Credit derivatives were once the domain of banks and hedge funds with an appetite for exotic deals. Now the fast money is giving way to traditional asset managers with simpler tastes. Goldman Sachs adapted to this change by restructuring its credit derivatives business, with the payoff coming in the form of popular new products and some record-breaking trades.
“The biggest change we’ve seen is really the growth of money managers, and the different ways we can service that client base,” says Jason Brauth, co-head of US leveraged finance trading, and head of US investment grade and US index trading at Goldman Sachs in New York.
In October, the firm was the first dealer to begin trading total return swaps (TRS) linked to banks’ additional Tier 1 (AT1) bonds, which convert to equity or are written off entirely when the issuer’s capital ratio slips below regulatory minimums.
The TRS on AT1s, which ranked among the best-performing credit investments of the year, were met with an enthusiastic response from investors on the long and short side. Luca Lombardi, head of European credit and mortgage trading at Goldman Sachs in London, says they could be the first in a series of total return swaps that provide exposure to specific subsectors of the bond market.
“Our aim was to create a liquid product that can be tailored to meet the needs of clients that may not want take a view on the whole market, but just a subsector of it, without having to execute individual bonds or credit default swaps (CDSs) one at a time. The TRS product generates efficiency savings for clients,” he says.
The foundations for the TRS on AT1s and several other recent initiatives were laid four years ago, when Goldman established a ‘macro credit’ desk to trade CDS indexes, tranches and options alongside TRS and exchange-traded funds. The aim was to minimise trading costs, while making it easier for clients to access a broad suite of products for hedging and risk management.
“Our view was that if we were able to do those things, it would drive more market share to Goldman Sachs,” Brauth says.
The restructuring has delivered a number of benefits for Goldman’s clients – especially asset managers. “The macro business allows clients to look across different products to find relative value,” Brauth says. “For instance, when exchange-traded funds are trading rich or cheap versus TRSs, we see large asset managers going back and forth between the two to optimise value. That’s an example of the kind of trades we’re doing with clients on a large scale.
Our single-name trading business has worked in conjunction with the macro credit desk to do some very large index arbitrage trades for clientsJason Brauth, Goldman Sachs
Asset managers have also become a big source of demand for the firm’s CDS options business, which has seen significant growth over the past three years. “Money managers and systematic volatility sellers are getting more involved in options,” says Brauth. “Whereas in the past the larger trades were with banks and hedge funds, we’ve seen that expand to other groups.”
Goldman executed its largest credit volatility trade to date in the third quarter – a customised hedging programme comprising a series of three-month put options on Markit’s CDX index of investment-grade names.
“We were able to facilitate that in very quick fashion without moving the market, which required coordination between our options business and our one delta business,” says Brauth.
The macro credit desk works closely with Goldman’s single-name CDS business, which has an estimated market share in excess of 20% across investment grade and high yield in European and North American names.
This business has also seen a bit of restructuring in recent years. The firm has a desk dedicated to trading investment-grade single names, while high yield is handled by sector specialists who trade across cash and derivatives products.
“The reason we did that is because we wanted the investment-grade traders to integrate significantly with our macro business and facilitate index arbitrage, which really drives the investment-grade CDS product,” Brauth says. “And in high yield, we wanted to be able to hedge the bonds with CDSs and allow clients to put on basis trades in names that become very troubled.”
The integration between the macro credit and investment-grade, single-name desks has paid off in a big way. “Our single-name trading business has worked in conjunction with the macro credit desk to do some very large index arbitrage trades for clients,” says Brauth. The firm has been particularly adept at helping clients exploit mispricings during the biannual index rolls, when the new contract tends to trade rich compared with its single-name constituents.
“We’ve done trades in the billions to help clients manoeuvre their risk to the on-the-run index, which required coordination between our single-name and macro credit desks,” Brauth says.
