Derivatives change the high-yield fabric

High yield was a quiet area of the otherwise flourishing credit derivatives market. Quiet, that is, until indexes iBoxx and Trac-x merged earlier this year. Volumes in high-yield credit derivatives have exploded and changed the fabric of both cash and synthetic high-yield investing.


When indexes iBoxx and Trac-x merged in June to create the Dow Jones iTraxx credit derivatives index family, the event was trumpeted as a turning point for the global credit market. Some touted the new index as the holy grail for the market and predicted credit would never be the same. Market-makers and watchers alike were speculating on the impact the merger would have, discussing the liquidity that would surely enter the market and predicting what new products would emerge.

Most of this discussion was grounded firmly in the world of high-grade credit and only a few were considering the impact the creation of a market-standard index would have on high-yield credit derivatives.

But the high-yield credit derivatives market, especially in the US, has ignited over the past six months, with high-yield credit default swap (CDS) volumes rising dramatically and more market-makers stepping into the high-yield space to support the market.

“People are very excited about the improved transparency and improved liquidity they’ve seen from high-yield default swaps,” says Jared Epstein, managing director, credit derivatives at Morgan Stanley in New York. “It really started with the index. Once iBoxx and Trac-x came together and we had one index to trade, it really boosted volumes. People could move in and out of the index more easily and use it as a hedging tool. That’s led to a huge surge in trading volumes.”

Dan Frommer, head of high-yield credit derivatives at Bear Stearns in New York, says: “The big change in this market-place has been on the index side, which certainly has a positive effect on single-name high-yield CDSs. This has created a real market with six to eight genuine market-makers putting up real capital. It’s created a lot of confidence. There were a lot of accounts that did not play in the market because they were put off by the fact there was not a broad selection of market-makers. Now we have a competitive market-making situation.”

Liquidity quickly developed in the tradable index, which in turn facilitated a serious increase in the volumes of single-name high-yield CDSs. Assigning a figure to the high-yield CDS market’s growth is tough. Market-makers say the volumes in high-yield index trading have increased anywhere from 100% to 500% since the indexes merged.

Growth of single-name CDS volumes has been slightly less delirious, with dealers reporting growth of around 50% to 100% in the past few months.

Of the 100 credits contained in the Dow Jones North American high-yield CDX index, prices can easily be found for around 75 of them, say traders. Contrast that with the first quarter of 2004, when prices could be found for no more than 25 credits.

Changing the market

“The business of trading tranches on the high-yield index and bespoke synthetic CDOs went from a nascent market only a few months ago to an environment now with significant activity,” says Boaz Weinstein, head of integrated credit trading at Deutsche Bank in New York. “The stature of the high-yield market is firmly established within traditional financial markets. Finally, high-yield credit derivatives are heating up and changing the technical dynamics in the same way that credit derivatives changed the high-grade market.”

The inclusion of high-yield CDSs in synthetic collateralised debt obligations (CDOs) has boosted the single-name side of the market. That trend is expected to continue, and Weinstein believes it is just a matter of time before synthetic CDOs backed solely by pools of high-yield CDSs appear.

Dealers say they had largely been prepared to contend with the thriving market, and are confident it will continue to grow. In a few instances, banks are said to be seeking to add staff in high-yield credit derivatives trading.

Investors’ hunt for yield – a seemingly perennial topic – has also helped out the previously sedate high-yield CDS market. Hedge funds and investment banks’ proprietary trading desks are by far the largest users of high-yield CDSs, but real-money managers and insurance companies are starting to show interest.

“There have been leaps in growth. If the high-grade market were trading wider, it might be more interesting for investors, but with every credit trading in low double digits, people are migrating to high yield,” says Bear Stearns’ Frommer.

Frommer views the launch in July of the CDX3 funded notes by 10 dealers based on the US high-yield CDS index as also being an important source of new interest from investors, particularly mutual funds, insurance companies and other real-money investors.

New investors

“It’s a bond that you can trade just like you would any other bond,” says Frommer. “In high-yield markets, a lot of real-money accounts are not set up to trade derivatives and they need to trade a bond. So creating a bond that is tradable by 10 dealers allowed all these real-money accounts to get involved in our market – mutual funds, insurance companies, pension funds – that have not been set up to trade derivatives,” says Frommer.

That new customer base has been significant for the growth of the high-yield market over the past few months. Some investors using the CDX3 funded notes have been gradually setting themselves up to trade the US high-yield CDS index as well as single-name high-yield CDSs.

