What do you get the credit investor who has everything? How about an effective hedge against a major blow-up in bonds?
Hundreds of billions of dollars have poured into corporate bonds helping to boost the size of the overall U.S. market by almost a third over the past six years. At the same time, traders, investors and regulators have all been fretting over the ability to buy and sell the securities without massively impacting their prices. Everyone (and possibly their mothers) seems to be concerned about so-called liquidity in the $7.8 trillion market.
The combination of a booming asset class and declining liquidity means that investors are also worried about the bull market in credit coming to a sudden and inglorious end.
To protect their portfolios against a dramatic downturn in bond prices they need to offset, or hedge, their positions.
But protecting your portfolio is easier said than done and the menu of options on offer to the cautious credit investor has been shrinking.
The market for credit default swaps (CDS) which offer protection against corporate bond defaults, for example, has been dramatically transformed in the wake of the financial crisis and in the face of new regulation. Use of single-name CDS that insure bonds sold by a specific company, for instance, has fallen off a cliff thanks to new rules that make it more expensive for big banks to deal in the products. That's left many investors turning to indexes comprised of CDS instead. Those indexes, such as the CDX family owned by Markit, allow investors to buy protection on a basket of corporate names and are said to be much more liquid than the underlying cash bond market. But using such indexes can have its problems.
For example, hedge funds including Anchorage Capital and BlueMountain are leading an investor push to revamp CDS indexes that they say have become too disconnected from the market they’re supposed to track. As Bloomberg's Sridhar Natarajan reported this week, the issue here seems to be that Markit requires such indexes to include the companies with the most actively-traded swaps. Since single-name CDS trading is all warped, and since the corporate bond market has exploded in size, investors have been left with a mismatch. While energy companies have tapped global debt markets for $140 billion over the past three years, for instance, some of the most active borrowers aren't included in the CDX's high-yield index.
There are other options on the table for wary credit investors. Some have been using a smorgasboard of new derivatives such as total return swaps and options on CDS indexes to help make up for the lack of liquidity elsewhere. There are even efforts afoot to restart the market for synthetic CDOs, which once used CDS to generate returns for investors but helped trigger a wave of losses during the financial crisis. Exchange-traded funds have also become popular stand-ins for a cash bond market that can be difficult to trade in times of turmoil.
Then there are the credit investors who are getting even more creative and seeking protection against a blow-up in the world of bonds from -- bear with us -- the world of stocks.
Market participants say that more debt investors are turning to the volatility index owned by the Chicago Board Options Exchange to protect their portfolios from the risk of a bear market in bonds. The VIX, as the index is known, measures expectations of volatility by looking at the cost of buying a range of short-term options on the S&P 500 and investors can trade the benchmark using futures and other financial instruments (such as calls and puts).
While using the VIX to hedge credit is not an an entirely new strategy, we're told it's gained in popularity in recent months thanks to the concerns outlined above.
"This isn’t a new idea. As the process of putting on some hedges has gotten more difficult, investors have started to take advantage of this relationship more than in the past,” says Jared Woodard, senior equity derivatives strategist at BGC Partners.
Even if the CDX index is liquid, the VIX is probably even more so. As one trader put it to us: you know the VIX will always be there.
"We see a lack of liquidity in secondary market [for corporate bonds]. Most of it goes to the primary," says Ramon Verastegui, Societe Generale strategist. "Sometimes you have liquidity disruptions, that can even happen in credit markets, so the fallback is to find other sources of liquidity such is the VIX." Using VIX futures to offset bond bear markets would have outperformed in six out of the past seven major market sell-offs compared with buying the CDX, according to SocGen research.
Still, there are issues with the strategy. Similar to the CDX indices, you're using a macro overlay to hedge individual credit risks in your portfolio. It might not be the most effective tool if you're looking to protect against the possibility of just a few of your securities holdings defaulting, as opposed to a catastrophic event in debt (paging JPMorgan). Plus, the price of pursuing such an insurance strategy can be rather expensive given the current cost of buying protection through the VIX.
While using the VIX to protect a credit portfolio is a far from perfect hedge, it may still make sense given worries over market liquidity and a big "tail risk" event in corporate credit.
After all, why try to hedge volatility in bonds when you can simply own that volatility outright viz the VIX?
“It’s not perfect and it’s not going to capture any granularity in your book in terms of specific risks,” says Woodard. “For the risk that people are really worried about, which is those big tail moves, I do think it’s a relationship worth exploring.”