We are a very large part of the CDS market, so we are incentivised to get everybody involved with third-party compression servicesJason Brauth, Goldman Sachs
This co-operation also creates opportunities for better pricing on single names. Goldman typically shows clients a menu of what it calls ‘alpha’ and ‘beta’ bids for trades – prices quoted by its single-name desk as well as the bids derived from arbitrage plays.
The benefits of this approach to pricing were demonstrated in the third quarter, when the firm executed a custom basket of 50 single names for a client that wanted to trade around the dispersion in the CDX IG index – the largest trade of its kind in more than five years, Goldman claims.
The firm has also been working behind the scenes to improve liquidity and transparency in the single-name CDS market. The firm began talking to clients about voluntarily clearing their single-name CDS trades in late 2015, soon after the US Commodity Futures Trading Commission mandated clearing of indexes. “We saw that market adoption of single-name CDS clearing could benefit liquidity as it increases standardisation and allows for netting, which drives capital and margin efficiencies,” says Brauth.
The push for voluntary client clearing has delivered impressive results. In 2017, more than 60% of Goldman’s North American single-name CDS trades with clients were cleared, compared with only 15% two years earlier. That figure currently stands at 35% for European single-name CDS, up from around 7% in 2015.
“It took a little convincing, but I think our clients understood the health of the product was at stake,” says Brauth. “The most important thing for our clients was achieving better liquidity in the CDS product. The problem was that dealers were pulling back and liquidity was decreasing because the product was not capital efficient.”
Goldman was also a strong and early backer of portfolio compression services, which allow dealers to reduce risk and eliminate unnecessary exposures. The firm works closely with vendors offering compression tools for CDSs, and has even shared some of its proprietary algorithms with third parties in an effort to enhance the services.
We were talking to clients all the time about AT1s. It was trading a lot and there was demand from a variety of different constituencies: real money, hedge funds, insurers. However, there were a lot of investors that didn’t want to buy the bonds in a funded formatLuca Lombardi, Goldman Sachs
“We are a very large part of the CDS market, so we are incentivised to get everybody involved with third-party compression services,” says Brauth.
The behind-the-scenes focus on efficiency helped create the headroom to experiment with new product launches. The TRSs on AT1s, for instance, were a response to client demand for unfunded exposure to the securities.
“We were talking to clients all the time about AT1s. It was trading a lot and there was demand from a variety of different constituencies: real money, hedge funds, insurers,” says Lombardi. “However, there were a lot of investors that didn’t want to buy the bonds in a funded format. They wanted exposure in a synthetic format, so we came up with the idea of TRSs on AT1s.”
While AT1s have primarily been a long investment story, Goldman has been able to find a sufficient number of clients willing to take the short side. “Levels have rallied enough that you can find investors willing to buy protection to reduce some of their exposure,” says Lombardi.
Since Goldman launched the TRSs on AT1s in October, a number of other dealers have also started making markets in the product, and Lombardi anticipates that they – and other yet-to-be-launched TRSs on subsectors of the credit indexes – will ultimately become a staple of investor portfolios. “We want these products to stay and become benchmarks. The most interesting opportunity for us is to develop products that persist and are actively traded.”
Goldman’s push to improve efficiency and liquidity in credit derivatives has also benefited its in-house structuring teams, which have rolled out a series of systematic credit strategies for investors over the past couple of years.
The products, which are implemented using CDS indexes, provide exposure to strategies such as systematic volatility selling or curve trades where jump-to-default risk is sold in a DV01-neutral package.
“We developed these products in conjunction with the other equity and fixed-income structuring desks,” says Lombardi. “The most successful part of this product has been the multi-asset offerings, where we give investors a choice of different risk-premium products, whether it’s equity, rates or credit, and give them the ability to switch across them on our platform. Credit is now one of the ingredients they can choose from the menu.”
These structured products have proven to be extremely successful, but Lombardi is quick to point out that this was made possible by Goldman’s approach to trading macro credit derivatives. “The reason we were able to deliver on these products is because we have a single, integrated macro desk that is able to look at relative value and liquidity across all macro products, so we feel confident in our ability to actually offer liquidity in all of them.”