The great CDS debate which corner are you in?



Gartmore writes: "The argument for using credit default swaps in traditional mutual funds is a bit like that for jet planes over light aircraft in air travel: they are faster, more efficient, have a longer range and are much less prone to nasty turbulence.

Gartmore is one of the first investment management firms making full use of the new Ucits III powers, deploying CDS technology across all of its OEIC and Sicav credit funds. It's revolutionising the way we can manage this asset class.

Firstly, it brings symmetry to an otherwise asymmetric asset class. Event risk, the risk of a dramatic change in a company's capital structure leading to rapid credit deterioration, is a threat to any credit portfolio manager. The ability to go short in a particular credit turns this risk into an interesting, although lumpy, alpha-generation opportunity.

CDS technology can help protect a fund against market turbulence, creating the potential for all-weather performance. Traditional corporate bond funds are directional, meaning that returns will fall, or even turn negative, when credit spreads widen. In an environment of widening spreads, a good fund manager will be able to generate strong relative returns by reducing the fund's credit duration. However, even if the fund manager is excellent, absolute returns can still be poor.

Using CDS technology allows funds to put in place two types of protection, either at the index level (buying protection on an iTraxx index), or by seeking out cheap beta shorts (i.e. individual credits that are trading tight but that should widen out more than the average in a volatile market).

Secondly, using CDS allows for the creation of synthetic longs. What does that mean? Well, there are two ways of gaining credit exposure to an issuer. You can either buy a traditional corporate bond or you can own a credit risk-free asset, such as a gilt, and sell protection on the issuer. The risk is virtually the same, although there can of course never be any covenant protection in a CDS contract.

This has two applications: it allows investors to seek out the best value between the cash and the synthetic market, allowing us to invest more efficiently. More importantly, it means investors are no longer restricted to the debt maturities that are available in the bond market. For example, the duration of the exposure can be guided by both fundamental credit analysis (of an issuer's liquidity position, for example) and credit curve considerations.

You can deploy all sorts of complex investment strategies, but the bottom line is that CDS technology should allow fund managers to deliver much better risk-adjusted returns. In our view, there are very few real drawbacks to using this technology and most objections are little more than excuses for not being able to use CDS. At Gartmore, our hedge funds have been using CDS technology for years, so we already had the necessary portfolio management and risk systems in place and our legal and compliance teams were familiar with it. We were therefore better placed to roll out CDS technology than many others in the industry."

Karl Bergqwist and Simon Surtees are co-heads of fixed income at Gartmore in London


A hedge fund professional writes: "There is always an argument for staying away from something that banks are pushing so hard at you. Banks come to us and say they can solve our problems but what they mean is that we can generate a lot more trading revenue for them. However, there are more fundamental problems in the CDS market that make us cautious of it.

The huge notional amount of outstanding CDS ($26 trillion in the first half of 2006) highlights that it is a liquidity-driven product. We are cautious about liquidity-driven products because you rely on a small base of dealers to provide the liquidity that would allow you to monetise your position in extreme moments of stress. Historically, these dealers' track records have been poor in instances such as the correlation crisis of last year. We saw, for example, that GM, which used to trade in blocks of 25X25 traded in blocks of 2X2. Similarly, in 2002 and 1998 the main dealers seriously scaled down or froze their liquidity provision capacity.

But there are problems with CDS other than market liquidity. The CDS market is an over-the-counter market and is fairly lightly regulated. Consequently it is potentially open to abuse. There have been examples such as those involving Rentokil or ITV Carlton. These firms restructured themselves and one of the outcomes was that their CDS traded to zero and owners of the CDS were left holding worthless contracts. If you have a really long exposure in one of those entities you could lose a lot following restructuring.

We also find that markets dominated by prop desks and hedge funds - such as CDS - are less attractive. We try to keep in balance our exposure to crowded trade spaces because of the systemic risks. A prop desk could have its risk limit cut with the click of a finger. Hedge funds might not change direction quite so quickly, but certainly within three months they could have their money redeemed by investors. If there were any stress to either a prop desk or a hedge fund's ability to trade, then it is not clear how they would react - and that concerns us. One simple concern would be that bid/offer spreads in the CDS market would widen out substantially, creating punitive transaction costs.

I have traded credit derivatives and structured credit for 10 years as a manager of a hedge fund and before that as a VP running a proprietary book for a major US investment bank. So I don't avoid the credit derivatives market because I'm a Luddite. I recognise that it's a resource - primarily as a hedging strategy - and I use it in measured doses when it provides the best solution. But I prefer credit investments such as loans where I can rely on documentation to protect the investment rather than relying on dealers.

Credit sits in a risk space that is optimal for pension funds: it is between government bonds, which yield less than their ideal liability management target level, and equities, which have sub-optimal volatility. Pension funds can access credit exposure in a number of different ways. At the moment most funds have exposure in inefficient ways: typically they hold government and corporate bonds and perhaps CDS and even CDOs, all of which fit into a long strategy. But because spreads are tight, these investments are not necessarily the best way to gain exposure to credit.

Credit hedge funds or funds of credit hedge funds provide a different type of exposure with a long/short approach that can reduce volatility. There is substantial scope for pension funds to improve their understanding of the credit market and how they should access the opportunities in the market."

The hedge fund professional spoke to Credit anonymously.

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