It is one bad time to be a Credit Default Swap trader or even worse a hedge fund that specializes in credit. Politicians across the world, from initially Paul Volcker to now German Chancellor Angela Merkel have attacked speculators and threatened bans. Merkel was quoted yesterday as saying “Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb,” in reference to CDS markets. Yet, as we will address later, swaps have a clientele that consists of primarily of hedge funds and prop desks that pay very close attention to their counterparty risk. Markets are zero-sum and unless in this case Greece banks are buying or selling protection then the CDS market should have no effect on working economies.
Developing a Credit View
Bond traders for years have developed credit views on various entities and priced those accordingly into the prices. Just a review: bonds are usually issued at or around par depending on how close the offered coupon is to current rates; then once in the secondary market they can trade at any price. The price reflects the credit risk inherent in the bond and as a result the yield can be significantly higher than LIBOR. This difference in yield is often referred to as an asset swap spread. So, if traders feel that for example, McDonald’s is expected to have worse performance going forward they might demand higher yields on new issues - which lowers prices on existing bonds. At the same time if a company like AMD continues to surprise you might see the ASW spread starts to tighten as the bonds become “safer” and more attractive. The latter case is more common when companies with negative outlooks turn around and gain traction, with in some cases an improvement in their credit ratings.
The concepts are the same in the CDS market except players in it have found that in many cases it is much more flexible than the bond markets. For instance selling bonds short often proves difficult because it becomes very difficult to borrow cash bonds. Instead, they buy protection via CDS and as the spread widens (bond price falls) they receive a mark to market gain on their swap. Likewise if the spread tightens they would receive a MTM loss on the swap; while in both cases making protection payments to their counterparty. Credit investing in its simplest form is using a CDS on single names to express particular credit views. However, unknown to most people there exist a great number of trading strategies employed in the markets.
Utilizing Credit Indexes
One method that has gained significant appeal is buying or selling protection on credit indices, which is just a basket of single name CDS’s. This has proven to be much easier both in transaction cost and liquidity over developing a bespoke basket. Markit is the primary dealer for such indices and has constructed a host of indexes that include almost all the major geographic zones. Their two most popular offerings are the CDX and iTraxx indices which are broken down into IG (investment grade) and HY (high yield). Interestingly, they also offer a SovX index which is composed of government entities from across the world. This may see some volatility in the months to come as governments debate whether it is legal to “judge their economic impact and performance” through such instruments.
Regardless, the structure of the indices is the same as normal CDS, with protection payments being made quarterly. At the same time new indexes are rolled every six months to maintain liquid instruments while at the same time excluding recently unqualified names (drop in credit rating or mergers). These products have continually proven popular for traders looking to express broad market or sector credit views at low cost, very similar to equity index funds.
Spread Trading Strategies
Just as with the treasury yield curve you can also have a swap curve across multiple maturities for the same obligation. They usually trade in a similar direction however you can also have cases of flat, steep, and inversion. This can be brought about by overall deteriorating conditions and higher counterparty risk where traders flock to shorter tenor swaps over longer term. Or when a company issues a convertible bond, it has been shown to drive CDS premiums much higher at the convertible exchange date, while having negligible effects on the cash market. Swap curves also represent supply and demand pictures for protection on a company that which just like a yield curve has a variety of trading strategies.
Arbitrage and CDS Basis
Credit markets are susceptible to arbitrage opportunities just like any other market and the primary strategy is eliminating negative basis. Basis is defined as the CDS premium minus the comparable asset swap spread for identical maturities. In almost all cases the premium is higher, for a host of technical reasons including sell-side demand, than the comparable ASW spread. This is normal, however when a negative basis exists it becomes possible to buy protection in the Over-The-Counter CDS market and purchase the cash bond for a risk free profit. In the event of a default you will receive the full principal at the same time maintaining a positive carry until maturity. These scenarios generally do not last long and the advantage often belongs to the biggest institution; who are able to maximize the small spread thanks to low funding costs and leverage.
Introduction to Correlation Trading
The last strategy we will discuss has to do with default correlation - the likelihood that all assets will default across obligations and companies. In the case of the index example above it is possible to divide it into a host of separate assets called tranches. These are segregated by attachment and detachment points for losses on the entire portfolio. Starting usually at the equity tranche, then the junior and mezzanine tranches, losses will be absorbed completely by these subordinate investors before reaching senior and super senior levels. The subordinated tranches receive a greater portion of the pay out in return for the risk, yet traders try to take advantage of shorter time moves in default correlation.
Say they assume default correlation will increase across the pool of assets; they often purchase equity and junior tranches (Long Correlation) because it becomes less likely that they will experience losses. However at the same time senior tranche holders (Short Correlation) become worried that 1 default with high correlation will lead to multiple and their tranche will also experience losses. Changes in default correlation will result in MTM losses or gains across tranches and these help explain daily price movements.
Correlation trading encompasses a further look into CDS valuation and more complex structured finance topics such as the Synthetic CDO’s and tranching credit risk. In the future it will prove valuable to address the correlation investing and trading strategies available to credit investors apart from the generally macro driven concepts earlier addressed.
Conclusion
This is just a very simplified introduction to credit trading strategies within the Trillion Dollar notional market. Hedge funds and prop trading desks have employed variations of these in the past and continue to be the primary users. However, if politicians can keep their misguided and frankly unknowledgeable reforms to themselves, we will continue to see broader market adoption. Increased exchange clearing, improved liquidity, further standardization, and continued successful auctions may lead to the CDS to eventually being a tool of choice for funds and investors globally.
