A time for credit overlay

market view

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Credit overlay capitalises on the increasing size and depth of the credit default swap (CDS) market by using CDS to create a synthetic portfolio of credit exposures that best captures a fund manager's active investment views. The return of this synthetic credit portfolio is then 'overlaid' on a portfolio of a client's other assets.

This means that credit overlay offers clients such as pension funds the chance to gain exposure to credit alpha (a measure of a fund manager's ability to outperform the credit market) without needing to invest a significant portion of the pension fund's capital in the corporate bond markets.

This is particularly advantageous in the current environment, where pension funds are increasingly focused on asset-liability matching but may still want to retain the opportunity to capture some excess return in an environment of generally low investment returns. Indeed, there should be some diversification benefit to doing this, given that alpha is largely uncorrelated with the underlying pool of assets.

But we believe that credit overlay will enjoy a much broader range of appeal than just pension funds. There are attractive characteristics for a whole swathe of investors including private wealth clients and corporate treasuries.

Benefits

Notably, the advantages of credit overlay include the ability to profit fully from a manager's negative view on a credit (which is constrained by the size of a bond in the benchmark under traditional corporate bond strategies), the ease and cost-efficiency with which it is possible to pursue alpha using CDS, and the greater nimbleness of credit fund managers who are freed up to concentrate on their best investment ideas.

So why is it that traditional long-only fund managers are only now seizing the opportunity to develop a viable credit overlay product?

This development is partly a response to the changing needs of some client groups such as pension funds. But it is also important to appreciate the vital role played by the expansion and rapid maturing of the CDS market, especially in London.

Just like the equity and interest rate derivatives markets before it – where overlay strategies have been available to investors for some time – the size and depth of the CDS market has evolved at a rapid pace. In recent years, the global credit derivatives market has more than doubled every two years. According to the Bank for International Settlements' Triennial Central Bank Survey (2004), the notional amounts outstanding of credit-linked derivatives were $6.3 trillion at the end of 2004, constituting just over 2% of global over-the-counter derivatives markets, as against 0.7% in 2001. Of this, according to the Fitch Credit Derivatives Survey (2004), corporate credit dominated the market with a 65% share, versus financials with 17% and sovereigns with 6%.

Just as significantly, market participation is broadening all the time. Whereas CDS markets were originally the preserve of banks, a recent report by the British Bankers' Association forecasts that banks' market share is expected to drop from 51% in 2003 to 43% by 2006. Hedge funds, which currently account for 16% of the market, are forecast to make a small gain in market share with a 1% increase. But the majority of the market will be taken by new participants. In particular, mutual funds and pension funds collectively are expected to grow from 6% to 10% of the market.

As a result, while hedge funds and funds of funds were once the only avenue through which to gain exposure to alpha-generating strategies, investors will in future be able to take a much closer look at the attractions of using a traditional long-only fund manager as a provider of credit overlay strategies.

In particular, traditional fund managers should be able to offer investors the best of both worlds, combining their historic areas of strength with an innovative capability to exploit the growth of the CDS market. This should enable them to apply their strong in-house credit research resource and their tried-and-tested investment philosophy and process to the CDS market. And fund managers are also well-placed to offer the broader array of services required by clients including risk control, reporting and a close engagement with clients' needs.

Strategy

So what sort of alpha-generating strategies might a credit overlay fund employ? One opportunity would be to implement a simple long-short position between two individual credits. To cite a recent example, when credit market sentiment turned against companies that were seen as leveraged buyout (LBO) candidates and investors became concerned about the risk of such companies being downgraded to junk – as happened in Europe with Danish cleaning firm ISS – it would have been possible to exploit this development effectively by using a credit overlay strategy.

To do this, the overlay manager would have utilised bottom-up credit research to identify other companies thought to be at risk from an LBO, then used the CDS market to buy credit protection (go short) on one such company, while simultaneously taking credit exposure (going long) on a company thought to be safe from this risk. When perceptions of LBO risk then heightened, market spreads of those companies viewed as high-risk LBO targets would widen relative to those viewed as low-risk. As a result, the overlay trade would move into profit.

Such a trade is just one example of a situation where an overlay manager can use CDS to profit fully from a negative view on an individual credit (in this case LBO risk) rather than from a positive view. Importantly, what matters for the performance of the overlay trade is not what happens to credit markets per se, but rather what happens to the relationship between the two companies constituting the long-short position. In this way, credit overlay isolates alpha – in this case via good stock selection – from beta (the return generated by exposure to the credit market).

It's important to point out, however, that alpha-generating strategies are by no means confined to views on individual credits. For example, if an overlay manager believed that credit quality was set to improve in the utility sector but deteriorate among capital goods companies, it would be possible to implement this view on the relative prospects of two sectors through the CDS market. And it would be just as possible to exploit views on the credit curve in a single name or in a broader sector.

But a number of caveats still exist. Raising investor awareness of, and comfort with, credit overlay strategies remains key. Given that alpha can be negative for periods as well as positive, and that leverage can potentially compound the impact of this, strong risk management is crucial. Clients should therefore have the opportunity to agree with an overlay manager the degree of targeted excess return and the level of risk suitable for their individual requirements. Also, although the situation is changing fast, some pension funds may need to address guideline restrictions on the use of derivatives.

Nonetheless, with the CDS market expected to continue innovating and evolving, the development of credit overlay provision as part of a traditional fund manager's product offering looks to be an exciting opportunity for the industry. Perhaps the most important challenge of all will be to establish a proven track record of alpha generation using an overlay strategy and to develop the capacity to exploit ongoing growth and innovation in the CDS markets to do this. An overlay product lays bare the alpha of the credit fund manager's performance – so there will be no hiding place.

Whether it is to meet the needs of pension funds seeking excess returns while managing asset-liability requirements, or to appeal to private wealth clients and corporate treasury functions, provision of credit overlay is a challenge to be relished. There will be significant rewards for those fund managers who get it right – and, of course, for their clients.

Matthew Greenwood is a credit analyst at Northern Trust Global Investments

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