Fed Should Know Corporates Losing to Derivatives: Credit Markets
Bond investors’ purchases of derivatives averaged the most in five years in 2013 as they sought ways to both amplify bets and hedge against rising yields as the Federal Reserve slows its unprecedented stimulus.
The net amount of trades on the three most-active credit-default swap indexes tied to investment-grade companies jumped to a weekly average of $117.3 billion in 2013, the highest in data going back to 2008. A Pacific Investment Management Co. exchange-traded fund that attracted more investor cash than its peers last year has more than 10 percent of its net assets in derivatives contracts, while 2013’s biggest loser, BlackRock Inc.’s high-grade fixed-income ETF, has never used them, according to data compiled by Bloomberg.
Bondholders are walking a tightrope as the Fed slows $85 billion of monthly asset purchases, seeking protection from losses when borrowing-cost benchmarks rise while also vying for returns tied to an accelerating economic recovery. That’s guiding investors from retirees to wealthy individuals toward a type of wager, once primarily limited to hedge funds and banks, that tends to both magnify gains and accelerate declines.
“You’re going to see more as people try to become more esoteric or exotic in their fixed-income investments,” Peter Tchir, founder of New York-based hedge-fund adviser TF Market Advisors, said in a telephone interview. “They’re realizing that CDS or swaps aren’t the end of the world and that they might be the best way to get the exposure.”
Five years after the Fed started efforts to rescue the world’s biggest economy from recession, rising consumer spending and a declining jobless rate are bolstering central bankers’ confidence enough to start curtailing their bond purchases. Treasury yields will rise to 3.4 percent by year-end, from 3.028 on Dec. 31, according to the median of 64 economists surveyed by Bloomberg.
That would leave holders of the highest-rated bonds facing a second annual loss even as corporate default rates hold below the historical average. In response, investors are looking for hedges against rising rates while boosting wagers on company creditworthiness.
Bond buyers funneled $1.5 billion last year into two ProShares ETFs (TBF) that are designed to use leverage and derivatives to reap one or two times the inverse of returns on 20-year Treasuries, Bloomberg data show. They poured $2.8 billion into Pimco’s 0-5 Year High Yield (HYG) Corporate Bond Index ETF (HYS), which has 10.2 percent of its assets in Markit Group Ltd.’s two most-active credit-swaps indexes that wager on the creditworthiness of speculative-grade companies, according to data published on the Newport Beach, California-based money manager’s website.
The corporate-bond ETF that saw the second-biggest volume of deposits, Vanguard Group Inc.’s $7.3 billion Short-Term Corporate Bond fund, is also allowed to invest in derivatives including credit swaps, according to the firm’s website.
During the same period, buyers yanked $9.08 billion from two BlackRock ETFs that aim to mirror returns on broad indexes of company debentures, which have become more sensitive to interest-rate movements after central bank policies pushed yields to record lows. Neither of those funds, the iShares iBoxx $ Investment Grade (LQD) and High Yield Corporate Bond ETFs, have ever used derivatives, according to an e-mail from Melissa Garville, a BlackRock spokeswoman.
“There are significant signs that ETF investors are positioning portfolios for an increase in interest rates,” said David Mazza, head of ETF investment strategy for the Americas at State Street Global Advisors in Boston.
The net notional outstanding in the three most-actively traded credit-swaps indexes tied to investment-grade credit have increased to $116.92 billion on Dec. 13, according to data from the Depository Trust & Clearing Corp. Last year’s average was 3.3 percent higher than the $113.6 billion in 2012.
Transactions in credit derivatives, created in the 1990s as a way for investors to protect themselves from loans going bad, were once responsible for as much as two-thirds of the biggest dealers’ corporate-debt trading revenue. The market ballooned during the credit bubble, with a gross measure of outstanding trades in all contracts worldwide surging to more than $62 trillion at the peak in 2007 from $632 billion in 2001. Those figures were more akin to cumulative trading volumes than actual risk taken in the market.
After Lehman Brothers Holdings Inc.’s September 2008 collapse and a surge in company defaults, net wagers in the three most-recent series of the Markit CDX North American Investment Grade Index plunged to less than $50 billion in April 2010 from $197.3 billion at the end of October 2008. That’s when the DTCC first started publishing data from its central repository that provided more details on the size of bets in the market.
