As markets plunge globally, investors are seeking refuge in an all-but-forgotten place.
Trading volumes in the credit-default swaps market - where banks and fund managers go to hedge against losses on corporate and government debt -have surged. Transactions tied to individual entities doubled in the four weeks ended February 5 to a daily average of $12bn, according to a JPMorgan Chase & Co analysis of trade repository data. The volume of contracts on benchmark indexes in the market increased two-fold during that period to an average of $87bn a day.
The growth could represent a shift. The credit derivatives market has contracted for almost a decade, after loose monetary policies triggered a big rally in assets including corporate bonds, which made investors less eager to protect against the worst.
Regulators have also urged banks to curb their risk taking, reducing the appetite for at least some dealers to trade the instruments. Now, stock markets are selling off and junk bond prices are plunging, increasing investor demand for protection.
“The surge we’ve seen in trading is likely to stay with us for the foreseeable future,” said Geraud Charpin, a portfolio manager at BlueBay Asset Management in London, which oversees $58bn and has traded more credit-default swaps on individual credits in the past three months. “The credit cycle has turned, so there’s more appetite to go short and buy protection.”
Risk measures fell on Friday after soaring last week to the highest levels since at least 2012 in the US, and 2013 in Europe. The cost of insuring Deutsche Bank’s subordinated debt dropped from a record after the German lender said it planned to buy back about $5.4bn of bonds to allay investor concerns about its finances. The bank’s shares have lost about a third of their value this year.
Credit derivatives were one of the fastest-growing businesses for securities firms before the 2008 financial crisis claimed Lehman Brothers Holdings, which was a major dealer in the market.
The derivatives fell out of favour as regulators blamed them for exacerbating the financial and sovereign debt crises. The US government had to bail out American International Group in part because of its massive credit derivatives positions on securities linked to real estate.
Deutsche Bank and other dealers stopped trading all but the most liquid indexes because tougher capital requirements made it too costly. Investors also pulled back after loose central bank monetary policy globally helped suppress default rates.
The total size of the credit derivatives market - as measured by the face value of debt protected against default - collapsed to $12.8tn from more than $33tn in 2008, according to the Depository Trust & Clearing Corp.
The increase in trading over the past month on individual entities was the most since May 2014, while index volumes rose by the most in about a year, according to JPMorgan’s analysis of DTCC data.
“Credit-default swaps are a bear product,” said Soren Willemann, head of European credit strategy at Barclays in London. “When the market is volatile, that’s when they come into fruition. If you want to take a short view, credit derivatives are the place to go.”
The Markit iTraxx Europe Senior Financial Index rose to the highest since 2013 this week, according to data compiled by Bloomberg. Credit-default swaps on Deutsche Bank’s senior debt, the worst performing in the measure this year, reached a more than four-year high of 271 basis points on Thursday. Net wagers on the German lender jumped $180mn in the week through Feb. 5, the third biggest increase among non- sovereign entities tracked by DTCC, following a $358mn rise in bets on Barclays, the biggest.
“There has been reduced interest in CDS until now,” said Louis Gargour, chief investment officer of London-based LNG Capital, an alternative investment-management firm. “The banking sector is weakening, the commodities sector is weakening and the likelihood of bankruptcy is increasing for a number of different companies. Deutsche Bank is the latest example of investors rushing to hedge.”
Trading was picking up even before the latest bout of volatility as investors sought to protect against individual shocks. Credit-default swaps are easier to buy and sell than corporate bonds.