic we’re talking about US$30 billion a day in the US.
“The key point is that because investors are unable to add risk or de-risk their cash bond portfolios efficiently [during a downturn], everyone moves to CDS indices. What it means is that you have a continued orderly market and the rest of the market has become disorderly.”
Kazmi is slowly seeing change among his own clients as CDS indices become more accepted.
“We’ve had clients who are invested in such a strategy today who five years ago basically said: ‘No, this is not something we would look at.’ So you’ve seen that clear development and evolution over time,” he says.
“They probably realise that some of their other fund managers are using it tactically here and there already. So why not allocate to it more structurally?”
This article is sponsored by Union Bancaire Privée (UBP). As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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