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Dealers have encouraged fund managers to take more credit risk over the past few years using standardised credit default swaps, which are less balance-sheet intensive than bonds and are typically far more liquid. As well as helping capital-strapped investment banks, selling CDS is touted as a vital tool for fund managers struggling to match the bumper bond returns of recent years without overloading on risk in the face of patchy bond liquidity and a voracious reach for yield. But while many US investors are now happy to earn premium by selling credit protection, most European money managers are yet to be convinced.
A handful of real-money managers are prepared to sell CDS and even view the instrument as an integral part of their investment strategy. This is partly due to growing fears over the ability of buyside funds – which Citigroup says have mushroomed to almost $1 trillion on a glut of global debt issuance – to find a home for their bonds during market turmoil as Fed data show dealers shrinking bond inventory by 87 per cent since 2007. Another reason behind greater use of CDS is the flood of money pouring into European bonds, which has sparked fierce competition for allocations in primary issues. Numericable and Altice attracted more than $100 billion in orders for their €12 billion-equivalent deal – an unprecedented feat for a European high-yield offering. In some instances, selling CDS may be easier than buying the bond.
"Given the hunt for yield and structural issues in secondary markets, you have to look at other ways of accessing liquidity", said Fraser Lundie, co-head of Hermes Credit, which has assets under management of £26 billion. "If your mandate only allows you to buy euro bonds, your options are limited when half the high-yield market is trading above call price. Having a global mandate and the ability to use CDS are crucial for being able to take a position efficiently."
Still, dealers remain pessimistic about a new wave of protection sellers coming to European CDS markets. This is partly due to fund inertia when it comes to changing mandates. More significant could be the bad name CDS made for itself during the financial crisis, though. "There is this desire to appear plain vanilla, which is now more of a hindrance than a help to investors given the poor liquidity in bond markets. Investors should really sell much more CDS to take risk", said Matt King, head of credit strategy at Citigroup.