The market for options on credit derivatives indexes has surgedmore than 40 percent in the past month to $98.8 billion asinvestors search farther afield for cheap hedges protecting againsta sell-off in the bond markets.

The contracts, which give investors the right but not theobligation to buy or sell indexes of credit-default swaps at acertain price, have doubled from $48.7 billion a year ago,Depository Trust & Clearing Corp. data show. That compares witha 17 percent drop in the amount covered by swaps benchmarks on U.S.and European investment-grade debt and a 4 percent decline for allcredit derivative products in the year through June 14.

Demand for options is a sign that the bond market might benearing an inflection point with Federal Reserve officials sayingthat the economy is strong enough for them to curtail measures thathave supported fixed-income prices.

“Options offer a sometimes inexpensive way of hedging yourselfagainst market volatility,” said Geraud Charpin, a fund manager atBluebay Asset Management Ltd. in London which oversees $55 billion.“They take away the stress of managing individual index positionsconstantly.”

The cost of using options, which are priced on volatility, as ahedging tool remains below its historic average even with therecent rise in market swings, according to Raphael Dando, ananalyst at Societe Generale SA in Paris. He recommends buyingcontracts tied to the Markit iTraxx Europe Index of swaps on 125investment-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 constructstrategies that require no upfront payment while tracking movementsin underlying indexes. By buying and selling contracts on creditderivative benchmarks, an investor can get protection against ajump in debt risk at little or no cost.

“People buy options when they want to remain long but still wantto hedge themselves,” said Saul Doctor, a credit derivativesstrategist at JPMorgan Chase & Co. in London. “At the sametime, selling options has been a good way historically togenerate excess yield.”

Default Swaps

The Markit CDX North American Investment Grade Index of swapsjumped to the highest in almost three months after Fed Chairman BenS. Bernanke said June 19 that policy makers could begin to trim the$85 billion of monthly Treasury and mortgage bond purchases as soonas this year. A rise in the index indicates investors anticipatelosses in corporate bonds.

Company debt securities have lost 2.54 percent this month,following a 1.55 percent decline in May, Bank of America MerrillLynch's Global Corporate index shows. Losses this year total 2.11percent, after cumulative returns of 45 percent includingreinvested interest from the end of 2008 through 2012.

Elsewhere in credit markets, the cost of protecting corporatebonds from default in the U.S. rose. The Markit CDX North AmericanInvestment Grade Index increased 4.9 basis point to a mid-price of98.9 basis points as of 11:24 a.m. in New York, according to pricescompiled by Bloomberg.

The index typically rises as investor confidence deterioratesand falls as it improves. A basis point equals $1,000 annually on acontract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debtmarket stress, increased 1.25 basis point to 20.8 basis points asof 11:24 a.m. in New York. The gauge widens when investors seek theperceived safety of government securities and narrows when theyfavor assets such as company debentures.

Bonds of General Electric Co. are the most actively tradeddollar-denominated corporate securities by dealers today,accounting for 3.7 percent of the volume of dealer trades of $1million or more as of 11:24 a.m. in New York, according to Trace,the bond-price reporting system of the Financial IndustryRegulatory Authority.

The Bloomberg Global Investment Grade Corporate Bond Index haslost 1.96 percent this month, bringing the decline for the year to3.7 percent.

There are now 4,863 credit index options contracts outstandingprotecting $98.8 billion of debt, up from 4,260 covering $48.7billion last year, according to DTCC.

The current versions of the Markit CDX North American InvestmentGrade and the Markit iTraxx Europe swaps indexes together cover$110 billion of debt, down from $133 billion on the equivalentmeasures last year, DTCC data show. The total amount of protectionoutstanding across indexes fell by $260 billion to $1.38 trillion,while the overall credit derivatives market shrank by $1.1 trillionto $25.5 trillion.

'More Efficient'

“Accounts are trading more options and less indices because it'smore efficient,” said Olivier Renart, the head of European creditflow trading at BNP Paribas SA in London. “It's a way to expressyour views on the direction of the market without having noisearound small moves.”

IntercontinentalExchange Inc., which owns the world's largestclearinghouse for default swaps, said this week that trading hasstarted 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 andtrade in sizes of $250,000 of notional value and require cashsettlement at expiration.

The provisional list of index constituents will be updateddaily, determined by ratings, debt outstanding, liquidity, andspread level, according to a statement posted on Markit GroupLtd.'s website this month.

The world's largest banks that buy and sell credit swapsresisted efforts by CME Group Inc. and Eurex AG in 2007 to offercredit swaps-like futures. That was before the September 2008failure of Lehman Brothers Holdings Inc., one of the biggest swapsdealers.

Chicago-based CME Group, the biggest futures exchange, is nowworking on an offering for clearing credit-default swap options, orswaptions, according to Kim Taylor, president of the group'sclearinghouse.

Swaps tied to individual credits and “additional index products”are “reasonably high on our priority list,” she said at theInternational Swaps & Derivatives Association's annual meetingin Singapore last month.

That priority may increase as credit markets get whipsawed byspeculation about when the Fed will start tapering its $85 billionin monthly bond buying program.

“People are trying to trade volatility from one side or theother,” said Doctor at JPMorgan. “One side is expressing the viewthat central banks will be able to keep volatility low, the otherthat they won't.”

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