The market for options on credit derivatives indexes has surged more than 40 percent in the past month to $98.8 billion as investors search farther afield for cheap hedges protecting against a sell-off in the bond markets.
The contracts, which give investors the right but not the obligation to buy or sell indexes of credit-default swaps at a certain price, have doubled from $48.7 billion a year ago, Depository Trust & Clearing Corp. data show. That compares with a 17 percent drop in the amount covered by swaps benchmarks on U.S. and European investment-grade debt and a 4 percent decline for all credit derivative products in the year through June 14.
Demand for options is a sign that the bond market might be nearing an inflection point with Federal Reserve officials saying that the economy is strong enough for them to curtail measures that have supported fixed-income prices.
“Options offer a sometimes inexpensive way of hedging yourself against market volatility,” said Geraud Charpin, a fund manager at Bluebay Asset Management Ltd. in London which oversees $55 billion. “They take away the stress of managing individual index positions constantly.”
The cost of using options, which are priced on volatility, as a hedging tool remains below its historic average even with the recent rise in market swings, according to Raphael Dando, an analyst at Societe Generale SA in Paris. He recommends buying contracts tied to the Markit iTraxx Europe Index of swaps on 125 investment-grade companies.
The credit options, like those for equities or interest rates, are used to guard against or speculate on fluctuations in prices, or bet that volatility will rise or fall. Traders can construct strategies that require no upfront payment while tracking movements in underlying indexes. By buying and selling contracts on credit derivative benchmarks, an investor can get protection against a jump in debt risk at little or no cost.
“People buy options when they want to remain long but still want to hedge themselves,” said Saul Doctor, a credit derivatives strategist at JPMorgan Chase & Co. in London. “At the same time, selling options has been a good way historically to generate excess yield.”
The Markit CDX North American Investment Grade Index of swaps jumped to the highest in almost three months after Fed Chairman Ben S. Bernanke said June 19 that policy makers could begin to trim the $85 billion of monthly Treasury and mortgage bond purchases as soon as this year. A rise in the index indicates investors anticipate losses in corporate bonds.
Company debt securities have lost 2.54 percent this month, following a 1.55 percent decline in May, Bank of America Merrill Lynch’s Global Corporate index shows. Losses this year total 2.11 percent, after cumulative returns of 45 percent including reinvested interest from the end of 2008 through 2012.
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North American Investment Grade Index increased 4.9 basis point to a mid-price of 98.9 basis points as of 11:24 a.m. in New York, according to prices compiled by Bloomberg.
The index typically rises as investor confidence deteriorates and falls as it improves. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 1.25 basis point to 20.8 basis points as of 11:24 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.
Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.7 percent of the volume of dealer trades of $1 million or more as of 11:24 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
The Bloomberg Global Investment Grade Corporate Bond Index has lost 1.96 percent this month, bringing the decline for the year to 3.7 percent.
There are now 4,863 credit index options contracts outstanding protecting $98.8 billion of debt, up from 4,260 covering $48.7 billion last year, according to DTCC.
The current versions of the Markit CDX North American Investment Grade and the Markit iTraxx Europe swaps indexes together cover $110 billion of debt, down from $133 billion on the equivalent measures last year, DTCC data show. The total amount of protection outstanding across indexes fell by $260 billion to $1.38 trillion, while the overall credit derivatives market shrank by $1.1 trillion to $25.5 trillion.
“Accounts are trading more options and less indices because it’s more efficient,” said Olivier Renart, the head of European credit flow trading at BNP Paribas SA in London. “It’s a way to express your views on the direction of the market without having noise around small moves.”
IntercontinentalExchange Inc., which owns the world’s largest clearinghouse for default swaps, said this week that trading has started on credit index futures.
The contracts, called the Markit CDX Investment Grade WI Future, is tied to the Markit CDX North American Investment Grade Index and trade in sizes of $250,000 of notional value and require cash settlement at expiration.
The provisional list of index constituents will be updated daily, determined by ratings, debt outstanding, liquidity, and spread level, according to a statement posted on Markit Group Ltd.’s website this month.
The world’s largest banks that buy and sell credit swaps resisted efforts by CME Group Inc. and Eurex AG in 2007 to offer credit swaps-like futures. That was before the September 2008 failure of Lehman Brothers Holdings Inc., one of the biggest swaps dealers.
Chicago-based CME Group, the biggest futures exchange, is now working on an offering for clearing credit-default swap options, or swaptions, according to Kim Taylor, president of the group’s clearinghouse.
Swaps tied to individual credits and “additional index products” are “reasonably high on our priority list,” she said at the International Swaps & Derivatives Association’s annual meeting in Singapore last month.
That priority may increase as credit markets get whipsawed by speculation about when the Fed will start tapering its $85 billion in monthly bond buying program.
“People are trying to trade volatility from one side or the other,” said Doctor at JPMorgan. “One side is expressing the view that central banks will be able to keep volatility low, the other that they won’t.”