“It is important to have a product like CDX3 funded notes, which crosses the barrier into the mutual fund and insurance community. It gives them a product in the index space that they can trade easily and liquidly with multiple dealers,” says Bryan Mix, vice-president and head of high-yield credit derivatives at Goldman Sachs in New York.

The funded notes offer real-money investors a concrete solution to problems posed by the way the high-yield cash bond market can be driven by technicals, such as demand from CDOs and high-yield mutual funds, by the flow of money in and out of mutual funds and by the volume of new issuance.

As mutual funds and other investors build up cash positions, but have nowhere to spend it, staying un-invested or in a money market instrument negatively affects their potential returns. An average coupon in the high-yield bond market is currently on average between 7% and 8%: if investors have money sitting in a money market instrument at 1%, and up to 10% of their fund is invested in this way, it’s costing them a lot of money.

“The funded note actually provides them with a place to keep their money invested in high yield,” says Eric Oberg, managing director, credit derivatives at Goldman Sachs in New York. “As they see supply they want to buy, they can trade out of the index note and into any idiosyncratic risk they like. It’s been a value-added tool to real-money portfolio managers so that they don’t wind up taking lumpy risk by parking all their money in one particular bond issue. It’s provided the credit derivatives market with an interesting tool to trade that [supply and demand] technical that affects the overall high-yield market because all these players use the funded note.”

Four different types of funded notes based on high-yield credit derivatives are currently trading. There are notes based on the CDX 100 index, notes based on sub-sectors of the index made up of only double-B or single-B credits, as well as high-beta notes that track the 30 CDSs deemed to have the widest spreads.

“It’s a product where you can go long or short the market and there’s six to eight dealers making tight markets with a decent size. It allows everybody to trade effectively, whereas in high yield, it’s often difficult to get good-sized markets with tight bid/ask,” says Frommer.

Underlying impact

Although real-money investors have by no means piled into the high-yield credit derivatives market en masse, the growth and activity in that market has certainly already affected the underlying cash bond market, and is beginning to alter managers’ approach to high-yield investing.

Bond prices tend to affect CDS levels and vice versa, but the relationship can be magnified in the high-yield market, where companies issuing debt and deal sizes tend to be smaller.

If a synthetic portfolio were structured with a multi-million-dollar exposure for a single name, and if the single name were a major bond issuer such as automotive company Ford, the effect on Ford bonds might not be noticeable, because Ford trades hundreds of millions of bonds a day.

But for smaller companies with less outstanding debt, the effect of the credit derivative becomes a factor, because the size of the credit derivative is often relatively large compared with the size of the reference bond. “For high-yield companies that have a lot of CDSs trading relative to their total debt outstanding, credit spreads will often move because of the CDS more than any other factor,” says Deutsche’s Weinstein.

Even if a high-yield bond manager is not using credit derivatives, it will be essential to track the high-yield CDS market, as credit derivatives will increasingly drive the cash market.

“There are examples where two similar companies both have bonds trading at 500bp over Libor, but one has credit derivatives spreads at 600bp over with the other still at 500bp over. Why is that? Will this relationship normalise or is there another factor at work? Is the CDS at 600bp trading there because of some real technical factors such as a tight repo market, or bank loan desks buying protection irrespective of where the company’s bonds are trading?” asks Weinstein.

This kind of information and analysis is incredibly valuable to bond managers, even if they don’t use CDSs, to stay ahead of the curve. “The ones who don’t pay attention to the CDS process will find that with some of the actively traded CDS names, they aren’t going to understand why spreads on their securities have moved,” says Weinstein.

Investment banks’ proprietary trading desks and hedge funds have already gone some way towards transforming their approach to high-yield investing. These investors have been early adopters of credit derivatives strategies in the high-yield market, using an assortment of trading tactics to access the market in a way that was not possible before. And the way these investors analyse the market has also changed.

“The high-yield market used to be a market of individual credit pickers. Everybody used to be very much a bottom-up credit picker, now we see people managing their high-yield risk on a portfolio basis,” says Mix at Goldman Sachs.

Active traders

Investors are also becoming more active in trading relationships and using derivatives as a tool to trade credit on a relative-value basis, which until recently had been almost impossible in high yield.

“Two to three years ago, when there was little going on in high-yield credit derivatives and hedge funds were far fewer in number, the approach to trading high-yield bonds was much more homogeneous,” says Weinstein.

