The credit derivatives market has experienced a period of exponential growth over the last few years. Since their appearance in Europe around 10 years ago, credit default swaps have won wide acceptance from many quarters – banks, asset managers, insurance companies, hedge funds and pension funds. The attraction lies in their liquidity, flexibility, and diversity, qualities in which they outstrip the physical corporate bond market. Nevertheless, CDS are derivatives, and derivatives still make many investors nervous – and with some justification.
The British Bankers’ Association in a survey in September this year estimated the total volume of global credit derivatives at $20,000bn (€15,639bn). This is more than double the $8000bn that was predicted for 2006 in the BBA’s previous survey in 2004. The BBA estimates that by 2008 the market will have expanded a further 50 per cent to $33,000bn.
Credit default swaps are sometimes compared to an insurance policy to protect against the risk that a bond’s issuer will suffer a downgrading of its credit status. A CDS allows two types of risk associated with bonds – credit risk and interest rate risk to be separated from each other, so CDS investors can take a view purely on the credit risk of the bond issuer. The contract is agreed between two parties – the protection seller, who takes on the risk, and the protection buyer who offloads the risk. Under the contract, normally for a period of five years, the protection seller collects a regular premium from the protection buyer, and if a certain credit event takes place – for example, the issuer goes bankrupt, or restructures a bond or loan – the protection seller pays over a pre-agreed amount to the counterparty.
For investors credit derivatives have filled a gap in the supply of corporate bonds. Creating a portfolio of bonds is time consuming and expensive – investor demand exceeds supply, and maturities are limited. With CDS investors can get a product that exactly fits what they want in terms of size, maturity, currency, and rating. And by using a derivative they avoid having to trade the physical assets.
“By using credit derivatives you have the flexibility to create exactly what you want,” says Marcus Schueler, managing director, integrated credit marketing at Deutsche Bank. “For instance, you can create a portfolio of 250 names that all mature on the same date, which you would never be able to do in the corporate bond market.”
Another attraction is that they can be shorted, so can be used to establish a view on a company. However while possible, shorting a bond is a complex and costly exercise.
“If you want to go short in the credit derivatives market I show you an offer in protection, you trade and you know what the cost is, fixed for the next five years,” says Mr Schueler. “Secondly you can trade big sizes. With bonds you are restricted by availability. In the credit default swap market you can trade whatever size you want to trade because there is no actual exchange of assets, it’s just a transfer of risk.”
The development of the CDS swap indices, the iTraxx (covering the UK and European market) and the CDX, (covering the US) has occurred alongside the rising interest in liability driven strategies among pension funds. Both indices have a similar format: each consists of 125 of the most actively traded CDS single names in the market, and they are updated every six months. The terms of the indices are five or 10 years, reflecting the most common CDS tenors. (The term of the swap is the duration of the swap contract, which bears no relation to the duration of the underlying bond.)
“The liquidity of these indices has expanded hugely,” says Dominic Delaforce, co-head of LDI at Aberdeen Asset Management. “There are no official figures for trading, it’s all over the counter instruments, but the liquidity is far greater than the sterling corporate bond markets.”
Another prime area for CDS activity is collateralised debt obligations, where the existence of derivatives has increased flexibility. But the increased use of CDS rather than physical bonds is a concern in some quarters, because of the lack of transparency.
“The CDO market is huge and has grown tremendously in last few years,” says Han Altink, credit portfolio manager at F&C Asset Management in Amsterdam. “Ninety per cent use CDS rather than actual bonds. It is difficult to have an insight into what is happening in that market and how much leverage has gone with that. For us it’s a black box.”
All but the largest pension funds will mandate their fixed income exposures to external managers, but some of the largest do manage their own portfolios. The Dutch pension fund for civil servants, ABP, uses CDS in its fixed income portfolio, both for hedging and return purposes; on the other hand Cordares, the Dutch pension company which manages the industrywide fund for the construction industry, does not yet use credit default swaps in its fixed income strategy but is considering them for possible use next year.
