Concerns about illiquidity in corporate debt trading are leading some money managers to look to credit derivatives as a way of swiftly moving in and out of their positions when the next downturn hits.
Mutual funds that specialize in hard-to-trade corporate debt say indexes tracking the performance of credit default swaps serve as a useful tool to deal with redemption requests during times when trading in corporate bonds is at a standstill. This comes as global financial regulators led by the Bank of England have flagged how funds holding illiquid assets could struggle to sell their holdings and potentially fan market panic during a selloff.
“What we have been doing in the last number of years is utilizing credit derivatives to gain credit exposure, in addition to the cash bonds we already own,” Michael Temple, head of corporate credit research at Amundi Pioneer, told MarketWatch. “The index derivative market is so much more liquid than cash bonds these days.”
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Trading in credit default swap indexes by notional value have increased since 2016, according to ISDA, the trade organization for derivatives. The overall value of trading in the high-yield investment-grade credit default swap indexes rose by around 3% to 4% in the second-quarter of 2019 from the comparable period last year.
It’s unclear, however, how much of this activity is driven by market participants looking to manage liquidity in their portfolios.
Insurance or speculation?
Investors have traditionally used credit default swaps as a way to hedge against blowups in corporate bonds. Such derivatives can work as an insurance policy, increasing in value as the probability of a company defaulting on its obligations rise.
But holders of credit default swap indexes, however, benefit when the underlying corporate bonds gain in value as a result of their increased creditworthiness. Some investors see credit derivatives as an easier and cheaper way to bet on the performance of corporate debt, compared with owning the underlying bonds outright.
Because credit default swap, or CDS, indexes act as a more liquid proxy for hard-to-trade corporate bonds, money managers like Amundi Pioneer say such products can help satisfy a rash of redemption requests that can trouble bond funds who might otherwise struggle to sell their illiquid holdings and free up funds in sufficient time.
This is how it works. A fund manager would keep the majority of his portfolio in corporate paper, and a small sliver in CDS indexes. When markets freeze up and redemption orders stream in, the money manager sells the CDS index instead of the corporate bond and hands the proceeds back to the end-investor.
“What this allows you to do is if you have withdrawals at time of market pressure, you can essentially have this pool of cash available to satisfy withdrawals,” said Temple.
The advantage is that liquidity for credit default swaps peaks during moments of distress for financial markets as investors want to buy protection. As a result, they’ve tended to outperform their comparable peers in the corporate debt market, according to Adrian Helfert, head of multiasset strategies at Westwood Holdings.
During the financial crisis, Pimco bought indexes of credit default swaps from other money managers who were hungry for protection against the rising tide of corporate defaults. They later reaped significant gains from these CDS indexes once the U.S. economy and banking system stabilized.
The strategy benefited from the negative basis, the difference between credit default swaps and the underlying bond. Usually, traders arbitrage away the difference between the two assets, so a negative basis serves as an indication that investors are placing a premium on the liquidity of a credit default index versus plain vanilla corporate bonds.
Cost of liquidity
The cost of trying to buy or sell an individual bond can be hefty compared with a CDS index.
Investors might have to give up between 0.5% to 0.8% of the overall security’s value to get rid of a bond sold by a sub investment-grade issuer, based on estimates of the bid-ask spread according to Pimco. The bid-ask spread represents the difference in price between the average bid offered and the bid accepted.
On the other hand, the bid-ask spread for a high-yield credit default swap index could range between 0.15% and 0.2% of the derivative’s value, according Nick Maroutsos, co-head of global bonds at Janus Henderson.
In times of trouble, trading costs for corporate debt can skyrocket. The bid-ask spread for high-yield bonds doubled as a plunge in oil prices rocked the energy sector in 2016, and quintupled from current levels during the 2008 financial crisis, according to Pimco’s estimates in August 2018.
Max Gokhman, head of asset-allocation at Pacific Life Fund Advisors said another advantage of indexes bundling CDS is that investors don’t need to give up valuable space in their portfolio that could otherwise generate income. To buy a credit derivative, investors only need to set aside a small fee and use their existing cash or bonds as collateral.
This was a more attractive arrangement than setting aside a large cash allocation in anticipation of redemption requests. Cautious money managers who preferred to keep a lot of reserves on hand would underperform against their corporate bond benchmarks and those who were fully invested.
“In the event of a recession, owning CDX still lets you have benchmark exposure and meet redemptions without having to unwind positions,” said Gokhman, referring to the acronym for the credit default swap index.
Liquidity fears
The lack of trading in the corporate bond market has been particularly eyed by financial regulators amid increased questions of how investors will be able to buy and sell debt the next time the market seizes up.
Market participants have blamed regulatory changes resulting from the Dodd-Frank Act for pushing banks to pare back their market-making activities in more illiquid securities.
“Its all right in the market now. But when the market seizes up, credit spreads get wider and no one wants to move into or out of their positions,” said Temple.
Open-end mutual funds have attracted the spotlight due to fears their promise of allowing investors to redeem their shares at will sometimes conflict with their hard-to-trade holdings.
Alex Brazier, executive director for financial stability at the Bank of England, in a Sept. 2 speech highlighted the growing investments in illiquid assets by open-ended funds.
He said such investment vehicles may take too long to sell their holdings and deal with outflows, forcing them to put their bonds offer at fire-sale prices to free up cash. This could create a vicious loop of selling as this initial wave of discounting could drive further redemptions, leading investors to rush for the exit door at the same time.
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