VOLUMES AND LIQUIDITY in credit derivatives have grown at a rate that has pleasantly surprised even the market’s most dedicated supporters.The leading bank dealers couldn’t be happier. They say credit derivatives are revolutionizing corporate bond markets, bringing liquidity and two-way trading.
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Certainly the market has enabled these banks to manage their own credit exposures far more effectively – the purpose it was originally conceived for. But institutional investors in the corporate debt market have been slower to warm to the new instruments.
Those without access to credit derivatives were at a disadvantage in 2002’s harsh credit downturn and many investors are trying to level the playing field by gaining approval to use them. A few vocal corporate credit investors, though, have raised concerns about the credit default swaps (CDS) market’s effect on their returns, and are calling for tighter regulation.
Many asset managers are feeling irate after their experience over the past year in debt markets. Market-making commitments in corporate bonds have dropped as banks try to minimize inventory risk and conserve their capital. Particularly in volatile periods, trading gets concentrated in default swaps and often dries up dramatically for individual bond issues. For a bond fund manager, this can make unwinding a position extremely difficult at exactly the time he or she is most likely to want to do it.
David Hynes, head of fixed income, structured products, at Gartmore, is starting to wonder why he gives banks business at all. He says: “Liquidity in the cash bond market is dreadful. Banks are scaling back secondary positions to reduce capital usage in their fixed-income operations, so the levels of liquidity we’d become used to has dried up and it’s now harder to get trades done in the cash bond market.”
As derivative liquidity has grown, default swap spreads have come to be seen more and more as a leading indicator for bonds. But the younger market is still used by a comparatively small group of institutions, despite 2002’s growth. This makes price movements more violent. When widening default swap spreads drag secondary bond spreads after them, leading to downgrades and thus threatening companies’ ability to fund themselves, the results can be unfortunate for original buyers of bonds in the cash markets.
Bankers say this situation will improve as more participants come into credit derivatives and trading thereby becomes smoother. Mark Ames, head of European credit trading and CDOs at Lehman Brothers, admits: “The growth of the derivatives market probably has increased volatility in the cash markets, and you can see that as making things harder for some investors.
“On the other hand,” he says, “it also creates opportunities. At the moment the limited number of credit derivative market participants tends to make price movements in that market more exaggerated but this volatility will fall as more players come in.”
Buy-siders such as Hynes, though, think the growth of derivatives puts credit investors at a distinct disadvantage. They are not being properly compensated for their risk, or given enough information about it. “When a bank makes a loan, it gets much higher seniority and much closer access to information than a typical bond investor would have,” he says. “It can then sell the risk on to us, usually through a credit default swap or balance sheet CDO, while keeping its relationship and privileged access to information.”
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Frost: “the visibility CDS bring may |
Relaxed view There have been bond deals – and syndicated loans – in the run-up to which certain banks were informally accused of counterproductive front-running activities in default swaps (see Euromoney November 2002, page 98). If traders get hold of information, they are likely to use it. Obvious examples are rare, though. These trades could be intentional attempts to front-run an issuer. Or they could be innocuous portfolio trades.
Philip Hunt, head of credit strategy at F&C Management, takes a fairly relaxed view of the matter. He says: “If someone did have insider information, credit derivatives could certainly let them act on it more quickly and easily than would once have been the case. But the issue isn’t a new one – it just highlights all the different relationships banks have. Perhaps Chinese walls are never going to be 100% effective, but I haven’t been feeling any great need for more regulation.”
US and UK regulators agree for the moment. They’re relieved that the big banks have withstood the credit downturn with no failures, partly thanks to credit derivatives. Some that were initially suspicious are coming round to the market. The French regulator recently gave broad permission for fund managers to use credit derivatives.
Tim Frost, head of European credit trading at JPMorgan, argues that default swaps have acquired a level of liquidity that has never been available in cash. He says: “It used to be that trading stopped when spreads reached a certain point. The visibility the CDS market brings to weak credits is inconvenient for some credit funds – some may prefer things to be a little less obvious.”
The objections being raised by the buy side go further than this, though. Chris Dialynas, managing director and portfolio manager at Pimco, asked more radical questions about the effects credit derivatives are having on cash markets and the wider economy in a note the US bond fund manager released towards the end of last year.
He remains concerned about potential conflicts of interest at banks, mostly involving the abuse of inside information gained through a lending relationship.
For instance, a bank could hypothetically loan a company $1 billion then use information gained from the loan relationship to hedge this exposure. This will push out secondary spreads. Apart from the questions raised about how far this undermines the benefit to corporates of cheap relationship loans, there is also the possibility of the bank buying more protection than it has loan exposure. Shorting the credit might enable a bank to profit from inside information on the true seriousness of a borrower’s credit deterioration and even give it a covert and potentially damaging incentive to drive the borrower into default.