Mn Services, which runs the portfolio for the Dutch metalworkers’ pension fund and 12 other pension funds, has been using CDS for around 18 months, and these instruments now form a regular part of the fixed income portfolio. CDS are used as a portfolio management tool, so act both as a hedging tool and as a means to increase fixed income returns.
Head of fixed income, Hans Copini, welcomes the development of the CDS market, especially its increasing liquidity. “The liquidity of the instruments is increasing rapidly, which we think is good for the market as a whole. We see more and more investors using them, the investor base is broadening, which is good as well.”
VERSATILITY AND SHORT NATURE ATTRACTS HEDGE FUNDS
Hedge funds have become important players in the credit derivatives market, both as buyers and sellers of protection. The BBA estimates their share of the volume of credit derivatives has doubled since 2004. A particular attraction for them is the ability to go short, which is not easy to do with physical bonds. But shorting is not the only attraction: they can be used in different hedge fund strategies, for example to play relative value.
“Hedge funds buy bonds which are cheap and they buy protection against it, they trade the indices against single names,” says Marcus Schueler at Deutsche Bank. “They can take a view on credit versus equity – if you want to go short credit it makes sense to buy protection so you can go long the shares. You can play the curve, so they have a view on the five year versus the 10-year spread. It’s easy to do in credit derivatives.”
One issue which has been a blow to the market over the last few months, and which has particularly affected hedge funds, is succession. This occurs in the case of merger and acquisition or leveraged buyouts where one company takes over another, or there is a restructure. The increase in merger and acquisition activity over the last few months has brought this issue centre stage. The acquiring company buys back most of the debt from the target company, and fails to guarantee the remaining debt, or there may be no debt outstanding, which means there is no longer a relationship between the debt and the CDS.
“You need outstanding bonds for there to be a pricing mechanism for the credit default swaps,” says Roger Sadewsky, investment director at Standard Life Investments. “You buy protection, and you expect the contract to make money for you but if there are no bonds to deliver to the contract the performance of the CDS goes. An LBO or restructure of the company’s debt can leave the fate of the CDS in confusion. Within the market some participants, particularly hedge funds, have had problems dealing with succession issues.”
But Mr Schueler at Deutsche Bank thinks this kind of risk has been exaggerated: “It’s not a specific credit derivative risk – it’s a risk which every debt holder will have in the case of an LBO,” he said.
CONVINCING PENSION FUNDS OF CDS MERITS
Pension funds can use credit default swaps to manage their liabilities in conjunction with the use of interest rate and inflation swaps.
“If they were to discount their liabilities at swap rates that would produce a relatively high valuation of the liabilities and they would be in deficit,” says Dominic Delaforce at Aberdeen Asset Management. “They are looking for ways of enhancing the yield of their portfolio which better matches the yield they need for their discount rate. You do all your interest rate and inflation swaps, and in addition you would go and buy exposure to one or both of the CDS indices.”
Splitting exposure between the two indices provides diversification, so exposure to individual names is very low. There are nevertheless risks in CDS investment. The default of one name means the investor takes a hit. But an exposure to the total 250 names in the indices reduces the scope of potential losses.
“You have 0.4 per cent exposure if you have 250 underlying names, if one goes bust, maybe you get 50 per cent of your investment, because there is some recovery value, so you’d lose maybe 0.2 per cent,” says Mr Delaforce. “It becomes a trade-off against what you think the likelihood of default is. Actual default rates have been extremely low, that’s why corporate bond spreads and CDS spreads are tight now.”
Many trustees are nervous of the use of complex derivatives instruments in their investment portfolio, so one barrier which LDI providers have to cross is lack of knowledge on the part of trustees, and the need to convince them that credit derivatives are a useful tool.
“CDS are something we as an industry are going to have to educate pension fund trustees on, and help them understand it’s another attractive instrument to use,” said Mr Delaforce. But he thinks knowledge and acceptance are increasing: “Trustees accept derivatives are a powerful tool. By not using them you are putting yourself at a disadvantage. The realisation that they are not such dangerous things as people have thought in the past is becoming a more prevalent view.”
