Credit derivative volumes surge as bond liquidity concerns persist
Total return swap increase comes amid growing interest in credit indices
Trading activity in total return swaps linked to credit indices has hit a record high this year, as a growing number of investors embrace these credit derivatives to take views and hedge their corporate bond portfolios.
Volumes in total return swaps on iBoxx bond indices reached around US$70bn in the first half of the year, according to IHS Markit, roughly double the volumes over the same period three years ago.
The uptick is the latest sign of traders turning to products based on broad credit indices to shift risk, as buying and selling individual corporate bonds has become harder.
Volumes in credit-default swap indices averaged around US$326bn per trading day in the first quarter of the year, according to the DTCC, up from US$226bn five years ago. By way of comparison, average daily trading volumes in US corporate bonds was US$36bn over the same period, according to MarketAxess. Meanwhile, average daily trading volumes in global fixed-income exchange-traded funds have increased to US$14.2bn this year, according to BlackRock, the largest provider of such funds, up roughly 70% from 2018. That comes as assets in fixed-income ETFs have surpassed US$1trn this year.
Nick Godec, index product manager at IHS Markit, said the number of banks quoting TRS on iBoxx bond indices has grown from three in 2012 to 10 today. At the same time, a wider range of investors have entered the market, with asset managers joining the hedge funds that historically were the most active in this space.
“We think it’s at [an] inflection point and it’s bound to continue growing given the number of market-makers and increasing interest from” investors, he said.
iBoxx Total Return Swap Volumes
Total return swaps are a type of derivative that give investors exposure to an underlying asset like a high-yield bond index. That allows investors to match the risk in their bond portfolio more precisely than a CDS index, while enjoying the benefits of using derivatives such as decent liquidity and the ability to lever up positions. One downside to TRS is they currently aren’t cleared by central counterparties, potentially leaving the investor vulnerable if their bank trading partner defaults.
Market liquidity – or the ease of buying and selling securities – remains a major focus for investors. Nearly 70% of respondents to an investor survey released by Greenwich Associates in 2018 said bond market liquidity had continued to decline in the previous three years. Almost 60% had increased their usage of bond ETFs over that period, while 45% of European investors and 30% of US firms said they now used derivatives such as CDS and TRS.
Fraser Lundie, head of credit at Hermes Investment Management, said the zero to negative-yielding environment should increase investors’ focus on trading costs, encouraging the use of credit indexes.
“I think it’s the future,” said Lundie, who uses CDS indices and index options as well as government bond futures.
“The only way to be dynamic and opportunistic is through macro index products,” he added.
Many banks have reacted to the increased demand by setting up index-focused groups within their credit-trading units. JP Morgan launched such a group several years ago, appointing its then head of European credit trading to run it.
“Most banks are thinking about it,” said another global head of credit trading.