No Bonds, No Problem

As corporate bond trading volumes wane, some investors are using credit-default swaps to bet on whether bonds will rise or fall in value.

If corporate bonds don’t trade frequently enough for you, one solution is to turn elsewhere.

More and more investors are betting on whether the notes will go up or down in value without owning the securities, using derivatives. This has been attractive for asset managers looking to be nimble in markets or make big bets, especially as corporate-debt trading volumes wane.

Pacific Investment Management Co.’s (Pimco's) Bill Gross, manager of the world’s biggest bond fund, is one who’s using credit-default swaps (CDS) for bullish wagers on company debt. He accelerated his use of the contracts in the three months ended June 30 by selling protection against credit losses, according to a quarterly report.

Gross isn’t alone: Outstanding bets on a credit-swaps index tied to North American high-yield bonds have soared to the highest level since at least 2011. Net wagers on the latest Markit CDX North America High Yield Index rose to $31.5 billion as of July 18, compared with a peak of $29.1 billion on the last series in March, according to data compiled by Bloomberg.

Investors are looking for faster ways to express views on investment-grade and high-yield bonds, which are trading less as a proportion of the overall debt outstanding as Wall Street banks use less of their own money to make markets.

Credit swaps “can be managed more easily in some cases than bond portfolios,” Peter Tchir, Brean Capital LLC’s head of macro strategy in New York, wrote in a July 25 report. “Real money looking for an ‘edge’ will look to CDS.”

Investors are returning to securities that magnify returns and losses as they seek bigger gains with bond yields near record lows and muted volatility. They’re finding comfort in the fact that these swaps, which helped fuel the worst financial crisis since the Great Depression, are more closely regulated now that traders have to route transactions through central clearinghouses.

Pimco’s $225.2 billion Total Return Fund increased the amount of protection it sold against losses on corporate debt in the three months ended June 30, boosting a measure of risk tied to credit-default swaps by 62 percent in the period compared with the first quarter, according to the report.

Pimco representatives didn’t respond to e-mails seeking comment.

While these derivatives make it easier to place bets in the short term, they may magnify losses in a protracted downturn. Should defaults accelerate, swaps sellers would have to compensate their counterparties for any losses.

Of course, with the economy improving and central banks globally committed to their stimulus programs, that doesn’t look as likely for now.

About the Author

Lisa Abramowicz

Lisa Abramowicz

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets.

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