Credit default swaps are a proven strategy that investors struggling to generate uncorrelated returns from fixed income markets should exploit, Cheyne Capital president and director of research Stuart Fiertz argued.

Fiertz said credit default swaps allow investors to capture credit risk premia with less volatility, better liquidity, and the potential to capture excess return.

“We’ve been managing credit default swaps for 15 years – it’s a tested strategy,” he said. “And the market has evolved to the point that we think it’s highly appropriate for the savings market down here in Australia.”

Fiertz made the comments at the 2017 Conexus Financial Absolute Returns Conference, in a keynote address titled, ‘Expecting credit premia via credit default swaps’.

He told the gathering of local investment specialists there is a strong case for Australian institutional asset owners to invest in credit default swap strategies. Credit risk premia is a “not yet fully appreciated, not fully exploited” area that many organisations still shy away from because there is not yet decades of academic research to support the strategy, Fiertz said.

He described credit default swaps as a “simple instrument” that allows investors to be “protection sellers”.

“We take the credit risk, we get paid a premium for that. And we only have to pay out [if there is] a credit event,” Fiertz explained. “It’s similar, in terms of downside risk, to investing in fixed income in a traditional sense, except you don’t have to put up the money in the first place to do it. And that gives you various advantages that allow you to easily use your collateral efficiently. Some might call that leverage, others might call it being efficient.”

Pre-GFC problems gone

Fiertz said the credit default swap market is more attractive today than it was prior to the global financial crisis (GFC) in 2008, since the standardisation of terms in the market in recent years has reduced layered counterparty risk.

“In today’s market, and this is a post-GFC development, we can trade credit default swaps as easily as equities. And when we close out a position, we close it out and [in effect] the contracts are torn up,” Fiertz said. “What happened pre GFC is that you ended up with mille-feuille 10 times over. You had a thousand different offsetting positions. And that’s when the GFC happened and people were worried about the layered counterparty risk. But that’s no longer a factor.”

He said that while near record low interest rates have flattened bonds, the “juice has not been squeezed out of” credit default swaps.

“I believe credit default swaps are the future of how credit is going to be traded and, indeed, how it’s trading today, and one of the reasons that’s the case is that credit default swaps act as a future,” Fiertz said.

He argued they are more liquid than their underlying corporate bonds.

Liquidity after Diesel Gate

“The liquidity in corn is not the bushel of corn in Kansas or the bushel of corn in Alberta, it’s the bushel of corn that trades [on the futures exchange] in Chicago. The same is the case with credit default swaps.”

As a real-life example of how this liquidity has been tested, he pointed to trading data following the revelation that Volkswagen had cheated on its emissions reporting.

“If we take a case like Diesel Gate, where VW got caught with its pants down, during the week that happened” there was significantly more trading in single-named credit default swaps than in cash bonds, Fiertz said.

“The liquidity in the corporate bond area or the corporate credit area is in the future and it shouldn’t come as a surprise, when you think of it as acting as a future. Nobody wants to trade with their limited capital at an investment bank via the Swiss franc-denominated VW bond, the Yen one, or the Euro-denominated one. They’d much rather trade the credit default swap.”

Fiertz said daily trading volumes in credit default swaps are already at about half those of the main US equity benchmark, the S&P 500.

“Daily volume in the CDS Index is 77 billion and it’s a little hard to see this lightening,” he said. “And what’s even more interesting now is the development of the credit option market, where you’ve got as much as 20 billion trading a day – a very healthy two-way market.”

Fiertz said investors in credit default swaps are being paid for four-and-a-half times the average risk and more than twice the tail risk.

“In my mind, that is a useful definition of excess return,” he said. “I’d much rather be in credit default swaps than cash bonds.”

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