Don’t write off CDS just yet
Despite the knocking credit default swaps have received because of the credit crisis, David White finds they can still offer a useful hedge against risk
O ne of the effects of the credit crunch has been the demonisation of credit derivatives. The bankruptcy of Lehman Brothers, a leading player in the credit default swaps market, seemed to bear out Warren Buffett's 2003 warning that credit derivatives are "financial weapons of mass destruction that could harm the whole economic system".
This view has some heavyweight backing. In a recent report on the global financial crisis for the OECD, the OECD secretary-general Angel Gurría placed at least some of the blame on "ex-ante ignorance and ex-post uncertainty on the risk features of mortgage-based securities, related derivatives and credit default swaps".
Yet until recently credit default swaps (CDS) were perceived as a useful tool of active portfolio management for institutional investors, including pension funds. The primary role of a credit default swap is to insure against ‘event' risk - that is the risk of bankruptcy or any other reason for a corporate default.
Rather than weapons of destruction, they could be seen as instruments of protection. Lars Nyberg, deputy governor of Sweden's Riksbank, recently characterised CDS as "essentially insurances, neither simpler nor more complicated than a normal home insurance".
As well as providing protection, CDSs allowed institutional investors to broaden and customise their exposure to corporate credit. They provided investors with access to maturity exposures and credit risk that was not available in the cash market because of the shortage of underlying bonds. They also enabled them to invest in foreign credits without currency risk.
So will the CDS market roll up as quickly as it rolled out? In particular, will pension funds shy away from CDSs in future?
It could be argued that the CDS market has become indispensable to investors like pension funds. The market was originally created to enable banks to move credit risk off their balance sheet and free up capital. It allowed banks to shift their credit exposures to institutional investors which had liability structures and investment horizons better suited to these risks - typically insurance companies, mutual funds, and pension funds.
There are two ways pension funds can operate in the CDS market - as buyers or sellers, or sellers of protection. Increasingly, pension funds have become sellers, selling protection to other corporate bond holders, and taking on the credit risk in those bonds in exchange for a regular
One advantage of this strategy is that pension funds are no longer exposed to currency and interest rate risk, as they would have been if they had bought the cash bonds.
Credit derivatives surveys carried out by the British Bankers' Association in 2006 and based on responses from the main players in the market show that pension funds are principally sellers of protection, with 4% of the protection sellers' market. This is partly because many European pension funds are unable to hold or trade credit default swaps. In some cases this is as a result of direct regulatory prohibition, as in Germany, or because of the lack of a corporate bond market, as in Sweden.
The funds' role as buyers of protection has declined, however, with 3% of the protection buyers' market in 2004 and 2% in 2006.
Nick Horsfall, senior investment consultant at Watson Wyatt, agrees that most UK pension funds that participate in the CDS market are sellers of credit protection. "The vast majority of CDSs are being used to generate credit risk and therefore extra return. Pension funds are writing protection on CDSs and receiving a premium for doing that. The rest are using CDSs to hedge bond positions - going long a cash corporate bond and hedging that risk with CDSs.
"There are also a small number of CDS products whereby pension funds are effectively playing the long cash corporate bond, and short CDS to hedge the risk away and generate extra return by playing the difference between cash and synthetic credit."
Whether European pension funds use CDSs depends largely on whether they are big enough to manage their own money. Smaller funds' exposure to CDSs is likely to be indirect, through wider investment powers trustees or pension fund boards give to their fixed income managers.
Among the largest pension managers, APG - owned by the Dutch pension fund for civil servants - uses CDSs to increase or reduce credit exposure and to benefit from differences in yield between cash bonds and CDSs.
CDSs are also useful for moving down the yield curve. PGB, the industry-wide pension fund for Holland's printing and media sector, uses CDSs to gain greater exposure to the high yield credit market.
The growing interest in liability-driven investment (LDI) strategies has also encouraged pension funds to use CDSs. The Philips Pension Fund in the UK, which recently moved to a LDI strategy, is using a credit default swap overlay to hedge risk in its liabilities.
One possible use of CDS by corporate pension funds is to hedge against the possibility of a default by their own corporate sponsor. In theory, a CDS could be part of a pension fund's recovery plan or return to full funding. Yet there are few, if any, instances of CDS used in this way.
There are broadly two types of CDS which pension funds can buy or sell - single name CDSs and multi-name or index CDSs. Before 2004, most CDSs were written on single names. Since then most of the growth has been in index CDS. These offer protection on all the components of ether the CDX index, made up of 125 US investment grade bonds, or the iTraxx index, made up of 125 European bonds, mainly investment grade. Figures from the Bank for International Settlements (BIS) show that, at the end of 2007, the growth in the amounts of index CDS (40%) outpaced that in single name contracts (33%).
Pension funds are likely to continue to use ‘plain vanilla' single name or index CDS, even after the credit crunch, says Horsfall. "We still think they are good and transparent instruments, and we'd like to think that our client base will continue to use them. They will take the logical view that this is the same economic risk as cash bonds," he says.
Structured finance specialists also expect some retreat in the credit derivatives market, although this aversion likely to trades in the more complex instruments, notably collateralised debt obligations (CDO) and asset-backed securities (ABS).
Dominique Carrel-Billiard, CEO of AXA Investment Managers, which traded the first credit default swap in 1997, says credit derivatives have delivered what they promised to investors. "Like other investors, AXA was looking for the return which those products offered. And when you look at the track record of those products for the first years of their existence - over seven or eight years - they were, effectively, providing good and very stable returns."
Yet, for the time being, the credit crunch has scared off investors from CDOs and ABSs. "The run on these instruments has been enormous, and for a time people were avoiding anything with three capital letters," continues Carrel-Billiard.
"Whether they will return to favour eventually is as yet unclear, but there is no reason to throw out the baby with the bathwater. Hedging is a fundamental need of institutional investors, and we will need to keep hedging techniques.
"What is certain is that for an interim period people will go back to basics - simple, easy to understand products."
In future, issues such as liquidity and counterparty risk will deserve more attention, he says. "Liquidity risks and counterparty risk were vastly underrated in the previous framework. Measuring the liquidity risk and counterparty risk in any investments will become part of the economic equation that people use to assess risk/return trade offs."
The CDS market is as only as safe as its counterparties. The drawback of an over the counter (OTC) CDS contract between two parties is that it introduces counterparty risk.
Counterparty risk has so far not been a problem. Robert Pickel, the chief executive of the International Swaps and Derivatives Association, points out that the Lehman Brothers default and settlement did not create the financial disruption that critics of the CDS business have claimed.
This was largely because the CDS trades outstanding on Lehman Brothers included a large number of transactions that offset each other. As a result, settlement payments were only 1% to 2% of the $400bn of CDS trades referencing Lehman.
"Despite the failure of Lehman, the CDS business continues to function effectively. CDS contracts have been consistently more liquid than their cash market equivalents," Pickel says.
Yet regulators in the US and EU are working on proposals to bring CDS into line with futures. This means that they are likely to be traded on exchanges and that traders will have to meet capital requirements and margin restrictions.
One of the advantages of an exchange-traded CDS market is that many more users can use exchange traded products than OTC products.