Photographer: Simon Dawson/Bloomberg

When Systematic Trading Comes to Credit Markets

Synthetic credit derivatives pave the way.

A profound trend in credit markets has been borne out by the results of Citigroup Inc.'s latest survey of credit derivatives, with investors expressing continually growing interest in derivatives tied to corporate bonds.

While an overwhelming 94.5 percent of respondents to the survey said they expect corporate defaults to increase over the next year, the majority cited liquidity in the overall bond market as their top concern.

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Source: Citigroup
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Source: Citigroup

Worries over ease of trading, combined with the higher degrees of leverage on offer from synthetic products, have helped encourage credit traders to use derivatives that track the welfare of corporate debt.

From the widely used Markit CDX index tied to credit default swaps (CDS) on junk-rated companies to options written on that index, as well as total return swaps (TRS) linked to Markit's iBoxx cash bond index—investors now have a bevy of exotic, alternative instruments to trade the asset class.

So popular are the instruments, in fact, that the notional volume of credit index options traded has on some days surpassed the volume of trades in the underlying index, according to a senior credit trader at one of the biggest banks.

That has prompted worries from Barclays Plc analysts that such "swaptions," as CDX index options are sometimes known, may be overly affecting the underlying index. Meanwhile, as hinted by Citi's question in Figure 4, others have expressed concern that investors are assuming too much leverage by using the products.

Respondents to Citi's survey shot down that fear, however, with just 27.4 percent saying they were worried "about how investors are taking more leveraged risk using derivatives."

Such products are also said to be finding new use in a bevy of so-called systematic—or rules-based—trading strategies, according to Citi. Only 2.8 percent of respondents believe there is "no profitable systematic strategy in credit options," while two-thirds added that they believe selling volatility is a profitable area for such trading.

"This is an interesting trend given that the credit space has traditionally been heavily reliant on fundamental analysis to generate alpha," said Citi Credit Strategist Anindya Basu, referring to the highly valued outperformance sought by fund managers.

"We believe that the increasing liquidity in credit portfolio products—e.g. credit indices, options on credit indices, and standardized total return swaps on iBoxx indices—has made them more amenable to systematic strategies, and investors are beginning to engage in that space," he added.

Systematic strategies have made unflattering headlines this year, with JPMorgan Chase & Co. analyst Marko Kolanovic blaming such strategies for exacerbating recent stock market selloffs.

Some credit traders have drawn a parallel between the rise of synthetic credit products allowing investors to dabble in credit market volatility, and the way futures tied to the Chicago Board Options Exchange's Volatility Index helped spur the development of stock market volatility as its own asset class.

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Source: Citigroup

Lending further credence to anecdotal evidence that synthetic credit instruments are booming, more than 60 percent of investors polled by Citi said they are already trading or are considering trading such products in the future.

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