A few years ago, I assisted a large institutional fund manager with a programme to upscale their derivatives processing capability to enable them to use such instruments in the mainstream of their investment activity.
Whilst hedge funds had been using such instruments for some years, the big established fund managers had traditionally shied away – ignorance, fear and inability were factors in this. In many respects this particular fund manager was actually ahead of its field in taking an active decision to invest in facilities to bring on such capabilities.
Notably, rather than being young gun fund managers wanting to play with “new toys”, the pressure for use of the instruments was coming from the Chief Investment Officers (“CIO”), under pressure to improve investment returns.
One particular “speech to the troops” from the Fixed Income CIO stuck in my head. He forceably explained that traditionally his teams could only hold long positions in bonds as shorting bonds was a very onerous process. Hence, they could only invest in companies where they had a view that the companies credit position would under-priced if they were to benefit from upward prices. Yet the returns from this were rarely significant eg a bond price might move up by a few points. In contrast structural limitations meant they could not benefit from selling bonds they did not own in companies whose credit position they thought would worsen – these offered the biggest returns since bond prices for default bonds will drop dramatically.
By allowing the funds to “buy” credit protection via credit default swaps on specific companies or indeed credit indices, the funds could enjoy the returns from a decline in the perceived creditworthiness of a company or the whole market respectively.
The credit crunch has dramatically demonstrated this opportunity. As reported in the Financial Times today, the iTraxx Crossover index, tracking the cost of protecting European non-investment grade credit against default, is up about 40 per cent since the turn of the year. The equivalent US index, the CDX, shows a similar spike.
Actual default rates are yet to change, but the market is currently terrified of corporate credit worthiness and so is pricing in an expected increase default rates and so price of CDS insurance against such defaults has soared benefiting funds hold CDS protection.
As the FT highlights, with one-year protection on the Crossover at close to 500 basis points, it implies default rates among European junk issuers of about 6 per cent by the end of the year – double most banks’ internal estimates, which in turn are about triple the present level.
In contrast, 18 months ago similar protection could trade between 50-100 basis points. Juicy returns indeed.
For those fund management firms that didn’t invest in structural capabilities to trade derivatives, these investment returns were foregone. Of course, the fund managers still have to back the right horses and so anyone “selling” CDS protection will be sitting on big losses. However, fund management executives that failed to position themselves by doing nothing should be judged accordingly.