Credit-Default Swaps Are Back as Investor Fear Grows

  • Credit derivatives trade volumes doubled over the past month
  • Barometers of risk rose to multi-year highs this week

As markets plunge globally, investors are seeking refuge in an all-but-forgotten place.

Trading volumes in the credit-default swaps market -- where banks and fund managers go to hedge against losses on corporate and government debt -- have surged. Transactions tied to individual entities doubled in the four weeks ended Feb. 5 to a daily average of $12 billion, according to a JPMorgan Chase & Co. analysis of trade repository data. The volume of contracts on benchmark indexes in the market increased two-fold during that period to an average of $87 billion a day.

The growth could represent a shift. The credit derivatives market has contracted for almost a decade, after loose monetary policies triggered a big rally in assets including corporate bonds, which made investors less eager to protect against the worst. Regulators have also urged banks to curb their risk taking, reducing the appetite for at least some dealers to trade the instruments. Now, stock markets are selling off and junk bond prices are plunging, increasing investor demand for protection.

“The surge we’ve seen in trading is likely to stay with us for the foreseeable future,” said Geraud Charpin, a portfolio manager at BlueBay Asset Management in London, which oversees $58 billion and has traded more credit-default swaps on individual credits in the past three months. “The credit cycle has turned, so there’s more appetite to go short and buy protection.”

Risk measures fell on Friday after soaring this week to the highest levels since at least 2012 in the U.S., and 2013 in Europe. The cost of insuring Deutsche Bank AG’s subordinated debt dropped from a record after the German lender said it planned to buy back about $5.4 billion of bonds to allay investor concerns about its finances. The bank’s shares have lost about a third of their value this year.

Credit derivatives were one of the fastest-growing businesses for securities firms before the 2008 financial crisis claimed Lehman Brothers Holdings Inc., which was a major dealer in the market.

The derivatives fell out of favor as regulators blamed them for exacerbating the financial and sovereign debt crises. The U.S. government had to bail out American International Group Inc. in part because of its massive credit derivatives positions on securities linked to real estate.

Deutsche Bank and other dealers stopped trading all but the most liquid indexes because tougher capital requirements made it too costly. Investors also pulled back after loose central bank monetary policy globally helped suppress default rates.

The total size of the credit derivatives market - as measured by the face value of debt protected against default - collapsed to $12.8 trillion from more than $33 trillion in 2008, according to the Depository Trust & Clearing Corp. 

Bear Product

The increase in trading over the past month on individual entities was the most since May 2014, while index volumes rose by the most in about a year, according to JPMorgan’s analysis of DTCC data.

“Credit-default swaps are a bear product,” said Soren Willemann, head of European credit strategy at Barclays Plc in London. “When the market is volatile, that’s when they come into fruition. If you want to take a short view, credit derivatives are the place to go.”

The Markit iTraxx Europe Senior Financial Index rose to the highest since 2013 this week, according to data compiled by Bloomberg. Credit-default swaps on Deutsche Bank’s senior debt, the worst performing in the measure this year, reached a more than four-year high of 271 basis points on Thursday.

Net wagers on the German lender jumped $180 million in the week through Feb. 5, the third biggest increase among non-sovereign entities tracked by DTCC, following a $358 million rise in bets on Barclays, the biggest.

“There has been reduced interest in CDS until now,” said Louis Gargour, chief investment officer of London-based LNG Capital, an alternative investment-management firm. “The banking sector is weakening, the commodities sector is weakening and the likelihood of bankruptcy is increasing for a number of different companies. Deutsche Bank is the latest example of investors rushing to hedge.”

Individual Shocks

Trading was picking up even before the latest bout of volatility as investors sought to protect against individual shocks. Credit-default swaps are easier to buy and sell than corporate bonds.

The amount of debt protected by credit-default swaps on Volkswagen AG surged 41 percent after the German carmaker admitted to cheating on U.S. emissions tests in September, DTCC data show. Bets on Glencore Plc and ArcelorMittal increased more than 20 percent each since the commodity rout started last year.

“Since Glencore and Volkswagen, more people have bought single-name CDS,” said James Duffy, head of European investment-grade single-name credit-default swaps trading at Citigroup Inc. in London. “With lots of idiosyncratic events happening, there is a need to trade the underlying single name.”

Derivatives users are stepping up efforts to boost liquidity and prevent more banks from exiting the market. Ken Griffin’s Citadel pushed the U.S. Securities and Exchange Commission last week for rules to settle trades on individual companies and countries through clearing houses, after 25 investors including BlackRock Inc., Pacific Investment Management Co. and BlueMountain Capital Management pledged to clear their trades in December.

“The amount of trading this year so far has indicated growth in the credit derivatives market,” said Saul Doctor, a credit strategist at JPMorgan in London. “If the market enters a default cycle, increased levels of trading of single-name contracts is likely, and indexes should remain highly traded.”

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