Concerns about illiquidity in corporate debt trading are leading some money managers to look to credit derivatives as a way of swiftly moving in and out of their positions when the next downturn hits.
Mutual funds that specialize in hard-to-trade corporate debt say indexes tracking the performance of credit default swaps serve as a useful tool to deal with redemption requests during times when trading in corporate bonds is at a standstill. This comes as global financial regulators led by the Bank of England have flagged how funds holding illiquid assets could struggle to sell their holdings and potentially fan market panic during a selloff.
“What we have been doing in the last number of years is utilizing credit derivatives to gain credit exposure, in addition to the cash bonds we already own,” Michael Temple, head of corporate credit research at Amundi Pioneer, told MarketWatch. “The index derivative market is so much more liquid than cash bonds these days.”
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Trading in credit default swap indexes by notional value have increased since 2016, according to ISDA, the trade organization for derivatives[2]. The overall value of trading in the high-yield investment-grade credit default swap indexes rose by around 3% to 4% in the second-quarter of 2019 from the comparable period last year.
It’s unclear, however, how much of this activity is driven by market participants looking to manage liquidity in their portfolios.
Insurance or speculation?
Investors have traditionally used credit default swaps as a way to hedge against blowups in corporate bonds. Such derivatives can work as an insurance policy, increasing in value as the probability of a company defaulting...