The credit default swap (CDS) market is starting to win over doubters from the institutional investment community that credit investment portfolios can be enhanced and diversified through CDS exposure.
The growing demand from institutions to consider alternatives to credit and liability management other than placing spare cash in the corporate bond market, which is undergoing historically narrow spreads and investment yields, has increased the perceived effectiveness of credit derivatives, and to a greater extent, using CDS to reduce downside credit risk.
Supporting industry data is far from uniform (it is dependent on market participants providing such figures) however two key sources underline significant CDS growth in the past two years.
Growing demand
The latest figures from the International Swaps and Derivatives Association (ISDA) finds the notional amount of CDS grew by 52 per cent in the first six months of 2006 to $26,000bn (€19,500bn) from $17,100bn. The annual growth rate for credit derivatives overall was 109 per cent from $12,400bn at mid-year 2005.
Similarly, data from the Bank of International Settlements (BIS) reveals the two ‘types’ of CDS, those referencing single-name underlyings and those referencing multi-name underlyings, demonstrate rapid usage. CDS grew from $10,200bn in June 2005 to $20,300bn in June 2006 and of this, single-name CDS accounted for $13,800bn of total CDS. Multi-name CDS bounced from $2900bn in June 2005 to $6400bn last year.
Increasing transparency, marketability and innovation in CDS products, certainly since the start of 2006, has triggered a welcome response from a hitherto cagey demand-side.
As an effective alternative to investment grade bond liquidity, which at present is expensive for pension funds with spreads tight and yields low, the CDS universe has a crucial ally.
For example, Thorn Pension Fund, part of the now defunct Thorn EMI group, traded £380m (€559m) in credit swaps to ease ongoing liability concerns. Trevor Bennett, senior trustee, explains: “The price of UK gilts was prohibitive at the time, so the swaps market gave the pension fund a chance to smooth out liabilities through derivatives exposure.”
The relative maturity of the pension and degree and nature of liabilities has most bearing on whether or not using swaps to hedge against bad credit, or to protect and restrict inflation and interest rate volatility, will work their way into an LDI brief.
David Morgan, chairman of the investment council at NAPF, the UK pension fund association, reckons swaps, “provide investment funds with another tool of diversification”, particularly in the battle to tighten asset-liability matching techniques. Illustrating Mr Morgan’s point, the £900m pension fund of UK stationer WH Smith exposed itself to credit derivatives in the form of a Libor-linked cash fund to hedge interest rate and inflation risk.
Dutch and Scandinavian pension funds are more weighted in derivatives-led portfolios than their UK counterparts. For example ABP, the €186bn Dutch fund, has used CDS in its fixed income portfolio since the inception of the swaps market in the 1990s.
Lacking liabilities
For some investors, making up liabilities is not of an immediate concern, however. Shelia Gleig of Coal Pension Trustees, overseeing £27bn in assets held in four coal industry pension funds, explains: “We don’t have a need for swaps. Any liabilities are picked up by government. It is the tax payer that makes up any deficit”. The coal pension is covered by the UK government under a guarantee whereby the fund value increases in line with the inflation rate.
Yet there is caution and concern within the institutional investment community regarding the active use of swaps and other derivative products, whether this is down to price/fee transparency, trustee governance issues, or a perception that the providers – the investment banks – are overcomplicating matters with increasingly elaborate CDS products.
Terry Faulkner, director of pensions and benefits at Rexam (see FT Mandate’s Scheme Spotlight), the European consumer packaging company, finds CDS “a useful investment tool for liability matching”, and in this respect echoes the sentiment of a number of institutions. Equally, he espouses what some big investors feel might be the case about the sell-side as the growth market for CDS continues unbounded. “Timing is important for the investor - don’t do it just because an investment bank says so,” Mr Faulkner warns.
The investment strategy of the £1.4bn Rexam pension fund doesn’t incorporate the need for swaps at the moment, but this isn’t necessarily a rebuttal by its pension chief. “Certainly the use of swaps may become more mainstream in liability management in the future, just as absolute return strategies have become trendy on the asset side,” Mr Faulkner says.
Increasingly asset managers are discussing with their institutional clients the capabilities afforded by having some level of CDS exposure, either through straight single-name investing, or via the simpler (and therefore popular) index route.
