Asset managers often need to hedge their credit portfolios or quickly add or reduce risk to enhance their portfolio returns and generate alpha. For most corporate and emerging market bond portfolio managers, there are a limited number of financial instruments available to accomplish this:
- CDS Indices are very liquid and standardized, but often deviate from the underlying market.
- ETFs are tied to bond indices, but trade as equities. Their size can be an issue. For hedgers, the cost to borrow shares and the risk of buy-in are additional concerns.
- Futures work well for most government bond markets, but futures are not yet a viable product in credit markets. A liquid futures market could develop for credit markets, but so far the attempts at futurization have met with limited success.
Portfolio managers are increasingly turning to Total Return Swaps (TRS) as an alternative. TRS are derivative contracts linked to a bond index, such as the Bloomberg Barclays US Corporate High Yield Total Return Index. TRS allows investors to receive or pay the total return of a referenced index. These swaps enable market participants to effectively manage their risk in a cost-efficient manner minimizing tracking error versus their benchmark indices.
Asset managers make two decisions when choosing to hedge or add risk via a credit beta product (CDS Indices, ETFs, Futures, or TRS):
- When to add or decrease their portfolio risk, and
- What level of basis risk (the difference between how a product behaves compared to the relevant benchmark bond index) to accept
The largest driver of basis, or tracking error, is how closely the underlying financial instrument’s trading price tracks the performance of the reference bond index. While some portion of the basis is a result of the supply and demand of each product and changes over time, much of the basis is because the financial instrument does not always track a benchmark index closely enough (a problem which can be mitigated by using TRS).
Until recently, asset managers have had to accept relatively high levels of basis risk, which ultimately increases their tracking error. Not only is the basis large and impactful to returns, it tends to behave most erratically at times of market stress. However, in this scenario, tracking error can be reduced by using TRS.
There are countless examples of the problems asset managers have faced dealing with basis risk in financial instruments. These examples occur across time and markets. While we can find recent examples in Emerging Markets and European Credit, we will highlight two that occurred in the U.S. within the past year.
High Yield in late 2018 and early 2019
From November 7, 2018, the day after the US elections, until the end of January 2019, there was significant volatility in the high yield bond market as the election results and post-election rhetoric was priced in. This period of high volatility highlights how much basis risk is possible. The relative performance of the Bloomberg Barclays US Corporate High Yield Total Return Index and the CDX HY Index oscillated significantly.
Over a four-month period, the tracking error and potential P&L volatility of trying to manage a high yield bond portfolio (benchmarked to this index) with the HY CDX product was problematic. In some cases the basis risk was greater than the market risk. For example, if you hedged in the middle of January, the index only moved a small fraction of the amount that the HY CDX index moved. The composition of the CDX index, a portfolio of 100 equally weighted names with a fixed 5-year maturity, was a contributing factor to this basis risk. ETFs introduced different basis risks – as they also deviated from their net asset value and had limited liquidity around the holidays. The high cost of borrowing shares to short was a problem for hedgers.
Investment grade credit spreads during the VIX spike of 2018
Another example of this basis risk occurred at the start of 2018, when the CDX IG Index and the Bloomberg Barclays US Corporate OAS moved relatively in line. However, in late January and early February 2018, the VIX started to rise rapidly and was further complicated by problems several VIX linked ETFs and ETNs were having at the time. Stocks were volatile and also losing value. The CDX index also tracked stocks more than bonds. Even during the first week of February 2018, while CDS spreads were rising rapidly, the IG corporate bond market was relatively healthy and new issues were being priced at aggressive levels.
Once the rise in CDX spreads began, using CDX IG as a hedge added a tremendous amount of basis risk. There were days when CDX spreads tightened, while bond spreads widened – hurting returns and increasing tracking error. The movement of the CDS basis made it very difficult to control tracking error portfolios once a decision to add or reduce risk was made.
History repeats itself
The two examples explored above are just a few of many that have happened recently. This pattern of increasingly volatile basis when markets are under stress is common.
In order to prepare for future market scenarios, asset managers should continue to explore Total Return Swaps. TRS may minimize tracking error and unnecessary P&L volatility because they avoid the basis inherent in the CDS Indices or ETFs. That direct link to the benchmark index is crucial in reducing basis risk. Supply and demand will have an effect, but it is beneficial to understand if TRS can be a useful financial instrument for you.