With the Federal Reserve weighing the prospects of lifting interest rates from their recent low levels, many bond market observers, including Janet Yellen, are predicting that bond yields could seesaw violently when the tightening begins.
Because of this, institutional investors and banks around the world are increasingly looking at ways to avoid volatility when interest rates begin to rise. It is in this environment that investors in a number of markets are looking at increasing their exposure to single name credit default swaps (CDS).
CDS are derivative instruments that tracks the risk of default by a company that has sold a corporate bond and are designed to transfer the credit exposure of the bond between the buyer and the seller of the CDS. The purchaser of the CDS makes payments up until the maturity date, these payments being made to the seller. In return, the seller agrees to pay off a third party debt if this party defaults on the loan.
CDS were very popular before the GFC but have been out of favour since then because they were seen as one of the many ‘misunderstood’ derivative instruments that helped inflate the credit bubble that in turn helped feed the crisis: it is easy for people to make mistakes in financial dealings if they do not fully understand what they bought, how it works and how risky it is.
One of the issues faced by the CDS industry in the pre-GFC days was that they were traded on a bilateral market that was opaque and lacking in transparency. In the USA at present market players are increasingly looking towards developing a centrally cleared market that would make trading much easier for all concerned. In the light of this, the volume of new clients signing up to clear trades at the biggest credit derivatives clearing houses in the USA has boomed since January of this year.
The appeal of CDS is explained in large part because they have the added attraction that they can offer money managers exposure to a particular company even if the manager cannot get hold of the primary issued paper itself because it is in short supply or in great demand. Single name CDS can offer money managers an alternative way of accessing credit exposure to a corporate that the corporate bond market cannot guarantee.
The post-GFC revival of the CDS market is predicated on the lowering of capital costs for banks entering the market. Part of this shift can be achieved by moving trades into a clearing house but the other key element will require a significant pick up in trading volumes in order to make the CDS space cost effective for all concerned. Since the GFC, the number of CDS traded on individual companies has fallen by two thirds since their peak seen in 2008, according to data from the Bank for International Settlements.