As defined benefit (DB) pension schemes mature, their need to invest in bonds is increasing. This reflects both their decreasing risk appetite and the influence of regulation. At the same time, the fixed-income markets themselves have changed in recent years owing to the impact of changing regulation and quantitative easing (QE) programmes after the global financial crisis. Banks are trading less, with the result that the bond markets have become less liquid.
- DB pension funds could benefit from synthetic credit exposures provided by credit default swap (CDS) indices
- CDS indices typically offer a lower yield than physical credit but the difference is low at present
The upshot of all this is that it has become more difficult for institutional investors to source liquidity in the fixed-income markets and execute large bond trades. Against this challenging backdrop, pension funds are having to think carefully about how they can identify and access the most liquid and cost-efficient credit vehicles.
Pension schemes have a wide range of possibilities available to them in the credit markets. They typically use physical bond instruments, mutual funds and exchange-traded funds (ETFs). However, it is best that they broaden their horizons and consider synthetic credit exposures provided by credit default swap (CDS) indices. These vehicles provide a range of benefits, but this article will concentrate on cost, and discuss research we have conducted that shows that in some cases they can be more cost-efficient than physical bonds.
CDS indices: basics and benefits
CDS indices are standalone contracts that provide investors with liquid, standardised synthetic exposure to the corporate bonds of a defined set of companies. They are usually equally weighted baskets of single-name credit default swaps.
Investors can take long and short positions in CDS indices, which equate to selling and buying protection respectively. The volumes of CDS indices being traded have grown steadily over the years, and they are now well established as liquid sources of credit exposure.
CDS indices have several benefits:
• They represent a simple, cost-effective tool with which to adjust duration, hedge credit exposure or gain exposure to a particular region, rating or sector;
• They provide broad exposure to credit, which makes them an ideal tool to implement cross-asset views;
• They are typically unfunded, which enables investors to take leveraged exposure to credit;
• They often trade at attractive bid-ask spreads;• One of the main benefits of CDS indices is that transaction costs are always low, regardless of the trade size.
CDS indices typically offer a lower yield than physical credit but the difference is low at present. The basis – the difference in spread between CDS and physical bonds – arises from a combination of factors such as accrued coupon, CDS premia, funding costs and the protection level of CDS contracts. Market factors such as supply and demand, and the liquidity premium also have an impact.
Our study conducted a total-cost-of-ownership (TCO) analysis to determine the costs of holding physical bonds and CDS indices over different timeframes. TCO analysis considers costs throughout the entire lifespan of an investment – not just buying the securities, but also the costs of holding them and selling them.
The costs associated with trading and holding cash bonds and CDS indices are different. To enable us to draw a like-for-like comparison between these two kinds of vehicle, we add interest-rate risk to the synthetic position by investing in underlying Gilts that match the duration of the physical bonds.
“Research we have conducted shows that in some cases they can be more cost-efficient than physical bonds”
The analysis modelled a 50/50 US and Europe investment-grade credit exposure of £100m with holding periods of up to five years.
For the synthetic position, the credit exposure consisted of a £25m 50/50 CDX and iTraxx position with 4x leverage. It was supplemented with a position in Gilts to match the physical bonds’ interest-rate duration.
For the physical position, the analysis took into account the costs of investing £100m in two kinds of physical investment vehicle – ETFs and passive bond index funds. Both the ETFs and passive funds provide a 50/50 exposure to US and European investment-grade credit.
The figure shows the results of the findings.
It is apparent that for a holding period of six months to two years, CDS indices are the most TCO-efficient way of accessing the credit markets. Assuming it is traded on the secondary market, the ETF becomes the most TCO-efficient credit vehicle over longer holding periods. The passive bond fund has much the highest TCO over all the timeframes we consider.
The analysis above is based on the assumption that the ETF is traded on the secondary market, where the lowest transaction costs are to be found. However, sometimes it is not possible for big pension schemes making large trades to use the secondary ETF market, as the trades they make are in excess of the market’s average daily volume. In such cases, they have to turn to the primary market, where it can be much more expensive to trade (although to complicate matters, it is sometimes possible to trade ETFs cheaply on the primary markets, so an ETF can still be the cheapest option over longer timeframes).
It depends on individual circumstances, but using CDS and Gilts to gain access to the credit markets might be the cheapest option for large schemes. This applies not just for holding periods of six months to two years but over longer periods too. So pension schemes should at least consider this as a possibility. One of the main benefits of CDS indices is that transaction costs are always low, regardless of the trade size.
It is important to point out that while this article has considered the possible cost benefits of investing in CDS indices, pension schemes need to take into account a wide range of other factors when deciding how to access the credit markets. That is because CDS indices and standard credit indices have, for example, quite different exposures in terms of their sector, rating and country allocations.
Interesting points to note are that CDS indices tend to have a much lower weight in banks and higher weights in BBB-rated bonds.
If a scheme has a particular benchmark it needs to follow, a CDS index may not be an appropriate option. The research outlined in this article stemmed from a desire to find cost-efficient exposure to European and US investment-grade credit to complement UK pension scheme clients’ core allocations to sterling-denominated credit, so it was more concerned with maximising yield and minimising costs than tracking a particular benchmark. This may not be the case for all investors.
CDS indices’ potential to provide investors with low-cost access to the credit markets means they have a number of possible uses for pension schemes in addition to acting as a core credit allocation. As they are highly liquid, they can replace a portion of a scheme’s cash holdings to boost its return potential. They can act as a complement to a core credit portfolio, and they may also have a role to play as part of a liability-driven investment (LDI) strategy as they can enhance returns in a hedging portfolio when used with leverage.
Maya Beyhan is an investment strategist at Kempen