“High-yield securities were valued mostly from a fundamental perspective, with attention given to the technicals in the market. With new tools available, those technicals are changing at the same time as non-traditional high-yield players are emerging. Trading strategies based on equity volatility, implied recovery levels or implied default probability can be enacted using equity or credit derivatives, and bonds and loans in various combinations. The terrific liquidity of the CDS indexes has led to lower transaction costs and also the beginnings of an index arbitrage market for high-yield credit,” Weinstein adds.

Even though insurance companies and fund managers are tentatively entering the high-yield CDS market – mostly through funded notes – hedge funds and proprietary trading desks remain the primary customers.

Morgan Stanley’s Epstein says the bank is actively using the US high-yield CDX as a hedge for its high-yield positions: “If you get negative on the broader high-yield market, you don’t necessarily want to pare back your idiosyncratic credit bets, especially if you’re waiting for a positive credit outcome. We will often sell the index short versus our single-name positions, which reduces market risk while maintaining our bet.”

For example, Morgan Stanley is currently bullish on the high-yield utility market, because many companies in this area are seen to be de-leveraging, tidying their balance sheets and potentially heading for credit rating upgrades. Sometimes, the amount of new issuance poised to hit the high-yield cash bond market can cause secondary market spreads to widen.

In this case, Morgan Stanley is holding on to its energy positions, whereas in the past it would have sold them down if it thought spreads were going to widen. Shorting the index allows them to become risk-neutral.

Major customers

Hedge funds are deemed by investment banks’ high-yield desks to be the biggest customers in the high-yield CDS market. “No-one could have predicted how active hedge funds would be in the space,” says Epstein.

Hedge fund managers are also attracted by the flexibility the index and portfolio products provide for trading new ideas.

Hedge fund managers are deploying a number of strategies in the high-yield CDS market: capital structure arbitrage, basis trades (CDSs versus the underlying cash bonds), yield curve arbitrage, hedging and index-based trades.

“The great thing about the indexes is they are widely traded, extremely liquid and they give you exposure to a widely traded basket of high-yield names,” says Sam Vulakh, partner at New York-based hedge fund Panton Capital. “You can tranche the indexes. Do you need the riskier exposure or the less risky portion of the high-yield market? Indexes provide the opportunity to tailor that risk, because you don’t have to use just the composite portion of the index, but also its subsets. It creates even better exposure to the sub-sectors of the high-yield market.”

Nicolas Bravard, portfolio manager for the Alpstar European credit opportunities fund at Mignon Geneve in Geneva, says: “We use the index a lot to hedge our book. We run beta price calculations, and beta price changes on a single name versus the portfolio to hedge the portfolio.”

Vulakh says the new crop of credit hedge funds will boost liquidity in the high-yield CDS market, and some of the more established players will continue to seek out new opportunities there as well: “More and more debt or convertible arbitrage funds will try to branch out into the structured credit world. It’s only natural for traditional high-yield, distressed and convertible arbitrage players to get into the high-yield CDS market, because they already have expertise in cash high yield or cash distressed, and are looking at the synthetic side to augment their returns.”

Bravard says he mainly uses the US CDX 100 index rather than the European index, which he views as not being sufficiently robust. To some extent, the European index’s problems are a function of the markets’ smaller size. “In Europe, we don’t yet have a good high-yield index,” he says. “The iTraxx only contains 25 names and is composed of some illiquid credits. The day we have a CDX 100 for Europe, the market will be much more liquid and transparent. As new issuers provide diversity and issue sizes get bigger, the more we will have a CDS index that better reflects market volatility.”

Another problem, says Bravard, is that the European high-yield iTraxx index is largely comprised of double-B rated fallen angel names likely to be upgraded out of the index: “We need more lower-quality names in the index to reflect the real high-yield market – which means spreads of 300–450 basis points over benchmarks. The fallen angels in the index don’t trade like high-yield instruments. At 120bp over, I don’t call that high yield.”

Dealers’ position

After accomplishing so much this year in terms of market development, dealers are positioning themselves to build on their success. Supporting the market and making it sustainable for clients is the main focus for now, but new products are expected to develop – perhaps along the same lines as the high-grade CDS market. Options and recovery swaps on high-yield names as well as options on the various high-yield indexes are some of the new products dealers are developing.

“The dealer community is making a tremendous effort to keep high-yield CDSs sustainable, to educate the client base and to get as wide a universe of clients involved in the asset class as possible. As time goes by, there will be more products developing based on ingenuity and clients’ interest,” says Panton’s Vulakh.

Dealers say clients are asking for more liquidity and an increased number of names to trade. And, in time, they predict it will materialise, perhaps inspiring desks to combine to trade cash and synthetic instruments, high grade and high yield as a single venture.

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