Dialynas accepts that this is an extreme example. But he stands by the point. “Commercial banks,” he says, “will all say they’d never consider jeopardizing their client relationships in this way, but if that’s so there should be no reason for them to resist having their books examined. They should be inviting the SEC and the Fed to come in and retroactively check what they and any affiliated subsidiaries have been doing in credit derivatives over the last couple of years. The fact they don’t want this suggests to me that they may have something to hide.”
And on a wider level he thinks the ease of shorting credit the market now offers is undermining the Federal Reserve’s efforts to reinvigorate the US economy.
He argues: “The Fed is providing liquidity to banks because it wants to expand credit to stimulate the economy. But credit derivatives let them abuse their special licence and oppose what the Fed is trying to do. As credit spreads get pushed out in cash bonds via the default swap market, and more names start trading on a dollar basis, the result is a credit contraction that affects issuers’ ability to fund themselves. It’s a bad situation both for bond investors and for the global economy.”
Other investors agree that important issues underlie Dialynas’s concerns but many also think he’s going a little far in his assumption that banks are out to drive their corporate clients to ruin. Hynes at Gartmore says: “The potential is there but I’d be very surprised if banks were actually doing this kind of thing on a systematic basis. If investors thought one was, we would all stop buying anything from them, regulators would come down hard, and there would be huge damage to that bank’s reputation.”
Bankers, of course, agree. Eric Oberg, head of the US specialist sales and marketing team for credit derivatives at Goldman Sachs, points out: “Banks have been active on both sides of the market, both hedging and taking credit risk.” He adds: “Most of the protection buyers have been hedgers rather than speculators.” Likewise, Frost at JPMorgan, says that dark suspicions of the market as a hive of destructive shorting activity are unfair.
“Credit default swaps have given the market much greater liquidity,” he says. “That attracts participants with more aggressive trading styles. Perhaps this may have contributed to volatility in the cash markets but that seems like a minuscule factor in the context of where we are in the credit cycle.
“The fact that there have been more bankruptcies this year than ever before is a far more significant factor in explaining credit spread widening. Credit derivatives make it easier to go long or short, and, from what I can see, as many people have been making money from long positions as short ones.”
Perhaps unsurprisingly, then, few on the sell side think more oversight of the market is needed. Frost says: “Certainly good regulation is important but we took great heart from the Fed’s response to Pimco – that these issues are worth discussing but that equally credit derivatives are important for the market’s stability.”
Others argue that activities that are outright fraudulent will be uncommon but can never be entirely prevented. One head of a credit trading desk says: “The possibility of investment banks front-running deals is a potential issue, but it’s not a new one. The CDS market lets you short a credit more easily than before and unscrupulous people will always be able to take advantage of inside information. Certain traditional long-only funds have had their competitive advantage eroded by the CDS market’s greater flexibility and efficiency, and some of their complaints may be sour grapes.”
Commercial banks, unsurprisingly, say their Chinese walls between traders and loan originators are working fine.
Dialynas at Pimco isn’t satisfied with these assurances, though, and would ideally like regulators to start going through banks’ trading books looking for anomalies.
At the very least, he says, every corporate treasurer should make all their relationship banks disclose to him or her exactly what their positions are on that credit in default swaps. He thinks that even if nobody deliberately tries to misuse inside information, without greater regulatory oversight the possibility of this information finding its way into the wrong hands is still there simply because of the combination of commercial banking with trading and market-making.
Matt King, European credit strategist at JPMorgan, thinks there are far more basic reasons than market abuse for the miserable year much of the buy side has had. He argues that far from calling for a market clampdown, bond investors would be better advised to win approvals to enter it.
He says: “Many asset managers I’ve met recently have sought my assistance to help them get permission from their boards to use credit default swaps – it’s the only way they can put their risk where they have the most skill. Almost all of them have been losing money. Perhaps some of them could have been better diversified but the more I look at it the more I think it’s not entirely their fault.”
For European investors at least, joining the market may provide the best chance of shoring up returns.
King believes that in markets like last year’s, not being able to use credit derivatives, whether in tranched risk CDOs or credit default swaps, makes it very difficult indeed to make acceptable returns. He says: “Credit is different – it isn’t like equities or governments. The risk distribution is asymmetric, since credit managers have limited upside and big potential downside. So at the moment a whole year’s returns can get wiped out by a single blow-up.”
Spotting trouble
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King: “At the moment |
All they can do is not own that name, and the returns from doing this are small. And it is hard to make a credit portfolio that is sufficiently diversified to replicate the performance of the market as a whole.
Avoiding 2002’s 20 worst-performing credits would have resulted in outperformance of about 20 basis points. Being hit by just one of them would likely have lost more than twice that. King’s colleague, Frost, makes the same point: “It’s hard for fund managers to perform well while they can only buy or not buy bonds. They may manage to outperform the index but if the whole market’s in a downturn the returns will still be unimpressive.”
