Swapping bonds for CDSs

The debate over a downturn in the corporate bond market has moved from ‘if’ to ‘when’. The macro economic backdrop of higher inflation and rising interest rates, plus historically low spreads over government bonds are conspiring to form a grim outlook for the market.

Credit Default Swaps (CDSs) are being hailed by some as the solution. Allowable under the UCITS III rules, their supporters claim that they can hedge risk, help manage liquidity and, most importantly, make money in a falling market. Their detractors say that too much is being claimed for these instruments and they are not a catch-all solution to the problems of the corporate bond market. Who is right?

CDSs act like insurance transactions. One party buys protection on a company, paying a fixed coupon for the life of the agreement for that protection. The other party sells protection, so makes no payments unless a credit event (usually a default or liquidation) occurs, in which case he will make a payment to the first party.

Retail corporate bond fund managers are using these in a number of ways. Simon Surtees, co-head of fixed income at Gartmore, says they use CDSs in four ways across their range of funds: Initially, they would buy protection to reduce risk. If there was a concern over a company, instead of selling the bond (which might be illiquid), they could buy protection. They are most likely to do this to lay off general credit risk by buying a basket of CDSs rather than having to find buyers for a number of bonds and possibly moving the market.

Alternatively, they could buy protection to target a company they believe will go bust. That way, they benefit as the spread widens. This is how they could make money in a falling market. Thirdly, they could sell protection to alter the duration of a bond. If a bond was only available with a 15-year duration, for example, they could synthetically create a 5-year bond through CDSs. The final reason would be to employ some credit leverage. Surtees believes CDSs help him better manage risk either at the individual issuer level, the sector level or the market index level.

L&G is another big supporter and its new Dynamic Bond Trust employs CDSs. Richard Hodges, manager of the new fund, says that it inverts the naturally asymmetric risk in bonds, whereby the upside is the coupon and the downside can go to zero.

But CDSs do have some notable detractors. James Foster, manager of the Artemis Strategic Bond fund, says: “They are a good hedging tool because they are extremely liquid. But for the most part, if you want to avoid a company going bust, the best thing to do is not to own the bond. You can make money out of companies going bust with CDSs, but what does it cost you? The price of a bond is made up of the government bond yield plus a spread. If you buy a CDS it costs you the extra spread, so you get the equivalent of a government bond.”

Foster believes there are some issues around the deliverability of CDS contracts. He also thinks running short of the coupon – which a manager would do if he was selling protection – is a dangerous game when most bond investors are there for yield.

Foster concludes: “It is a help extra tool for bond fund managers, but it’s not a cure for cancer.” As with many of the new derivatives instruments allowable under UCITS III, CDSs can be useful and profitable in the right hands. But in the wrong hands, they can increase the risk. Any downturn in the corporate bond market will expose a manager either way.

1 June