Ever broader arb opportunities
A high-yield takeoff
KEVIN AKIOKA LIKES credit derivatives. In the past 18 months he has become much more comfortable investing in a product that he once would have regarded with scepticism. That's significant because his company is neither a hedge fund nor a total-return fund but a regular mutual fund with $50 billion in assets under management based in Los Angeles called Payden and Rygel. "Credit derivatives have definitely become a real market, and that's not something I would have said a few years ago," says Akioka, a senior fixed-income strategist. "From our side, a real money fund which is primarily long, it's another arrow in the quiver."
Akioka is just the kind of investor that proponents of credit derivatives – largely the big commercial banks and leading dealers – have for years been saying should start using them. Finally, it seems to be happening. "It's a very healthy market now in terms of types of users," says Jared Epstein, head of credit derivatives trading for Morgan Stanley in New York. "Insurance companies and traditional money managers used to account for less than 5% of total volume. That figure is much bigger now."
This growth, says Epstein, rests on "the increase in transparency, visibility and liquidity". That has come relatively fast. Single-name default swaps only hit the market in 1996. That year there was $40 billion of notional volume. Last year that grew 72% from 2002, according to the International Swaps and Derivatives Association (Isda) to $3.78 trillion.
Only in the past three years has liquidity developed. First, commercial and investment banks became big buyers of protection on their loan and bond portfolios as a result of the credit crises, with insurance companies as one of the big sellers. Second, hedge funds started playing around with default swaps, especially convertible arbitrage funds wanting to hedge out the credit risk as they became big buyers of converts from early 2001. Some of these funds then joined other hedge funds and proprietary trading desks in exploiting the dislocations in the markets in 2002 to put on capital structure arbitrage trades.
Converting the sceptics
It was at that point that Akioka's company got interested. "We started using them in late 2002, doing mainly smaller, simple trades. We had seen how the product coped with the Russia default in 1998 and the corporate defaults in 2002. It's been through a number of tests and lawsuits. It didn't kill the industry, and it led to more standardization. Everyone's on more or less the same page now."
Others took slightly longer to get involved, waiting for more signs of liquidity and, crucially, transparency. "We started using default swaps earlier this year," says Kristen Galanek, a credit strategist at Metropolitan West Asset Management in Los Angeles. "It was really the standardization of documentation that made it possible. Before last year, if you engaged in a default swap trade with one dealer you couldn't necessarily get out of the trade with another dealer. Standardization has brought better liquidity."
Metropolitan West was set up in 1996 by the co-heads of fixed income and several portfolio managers from Hotchkiss and Wiley and now has $14 billion in assets under management. "We're long-only by history, but are sufficiently sophisticated to understand more esoteric strategies and work out what's best for us to use," says Mark Unferth, high-yield portfolio manager and director of credit research at Metropolitan West, who joined in 2002 from CSFB. He qualifies: "Some of the uses for credit derivatives just aren't in our wheelhouse, such as buying and selling CDS tranches, or gamma correlation trading, and so we don't use them."
The growth of credit hedge funds is having a marked impact on real money accounts' approach to the credit markets. Last year, according to some estimates, well over half of all new hedge funds being set up were credit hedge funds of some description or other.
"Real money managers are definitely feeling the pressure from the hedge funds – from the larger, well-capitalized ones, not the two guys with a Bloomberg terminal," says Jim Ballentine, global head of structured credit at Lehman Brothers. "Setting up a long/short fund or a structured credit fund can be a great way for them to raise new money," continues Ballentine. "Some managers have found balancing the more highly structured credit products with their traditional total return strategy to be cumbersome."
The real benefit for regular funds, though, says MetWest's Unferth, is that "rather than our choices being limited to a binary buy or sell choice and simply having to sit on long negative carry, credit derivatives allow us to be more precise in expressing our credit views".
And that can help improve performance. "A lot of people think there are few opportunities in fixed income with rates and volatility so low," says Brian Zalaznick, head of alternative fixed-income strategy at Barclays Global Investors. "Which maybe is true, if you are benchmarked against the Lehman aggregate index, but there are huge alpha generation opportunities once you release the long-only constraint. Everyone is looking for strategies to perform and outperform in an environment of flat and negative returns for credit. We're now in an environment where the skilful managers should prevail as volatility returns to more normal levels."
Credit market transformation
With the real money getting involved, developments in credit derivatives are transforming the overall credit market. "Credit used to be a long-only game, but now it's a long/short market," says Eric Oberg, head of credit derivatives trading at Goldman Sachs. "And it has a lot to do with the growth of credit derivatives."
For years certain players have bemoaned the inability to go short credit. Now they can. "CDX and iTraxx are like a Bund future for credit," says Paul Czekalowski, co-head of European credit derivatives for UBS. "They are becoming the generic first-order hedge for market moves. The interest-rate derivative market could not have developed to where it was today without the Bund future."
And as all types of investors join the party, they are collectively spurring a change in the way the whole credit market operates. "There's an evolution going on," says the head of a credit long/short hedge fund on the US east coast. "Credit used to be viewed as a risk you wanted to manage away by being smart. Now people are realizing that it's dynamic, can be accurately priced, that the risk is hedgeable and manageable and that you can get compensated for it. Credit is evolving into an asset class, and it's growing fast."