For many investors, particularly in certain markets such as the UK and for public funds, gaining access to default swaps and structured credit derivatives is a fairly complex process involving persuading trustees, board members and consultants to accept largely unfamiliar and vaguely suspicious new instruments.
Trustees’ understanding of credit markets leaves something to be desired. One European asset manager complains that a client asked him to manage his fund’s credit exposure by only keeping 20 names in the portfolio so as to avoid blow-ups. Perhaps a lesson in the benefits of diversification might be in order.
But for many fund managers themselves, the transition is less of a problem. Buy-side analysts try to spot problem credits anyway, and these recommendations would be much easier to act on in liquid credit swap markets.
Some are starting off by using basket products such as JPMorgan’s Jeci or Morgan Stanley’s Tracers, both of which provide a liquid way to go long or short a representative basket of default swaps.
Others can use credit-linked notes – default swaps wrapped in bond form – and hope to use these to lead into outright derivative trades. And others still are either setting up dummy portfolios to show their bosses how much better returns can be with access to CDS.
If you can’t beat ’em… If some clients agree and others don’t, one option for credit fund managers is to move the first group’s funds into a separate, more hedge fund-like vehicle. If the shift helps returns as much as many think it will, the hold-outs may change their minds when they see how much the other fund has outperformed theirs.
Hynes says Gartmore has bought a certain amount of credit protection but wants to move into the market a lot more in 2003. He says getting trustees onside takes a while but that once they understand the market they tend to be enthusiastic. Another European asset manager says he has been pushing to move quickly into credit derivatives. “We’re finally getting somewhere” he says. “We hope to gain the ability to use default swaps early next year.
“This won’t affect my views on the market but it will make them much easier to act on – there’s nothing more frustrating than spotting a great trade that you know you won’t be able to do because the cash market’s too illiquid.”
Bid-offer spreads are not necessarily tighter than in cash, though bankers expect them to come in over the year. But it is usually much easier to find a tradeable price in derivatives. Ames at Lehman Brothers expects bond investors to move increasingly quickly into the market. He says: “Most accounts on the total return side say they’d like to use credit derivatives, and many are in the process of getting permission to do so.”
These investors aren’t going to start acting like hedge funds overnight. Many will probably start by using default swaps to take up long positions more quickly, easily and often more profitably than the cash market would allow. Many may end up with a core cash bond portfolio, around which they trade default swaps to respond to market events or make changes in strategic view. A fund benchmarked against an index, for example, might hold a cash portfolio weighted to represent that index exactly but then use CDS to overweight or underweight specific names.
Positions created this way will be far easier to unwind in a month or two than switches done in the cash market. Ames at Lehman Brothers says: “Many of these accounts will probably still be long only but they’ll use credit default swaps for some of these positions – often much higher returns are available for the same credit risk.”
As this process goes on, it may get harder to distinguish asset managers from hedge funds as both trade market movements more aggressively.
Not all fund managers seem to be moving in this direction, though. Hunt at F&C doesn’t intend to use default swaps at any point soon.
He says: “Credit derivatives are great in concept, and are obviously wonderful for the rocket scientists at investment banks who create and trade them. They can extract much bigger margins than in debt or equity, because the product is more opaque. But it doesn’t really fall within what we’re looking to do. We’d expect the buy side to manage their portfolio’s risk and diversification without resorting to derivatives – on the whole, they’re better business for investment banks.”
The buy side remains divided.
Dialynas at Pimco maintains that the market at present raises real dangers for the economy at large as well as for bond investors. He acknowledges that in the longer term the instrument is a potentially useful one, enabling more efficient and precise transfer of risk for those with legitimate needs, such as convertible arbitrageurs or banks trying to manage their loan books. But he also thinks some banks have probably been taking advantage of their privileged access to credit-sensitive information.
He says that since his paper came out, spreads have come in rapidly as many traders sold credit protection. This could just be a coincidence, caused by the Fed’s latest rate cut. Or, he says, it could represent the unwinding of the kind of improper trades he warns of. “The point is we don’t know if this is happening or not,” he says. “As an educated guess, I’d say it probably is, although it’s probably not being done by loan officers themselves. There are really no public officials monitoring this vitally important market to tell us what’s going on.”
The sort of shock this kind of discovery would cause if made public would be far from healthy with markets this nervous. He says: “The dilemma is that, because many pension funds out there are close to being underfunded, the stock market itself forms a big part of the creditworthiness of many US companies. Policymakers need to be very careful of how their actions affect equities.
“If someone really investigated these questions, I suspect they’d find a whole lot there. But if this happened now the stock markets would fall, and so even if in theory it’s the right thing to do the outcome could be very, very bad. So we probably need a more gradual process. But certainly if the penalty function was tough enough, the temptation would go away very quickly.”
