AFTER YEARS OF excess liquidity flooding the European secondary bond markets, the US sub-prime disaster has coursed through trading channels. Over the past three months, credit fundamentals have broken down, and liquidity has contracted severely in the cash bond and loan markets. This time last year, investors were buying up debt instruments as fast as originators could devise ever more diverse structures for them, as tight spreads and the search for yield drove much of the buy side to look for more value-added areas to invest in. Now many of these complex instruments have gone from semi-liquid to practically solid and are responsible for significant mark-to-market losses. The crunch has already claimed its share of banking stars and has not yet reached the end of its trail of destruction. The primary debt markets have stuttered and stalled as volatility has increased dramatically.
But secondary trading continues to flow in some sectors of the market, namely in credit default swaps (CDS) and credit indices, a significant amount as a direct result of hedging and speculation brought about by the rise in volatility that did for the cash market. Although the credit indices are very active, there is some contention about their suitability as a hedging tool. Mahernosh Engineer, senior credit strategist at BNP Paribas, says that the rise of indices has not had a great impact on the markets, as one still needs to look at the individual names to assess accurately the underlying risk. "Credit indices were used for hedging but not very successfully," he says. "They are now used for more speculative purposes."
Dynamic shift
All of this has contributed to the dominance of CDS trading in European secondary debt markets. CDS became a more liquid instrument than cash for various reasons. Most important, they are a more efficient means of expressing negative credit views than trying to short a cash instrument. Furthermore, it is frequently very difficult to find a cash bond once it stops trading on the new-issue primary trading desk. The most important factor influencing trading volumes is the age of the original issue. Newly issued bonds are traded much more regularly than older issues, which tend to become parts of less active portfolios (see chart). The turnover of sterling and euro bonds in the European market has been pitifully small, and as the primary issue market is so muted, this is unlikely to change. There is a lack of liquidity irrespective of whether a dealer is looking to buy or sell, and what little trading there is has been confined to a small amount of benchmark bonds.
So the trend of high liquidity in CDS and almost no liquidity in cash bonds will continue and, as one is largely responsible for the other, it could become much more pronounced. According to the International Swaps and Derivatives Association, the notional amount outstanding of credit derivatives at the halfway point of this year was $45.46 trillion. It is clear that most issuers are turning over far more in CDS than in bonds. "Most firms were seeing their derivatives volume grow faster than cash even before the money market problems developed," says Simon Morris, head of European credit trading at Goldman Sachs. "When the cash market stalled, CDS continued to be liquid."
It is now not only easier to hedge a bond using CDS than it is to try to trade away exposure to it, it is also far cheaper. On top of that, it is possible to efficiently take a view on credit curves by using CDS with different maturities. It is not always possible to do likewise using bonds.
So investors are not trading bonds because, with the rise of CDS, most of them simply don’t have to. If an investor is able to hedge with CDS, then he or she will do so because of its superior liquidity and efficiency over the cash equivalent. And the more this happens, the more the cash markets will wallow in a quagmire of low liquidity.
And as the credit universe has expanded it is hardly surprising that dealers have seen their credit derivatives volumes growing faster than cash. The rise of negative basis trades gave investors access to what was in theory free money. A negative basis trade can occur when it costs less, in spread terms, to buy protection on a bond than you earn from the coupon of that bond. An investor can purchase a bond, then purchase protection on that bond in the form of a CDS, and pocket the difference between what the issuer of the bond pays him and what he pays the seller of protection.
During the summer, relationships such as these changed. Suddenly the basis turned from negative to positive. Meanwhile, the credit market widened dramatically, leaving a number of players long and wrong.
"This has been the most opportune year to make or lose money in the 15-plus years that I’ve been in the business," says Morris. "If you’re on the wrong side it can be very painful. Volatility can be good and bad." Morris is one of few in the market still enjoying his work. Goldman Sachs is one bank that has managed consistently to provide liquidity in the debt markets while others have found the task beyond them. In terms of trading volumes, each of July, August and September were bigger for Goldman Sachs than the whole of 2004. All three together were bigger than 2005. Morris points to three factors as the key to providing liquidity and maintaining profitability in a difficult market. First, one must have a large enough market share and customer footprint to absorb the danger. Secondly, a single trading unit for high-grade through to distressed debt, rather than separate, disjointed trading departments, is essential. JPMorgan started this trend in 2000 when it merged its credit derivatives and bond-trading teams, as well as its high-grade and high-yield people, and most banks have followed suit. Last, and perhaps most important, a trading house must be sensibly positioned. Goldman Sachs was caught long on sub-prime mortgages along with everybody else but was sufficiently well balanced to trade its way out, both through its prop desk and through making markets through agency trading. "Banks that lost out failed on the third point," explains Morris. "The price for liquidity and risk changed and if you’re slow to react, you get killed. It sounds easy, but it’s the biggest mistake a trading house can make. Once you’re off balance, you cannot provide liquidity."