The International Swaps and Derivatives Association reports the notional amount of credit derivatives grew by almost 48 per cent in the first six months of this year to $12,430bn (€10,580bn), or 128 per cent growth year-on-year from mid-2004. But, as with any instrument where activity has heated up so much, there are concerns that the bubble might burst.
Flexibility is the key attraction of CDS. For investors they vastly increase the universe of credit options, they have greater liquidity than the equivalent cash bonds and as derivative instruments do not require a vast pool of cash upfront to buy.
A credit default swap 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. A CDS has been likened to an insurance policy against the risk that the bond’s issuer will suffer an event which affects its credit status. The credit event could be that the issuer goes bankrupt, misses payments on its debt obligation, or restructures a bond or loan. A CDS contract is agreed between two parties – the one who shoulders the risk, the protection seller, and the other who offloads the risk, the protection buyer. The protection seller collects a regular premium from the protection buyer for the length of the contract, usually five years, though other tenors can be arranged. If during that time one of the trigger events occurs, the protection seller pays over a pre–agreed amount to the counterparty.
Hit with bond managers
Many bond fund managers have eagerly embraced CDS, welcoming the increased flexibility and diversification opportunities compared with the cash bond market, which is limited by bond availability. With CDS you can sell protection on an issuer for five years even if the company only has 10 year bonds available.
Insurance companies are also cottoning on to CDS, though they have lagged behind some other types of investors, probably because of regulatory issues.
Standard Life is an active investor. “Where we find them useful is when we get market dislocation,” says Roger Sadewsky, investment director at Standard Life Investments. “To reduce credit exposure through CDS has been more efficient than selling cash bonds.”
But he highlighted the need to satisfy the derivative regulations that apply to insurance companies: “With derivatives you need to be able to measure and monitor what you are doing. Before using them we had to build a robust compliant system for documenting, executing and measuring these trades.”
Pension funds are likely to be exposed to CDS through their fund managers. But the Dutch pension fund for civil servants, ABP, manages its own fixed-income portfolio and has used CDS to hedge individual names, to add or reduce exposure, and to benefit from discrepancies between physical bonds and CDS. “CDS has broadened our universe, when the bonds are not that liquid CDS can be a good way to buy or sell protection, and for single names we can play the relative value between CDS and bonds where the CDS might have a different spread than the bond,” says Peter Prins, fund manager at ABP.
Protection
A rather more emotive use of CDS by pension funds is for protection against sponsor default. Interest is increasing in the wake of proposals from the Pensions Regulator for trustees of underfunded schemes to come up with a plan to get back to full funding within 10 years. In this case, trustees are showing interest in using CDS for protection.
 Whitney: significantly away from targets | “If they are a significant way away from the ongoing target and trustees are not comfortable with the length of time it’s going to take to get there, this can give them security while they are saving up,” says Lynda Whitney, trustee adviser at Hewitt Associates. “Trustees have to worry about what will happen if the company fails even if they don’t expect it to happen.” |
Investors may have concerns about volatility. As with most derivative markets the CDS market tends to be more volatile than the underlying physical market.
“If we look at April/May 2005 when both cash corporate bonds and CDS were volatile and were trading down, CDS underperformed during that time, and late August 2004 when both credit markets were recovering the CDS outperformed,” says Jamie Stuttard, fixed income portfolio manager at Schroders.
CDS seem to have come of age, showing signs of greater maturity recently, which should also reassure investors who are nervous about derivatives. Neil Walker, head of EMEA exotic credit derivatives at Merrill Lynch, points to the recent collapse of American auto parts maker Delphi and the orderly resolution of the aftermath among buyers and sellers of protection as evidence of maturity: “There were perhaps tens of thousands of contracts that settled, as far as I can see with no real issues.”
Other signs of maturity are also evident. Documentation has become simpler and more standardised. And after issues about timeliness of documentation were raised both by the FSA in the UK and the Federal Reserve Bank in the US market participants have come together to resolve the issue. And benchmark indices have been launched with 125 names in both Europe and the US, which are liquid and trade actively. All in all evidence that the CDS has moved into the mainstream, and is not just an obscure fringe activity.
CDS POPULARITY SEES CDO DEMAND ROCKET
The market in collateralised debt obligations (CDOs) has also grown alongside CDS. CDOs are packaged debt instruments, structured by investment banks, which establish a pool of different debt instruments. This is then split into tranches of different credit qualities and sold to investors. CDS have become favoured instruments for inclusion in the pool and facilitate the growth in synthetic CDOs. Before the advent of CDS, CDOs were limited to using only physical bonds.
 Grant: CDS liquidity perfect for hedge fund | “The investment bank slices up the CDO into tranches according to riskiness and issues bonds on the back of it and the risk is transferred to the bondholder,” says Jamie Grant, investment manager at Axa Investment Managers. “CDS are the perfect tool for that. They might sell protection on 100 names so the special purpose vehicle they use for CDOs has exposure to 100 names in that vehicle.”. |
Demand for CDOs began to rocket upwards a couple of years ago alongside wider availability of CDS. Hence the two markets have grown hand in hand.
“CDOs built with synthetic or unfunded CDS were more attractive for yield seeking investors because credit markets were relatively cheap in late 2002 and early 2003. That really helped encourage CDO demand at that time,” says Jamie Stuttard at Schroders.
A recent development in the single tranche CDO field has been the use of an asset manager to manage risk within the CDO, according to Dale Lattanzio, head of EMEA credit, real estate and structured products at Merrill Lynch.
“More recently we have been using asset managers to manage the credit risk in these portfolios to protect the interest of those who buy the different portions of the capital structure to avoid defaults. The amount of credit backing these tranches can be quite high. It feeds demand for CDS in the market when you ramp one of these deals up. It creates flow in the underlying names.”
HEDGE FUNDS GET MANAGERS OFF THE FENCE
Hedge funds have also had a big impact on the popularity of CDS. Hedge funds have a natural affinity with this kind of instrument because of its flexibility: it can be shorted, so allows funds to take different views over a period of time. It also does not need to be backed by a large pool of cash upfront and is very liquid.
“Hedge funds are very active. This is natural – CDS is a leveraged product, so you don’t need the cash behind you to start trading it,” says Jamie Grant at Axa Investment Managers. “A hedge fund doesn’t necessarily have the same resources behind it as a traditional asset manager would. Liquidity in CDS is so great – it’s perfect for a hedge fund, which wants to get in and out of the market as quickly as possible.”
Ability to short is one feature of CDS that makes them attractive to hedge funds. Going short in the physical bond market is not easy, and would not be efficient.
“A hedge fund may have specific views on a company,” says Daniel Berman, head of European credit management at JPMorgan. “They may think a company is a safe bet at three years but not thereafter. To express that view they can sell three year protection CDS, but if only five year bonds exist for the company they wouldn’t be able to express that view of the company.”
The exponential growth of the market and the presence of hedge funds as major participants have served to raise concerns about risk in some quarters. But Neil Walker at Merrill Lynch is reassuring: “Exponential growth can’t continue forever – it has to slow at some stage. The fact that this market has grown a lot doesn’t give anybody any reason to be afraid.”
