The $9.8 trillion U.S. corporate-bond market may look pretty sleepy right now, but there’s more and more happening in its shadows.
Instead of bothering with trading investment-grade bonds themselves, investors are increasingly turning to derivatives tied to the creditworthiness of specific companies. Volumes in such synthetic wagers have surged to the highest levels since at least the beginning of 2011, in many cases outpacing trading in the underlying bonds, according to Barclays Plc data.
This reflects investors’ concern that they can’t get in and out quickly enough in the market for cash bonds. Wall Street is pulling back in debt trading, potentially leaving investors vulnerable at a time when the outlook may change quickly, given that the Federal Reserve is grappling with how to exit from a sixth year of record stimulus.
Fed Chair Janet Yellen said Aug. 22 in Jackson Hole, Wyoming, that the U.S. labor market is healing and policy makers are shifting to debating when “we should begin dialing back our extraordinary accommodation.”
The boom in derivatives also underscores how traders are delving back into more complicated structures that are inherently leveraged, amplifying potential gains or losses.
When using credit-default swaps, “you’re not constrained by what bonds are out there or how often they trade,” Jigar Patel, a credit strategist at Barclays, said in a telephone interview. “People are looking for different ways to invest and take on risk.”
Corporate-bond managers are more focused on staying nimble in part because Wall Street’s biggest banks have curtailed their role making markets in the face of new regulations. Investors are returning to derivatives that fueled the worst recession since the Great Depression because they’re often easier to buy or sell.
Trading in credit swaps tied to specific investment-grade companies almost doubled to about $900 billion in the three months ended June 30, compared with less than $500 billion in the same period in 2013, Barclays data show.
In the same period, volumes in actual investment-grade bonds decreased to an average $13.1 billion a day from $13.2 billion, even as the size of the market grew, according to Financial Industry Regulatory Authority data.
For some companies, such as Nordstrom Inc., Staples Inc., and Whirlpool Corp., traders were more active in derivatives than their actual bonds, Barclays data show. After all, if a company doesn’t issue enough debt to meet investor demand, traders can just create more swaps that move in tandem with the underlying debt’s value.
Credit-derivatives are used in a variety of ways.
They can provide a hedge against losses, with buyers paying a fee in return for a promise that they’ll get their money back in a default.
The wagers also allow behemoth fund managers, such as Pacific Investment Management Co.’s (Pimco's) Bill Gross, to quickly receive income from a bet that high-grade bonds will keep doing well by agreeing to provide such insurance, without having to actually find debt to buy.
Pimco’s 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 its risk tied to credit-default swaps by 62 percent in the period compared with the first quarter, according to a quarterly report.
Investors are turning more and more to the shadow world of credit, and all the leverage that comes with it, to make their bets. And that may mean bigger losses for some when the tide turns.