Roger Sadewsky, investment director, Standard Life Investments, who prior to joining SLI in 2004 worked on structured products at JP Morgan Securities, notes the attraction of CDS to the institutional investor as a twofold phenomenon. “Swaps may allow exposure to names where bonds or maturities do not exist and there also may be better liquidity or price advantages (lower bid/offers),” he says.
Cashing in
But what of the comparative expense of swaps to cash, particular the trading fees incurred from the investment banks? “The bid/offer (and the size an investor can trade) tends to be equal or superior to that which is available in the cash market. A good example would be trying to buy or sell a position in high yield bonds, the bid/offer can be 1 per cent of face value. In credit default swaps indices bid/offer trade around 2 basis points (0.02 per cent),” explains Mr Sadewsky.
Mitesh Sheth, investment director at Henderson Global Investors, points out that it may not be only apprehension over CDS pricing making the plunge that much tougher for institutions. “Historically, anything new for pensions is viewed as scary, and there are still concerns with the past, such as the LTCM fallout, with respect to counterparty risks,” says Mr Sheth, who nevertheless believes risks have been minimised with regards counterparty downsides and that the “mentality is titling in favour of swaps and derivatives within the LDI process.”
There also remains the question of education and level of investor training, and whether custodians are fully up-to-date with the sophistication and complexity of structured investment products such as CDS, or hybrid products such as collateralised debt obligations (CDOs) and constant proportion debt obligations (CPDOs).
SLI’s Mr Sadewsky says: “Any time we are not pitching, we spend on education of trustees and developing new investment approaches to present to consultants. I doubt there is any difficulty in obtaining training for trustees as long as they are able to make time for it. Ultimately, as long as trustees truly understand what the solutions will do for them and crucially, what is not covered, then it is for their investment consultants to perform the due diligence on the provider and the nuts and bolts behind the scenes.”
The availability of pooled investment products, which encompass credit asset class exposure without the need to go head first, are proving popular for the cautious funds. “The client can dip in and out through pooled units. It looks more conventional this way and they can sidestep any governance concerns trustees might have about full-on swaps or derivatives exposure,” adds Mitesh Sheth.
From the sell-side, talk is expectedly buoyant. Marcus Schüler, head of integrated credit marketing at Deutsche Bank, believes institutional investors are finally getting excited about using credit default swaps as a tool for diversifying their portfolios in the light of tight investment grade bond spreads.
“Real money, in other words pension funds, have been slow to move into CDS, but the big shift in interest has taken place in the last year and now all the significant money managers are involved,” says Mr Schüler.
He explains that growth in interest is closely tied to the rise of credit trading indices, such as iTraxx in Europe and CDX in the US, which make it easier for institutions to access credit derivatives such as swaps without being exposed to single names.
“Pension funds tend not to have the resources to run a big credit portfolio, so trading on an index offers a tool to invest in the asset class without having to make a single name decision,” he says.
Severe delays
However, Mr Schüler says there are delays, and often quite lengthy, between deliberation and execution of CDS mandates by investors. “It takes time to convince clients of the merits of using such products and then, after the product approval process, a master agreement has to be confirmed, which can sometimes take over a year to complete,” he says.
Deutsche Bank’s Mr Schüler is referring to the ISDA master agreement, which is the standard contract that must be agreed on between the two trading parties of the swap or derivative, i.e. the investment bank and the investor. “Work on this can be intensive and takes time,” he stresses.
The growth of credit indices and the rolling out of new CDS hybrids, in addition to existing pooled products, has spiced up the swaps offering for investors. Indices in particular offer investors the opportunity to build diverse credit exposures efficiently and relatively cheaply.
The launch last month of the Eurex iTraxx CDS futures, targeted specifically at institutional investors, is being heralded by Eurex as giving access to credit markets for investors previously unable to access over-the-counter derivatives instruments. “From the point of view of transparency and operational efficiencies, this is something that investors have not had in the OTC credit market before,” says Byron Baldwin, business development, Eurex.
Mr Baldwin explains that the introduction of a new credit product on tradable indices “will give flexibility to the investor in terms of investment portfolio overlay strategies” and “widen the scope to reduce or increase exposure to credit when necessary”