The derivatives indexes, in which a seller of protection is paid an annual premium for agreeing to cover the buyer’s losses, track the creditworthiness of 125 companies from Wal-Mart Stores Inc. to McDonald’s Corp. The swaps are traded under standardized contracts, making it easier to transact in bigger volumes than in corporate bonds, which are governed by terms that vary by issue.
The Fed took the first step toward unwinding the unprecedented stimulus that Chairman Ben S. Bernanke put in place to help the economy recover from the worst recession since the 1930s on Dec. 18, saying it would taper the pace of its monthly asset purchases to $75 billion from $85 billion.
Bernanke, whose term ends Jan. 31, orchestrated the most aggressive easing in the Fed’s 100-year history, pumping up the its balance sheet to $4.02 trillion from $869 billion in August 2007 and holding its main interest rate close to zero since December 2008.
The U.S. unemployment rate fell to 7 percent at the end of November from as high as 10 percent in October 2009. Consumer purchases, which account for almost 70 percent of the economy, increased 2 percent in the third quarter, Commerce Department data showed last month, more than the previously reported 1.4 percent.
The central bank’s efforts pushed investors into riskier assets, causing corporate-debt yields to plummet to an all-time low of 3.35 percent in May 2012, according to Bank of America Merrill Lynch index data. They’ve since increased to 4 percent as Treasury yields rise in preparation for less central-bank buying.
“It is not healthy to have a ‘rigged’ market,” CQS U.K. LLP founder Michael Hintze said in a December letter to investors. “Shifts when moving from one state to another can be difficult and abrupt.”
While souring on rates, investors are showing faith in the health of America’s corporations in the face of improving economic data. Relative yields on dollar-denominated company debentures fell to 186 basis points as of Jan. 3, equal to the lowest level since July 2007.
Michael Barnes, co-founder of Tricadia Capital Management LLC, said his $3.5 billion hedge-fund firm has been taking advantage of rates volatility and fixed-income outflows to add risk to its credit funds.
Even as investors withdrew $14.2 billion from corporate-bond mutual funds last year through November, they poured $51.7 billion into non-traditional debt funds, which often use swaps, futures and other wagers tied to company performance to provide returns that aren’t reliant on the market’s direction, Morningstar Inc. data show.
“Investor flows follow those who perform better,” Oleg Melentyev, a credit strategist at Deutsche Bank AG in New York, said in a telephone interview.
Elsewhere in credit markets, Union Pacific Corp. (UNP), the largest U.S. railroad, plans to sell bonds in a three-part offering of benchmark size. YRC Worldwide Inc. (YRCW), the U.S. trucking company that averted bankruptcy in 2011, is seeking $1.15 billion in loans to refinance debt.
The cost to protect against losses on U.S. corporate bonds rose. The Markit CDX investment-grade index increased 0.5 basis point to 63.5 basis points as of 11:13 a.m. in New York, according to prices compiled by Bloomberg. The benchmark has climbed from 62 basis points on Dec. 26, the lowest since October 2007.
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, declined 0.19 basis point to 10.5 basis points. The gauge typically narrows when investors favor assets such as corporate debt and widens when they seek the perceived safety of government securities.
Union Pacific, ranked Baa1 by Moody’s Investors Service and A at Standard & Poor’s, plans to issue five-, 10- and 30-year notes, according to a person with knowledge of the transaction who asked not to be identified because terms aren’t set. The sale, along with an $800 million offering of senior notes from units of CBS Corp. (CBS)’s outdoor advertising business to help finance its separation from the parent, would add to about $5.6 billion of corporate debt sold in the U.S. so far this year.
Credit Suisse Group AG is leading YRC’s funding, which includes a $700 million term loan and a $450 million asset-backed portion, both due in five years, according to a person familiar with the transaction, who asked not to be identified without authorization to speak publicly.
YRC is rushing to complete the financing before a $69.4 million bond matures on Feb. 15. With annual losses since 2007, the company last year asked its 26,000 union workers to extend a labor contract and keep enduring a 15 percent wage cut to help it survive. YRC reached an agreement in December with creditors and some investors to reduce debt by $300 million, it said in statement at the time.
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