Investors are reviving credit derivatives trades they used to boost returns before the financial crisis as unprecedented central bank liquidity drives down yields and default rates.
Investors accumulated 47 contracts insuring a net $461.6 million of debt on so-called tranches of the current series of the Markit iTraxx Europe Index of credit-default swaps since trading started April 3, according to the Depository Trust & Clearing Corp. Tranche trading allows investors to make concentrated bets on a pool of companies with varying risks and returns.
The strategy was widely used by investors before the U.S. housing crash and contributed to a $6.2 billion loss at JPMorgan Chase & Co. after wrong-way wagers by dealers including Bruno Iksil, nicknamed the London Whale. Trades are now being buoyed by the European Central Bank’s pledge last year to protect debt markets.
“The ECB backstop along with high liquidity provided by central banks globally should promote risk taking and entice market participants to search for yield through standardized tranche products,”said Ioannis Angelakis, a credit derivatives strategist at Bank of America Merrill Lynch in London. “It’s encouraging seeing traction from the very first couple of weeks.”
Pricing Haywire
The financial crisis sent complex mathematical pricing models for tranches haywire, causing large market losses even without defaults. Because prices at the time were so low, small changes generated big differences in the market value of the trades. The index now costs 111 basis points, compared with a record low 20 basis points in June 2007 and all-time high of 217 in December 2008.
With yields on corporate bonds now at record lows worldwide, credit traders are being tempted back to the products, which pay as much as 10 percent. The average yield on notes in Bank of America Merrill Lynch’s Global Corporate & High Yield Index fell to a record 3.19 percent April 18.
The global speculative-grade default rate is forecast to end this year at 2.8 percent, compared with an average of 4.7 percent since 1983, Moody’s Investors Service said April 8.
“It’s a sign of a bullish market,” said Paola Lamedica, an analyst at BNP Paribas SA in London. “The environment is very conducive to yield-enhancing strategies. There is a need to find yield somewhere.”
Safer Environment
The safer environment triggered by the ECB has caused most trades to be in the so-called equity tranche of the credit- default swap index. That slice pays the highest yield because it is the first to absorb losses; the super-senior portion has the lowest yield and is the last to take losses.
Equity tranches on some indexes provide about 10 percent returns, according to Citigroup Inc. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.
“In Europe, we think buying tranches is preferable to moving down in quality, and is much better than buying peripherals,” said Abel Elizalde, a strategist at Citigroup in London. “A growing number of real money and hedge fund investors are coming to the same conclusion.”
Tranches on the current series of the European index linked to 125 companies started trading alongside portions of the equivalent U.S. measure, which have been active since September. Both are tied to the 19th series of their respective benchmarks.
U.S. Trading
There are 264 tranche contracts protecting $1.6 billion of bonds on the Markit CDX North America Investment-Grade Index and a total of $306.5 billion outstanding across all series of indexes.
JPMorgan’s losing bets were mostly on the ninth series which was created in 2008 and is still the most liquid. New indexes are created, or rolled, every six months when companies are added or dropped depending on their ratings, cost of protection and ease of trading.
“Market-makers are making another attempt to roll tranches,” Morgan Stanley analysts led by Phanikiran Naraparaju in London wrote in a note to investors. “Tranches remain one of the most attractive ways of achieving high-yield-like returns in a low-yield world.”
Notional Contracts
There’s $79 billion of notional contracts outstanding on the ninth series in Europe and $35.8 billion on the same version in the U.S., according to DTCC, which runs a central registry for the market. Those volumes don’t necessarily reflect the amount at risk because they don’t account for differences in leverage, traders said.
The new version offers a complement and replacement to that series, according to analysts at Bank of America, BNP Paribas, Citigroup and Morgan Stanley. The current portfolio has fewer distressed and peripheral companies, and new rules have made it easier to trade different series against one another.
“Investors that are looking for spread are definitely looking more to the derivatives space,” said Citigroup’s Elizalde. “Investors want to get into something which they can trade in a relatively liquid manner -- something that’s more liquid than cash bonds, which pays a higher spread and doesn’t have long maturities.”
