Credit default swaps are back in favor for asset managers

Nomura Asset Management’s Richard Hodges began the year by buying credit default swaps, worried that rate cut bets were becoming too aggressive. He reduced the hedge when the cost of protection increased, and now stands ready to dip in again.

He’s among money managers using CDS indexes to insure against the pain that could be unleashed if central bankers fail to deliver what bond traders have already priced in for the year. For these investors, moderating expectations on rate cuts will boost government bond yields, which would in turn hit spreads on corporate debt. But instead of selling bonds that could be harder to buy back down the line, they’re hedging any volatility with liquid CDS contracts.

Hodges, who manages the $2.4 billion Nomura Global Dynamic Bond Fund, said that this year part of his fund has “experienced some losses on the underlying holdings but had sufficient profits on the index hedge to offset the weaker prices on the assets.” He may add to CDS hedges again if there is “greater economic deterioration or a further adjustment to interest rate expectations.”

The market will get more clues on the trajectory of rates in Europe today, when the European Central Bank is expected to hold the deposit facility rate steady at 4%. The next Federal Reserve decision is on Jan. 31.

AXA Investment Managers and RBC BlueBay Asset Management have also been using CDS indexes in the quest to get ahead of the market’s reaction to what central banks do next. These index contracts insure a broad basket of companies and are the most liquid instrument in the credit market, with hundreds of billions in notional amount changing hands every month, based on Depository Trust & Clearing Corporation data compiled by Bloomberg.

“The market can be exuberant,” said Nicolas Trindade, a senior portfolio manager at AXA, who opened a long position on swap indexes in December. Back then, he thought that expectations of rate cuts had “got too far and there was a risk of a back-up in yields and credit spreads widening.”

And BlueBay’s chief investment officer, Mark Dowding, is also keeping hedges in place to insure against the risk of spreads widening. “We remain modestly constructive for now and happy to add cash corporate risk in attractive new issues, while adding index hedges on the other side to maintain a relatively modest long overall corporate risk position,” he wrote in a note last week.

Reflecting the uncertainty — and the risk if markets misprice central bank actions — a volatility metric that measures price fluctuations within a 30-day period has shot up since mid-December to its highest level since April for Europe’s junk CDS index and since May for the high-grade tracker.

Fears that markets were getting too optimistic about cuts were vindicated in the first few weeks of the year, which saw a jump in the cost of protection against defaults in a basket of investment-grade and a guage of junk corporate bonds as expectations for central bank easing came down. And with uncertainties building for the year ahead — including conflict in the Red Sea, risks around inflation and a US election — many think it is prudent to hedge themselves.

CDS prices have since come back down — while rates traders have been revising their lofty rate cut expectations. As of Jan. 25, swap rates indicate more than five 25-basis-point cuts by the ECB and the Fed by the end of 2024, down from December bets that both banks would cut more than six times.

To be sure, the early-year selloff has reversed across large parts of the credit market, reducing the need to hedge with CDS.

But the tug-of-war between central bankers and markets that created the triggered activity in the indexes in the first place is yet to be resolved.

“Central bankers are trying to push back but the market is not listening,” said AXA’s Trindade. “The only time the market is going to listen is when we get data, not central bank speakers.”