Credit Derivatives Are Losing Popularity As Corporate Bond Managers Shift To ETFs For Hedging

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Investors in corporate bonds are seeking out new ways to reduce their risk and gain market exposure as bond prices soar – and they’re looking increasingly toward ETFs instead of traditional credit derivatives, according to Bloomberg.

Trading volume in products like exchange traded funds and total return swaps is increasing at the same time as volume for credit derivatives has stagnated or, in some cases, fallen. For example, volume for the Markit iTraxx Europe Crossover credit
default swap index has dropped around 40% this year.

This goes to show that credit derivatives are beginning to lose their popularity after being an important way for investors to hedge market exposure quickly. While the corporate bond markets were tanking last year, liquid high-yield bonds weakened more than the high-yield credit derivative index.

Matt Toms, chief investment officer for fixed income at Voya Investment Management said:

Credit hedges don’t need to match underlying bonds perfectly — ideally, they should be more liquid and volatile to provide better protection.”

He continued:

“This is an environment where you’re meant to be looking for what’s the most effective and cheapest hedge for your portfolio. We think there are reasons to use both swaps and ETFs.”

Investors have complained about tracking errors in credit derivatives for years and, despite improvements, a number of money managers are embracing new products like ETFs that can more closely track the market. Trading in the largest high-yield ETF was up more than 30% from the same period last year in Q1. 

In addition, a Greenwich Associate survey pointed out that 40% of credit investors thought ETFs were the most effective products for gaining credit exposure, compared to 27% who thought credit default swap index products were. This, of course, has banks trying to meet the new demand. For instance, UBS recently expanded an algorithmic pricing tool to help advise clients on the best way to cut the exposure using both products. Other banks are moving into portfolio trades, which can help customers buy or sell large box blocks of bonds by breaking up or putting together ETFs.

Kevin McPartland, head of market structure and technology research at Greenwich Associates said: 

“It’s been a bit of an issue for credit for a long time — there aren’t a lot of liquid hedging tools. ETFs have really been the only bright spot.”

Volumes for single name credit default swaps are mostly unchanged this year. And the $10 trillion credit derivatives market is definitely not going away anytime soon. 60% of that figure is said to be linked to indexes and Barclays has pointed out that volume in trading the CDX.HY jumped about 95% in the first 22 weeks of 2018.

Over longer periods, derivatives may create problems by performing better or worse than the corporate bond markets.

Bloomberg says this is pushing people toward alternatives: 

Those kind of variances are pushing at least some investors to alternatives. Peter Tchir, who heads macro strategy at Academy Securities Inc., said he expects derivatives known as total-return swaps to become the hedging tool of choice for investors in the coming years, in part because they’re more customizable. In a total return swap, an investor might pay a fee in exchange for the receiving the total return on an index at the expiration of the trade.

The customization allows investors to link them to forms of debt that are otherwise hard to hedge, such as loans to junk-rated companies. The U.S. leveraged loan market has jumped more than 25% since 2014 to more than $1.2 trillion outstanding. Trading of total return swaps tied to leveraged loans rose almost 60% this year from the same period in 2018. Barclays expects that to continue as long as the asset class grows without the creation of a loan-specific CDS index.

Tchir said: “Total return swaps are where ETFs were four to five years ago. Ultimately now ETFs are more important in high-yield than CDS indexes. I’m seeing the same trends in total return swaps.”

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