Some Credit Investors Are Getting Ready for a Market CorrectionBy
Credit-index options volume more than twice past-year average
Surge in tail-risk hedging comes as debt ceiling, Fed loom
Trading in an obscure corner of the credit-derivatives market shows that some investors are preparing for a looming sell-off in corporate bonds.
About $10.3 billion worth of options on Markit’s CDX North American Investment Grade Index -- a basket of credit default swaps on 125 North American companies -- have been switching hands daily over the past week, according to data compiled by JPMorgan Chase & Co. About 80 percent of the volume is in put options, a bearish bet against the performance of corporate credit.
The figure is more than twice the $4.9 billion in average credit-index options traded over the past year, when bearish put options averaged 65 percent of total volume, the bank said.
"Recent CDX option-market price changes, as well as trading activity, indicate that more investors are hedging for a sell-off," JPMorgan credit analysts wrote in a note.
The options give the right to buy or sell credit risk at a certain level, and have surged in popularity as investors seek to lever up their trades in the face of ultra-low interest rates, or put on a relatively easy hedge to protect against a broad downturn in corporate debt.
With several potential flash points emerging before of the end of the year, including another deadline on the U.S. debt ceiling as well as a Federal Reserve interest-rate rise and balance-sheet reduction, investors may be positioning for a “correction,” said Anindya Basu, a strategist at Citigroup Inc. in New York.
“Anecdotally what we’ve seen is that interest in some of the tail-risk hedges has been growing over the last few weeks,” he said. “Some are concerned about the debt ceiling and how that’s going to run. Volatility being as cheap as it is, people are preparing to have hedges further out on the curve so that if there is some spike in volatility they’ll get protected.”
Such hedging activity comes as the CDX Investment Grade index trades at 57.7 basis points, not far from the post-financial crisis low around 55 reached in 2014 and mirroring broad strength in the market for corporate debt. A similar index for junk-rated credits is at 322 basis points, compared with the low around 292 reached about three years ago.
The JPMorgan analysts added that options-implied volatility for the CDX Investment Grade index has jumped even as the gauge itself drifts towards a multi-year low. “This means that out-of-the-money put options have become relatively more expensive than at-the-money options -- a sign that tail-risk hedging has increased,” they said.