Pension fund managers should look to take advantage of a rare opportunity in corporate CDS

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

The October sell-off in gilts highlights a glaring lack of exposure to CDS

October 20th seems like an aeon ago. While the length of residence in number 10 that ended on that day has been consigned to the Trivial Pursuits question pack, the impact of Liz Truss’s departure from UK economic policy orthodoxy on the gilt market and pensions sector remains topical.

The ensuing unprecedented increases in gilt yields exposed major flaws in liability-driven investment (LDI) strategies, which had liability matched by buying long-dated receiver swaps, but had sought to boost returns by investing cash in higher yielding but often illiquid assets — property, private credit, EM debt, private equity, etc — which proved ineligible collateral for margin calls that followed. However, if pension funds are willing to dig deeper in the synthetic credit toolbox, they may find some means of boosting returns without sacrificing liquidity, while benefiting from additional diversification and reduced volatility.

Alternative pension portfolios

The traditional UK pension fund construct consists of physical gilts and linkers, plus leveraged/synthetic gilts and linkers, combined with semi-liquid bonds and less liquid growth assets. Instead, managers could consider retaining the physical gilts and linkers, but replacing growth assets and semi-liquid bonds with leveraged synthetic credit (CDS) strategies. The unfunded nature of CDS enhances the liquidity of the fund and reduces the risk of forced deleveraging, since underlying the CDS is a pool of cash. The CDS are self-liquidating or can be unwound, leaving the fund with cash, gilts and linkers.

In addition, CDS are inherently shorter-tenor instruments than gilts and bonds. The option-adjusted duration of the Bloomberg Global Aggregate Corporate Return Index and Bloomberg Sterling Gilt Indices are over 6.3 years and 10 years, respectively. The most liquid part of the corporate CDS curve is five years, while a full array of maturity options facilitates the creation of three-year exposure to investment-grade credit.

Not merely does this ensure that leverage is only applied to short-dated assets, limiting volatility and correlation with the markets, but it enables pension fund managers to take advantage of a rare value opportunity in corporate CDS. Bank buying of short-dated protection in response to the sell-off in short-dated bonds earlier this year has flattened IG corporate CDS curves. Three-year spreads typically traded around 50% of five-year spreads, whereas the relationship is 70-75%, or in the 90th percentile range on a 10-year look back.

Given the healthy liquidity position of most IG corporate credits in terms of balance sheet cash and access to alternative liquidity, there is little explicit default risk over this time horizon. The most cogent value opportunity is therefore located at a point in the curve where investors have excellent visibility over credit risk in the individual companies to which they have exposure.

An active approach to the management of IG corporate CDS can also pay dividends in terms of diversification. At the very least, managers can reduce exposure to banks, which, by dint of their prolific issuance, constitute over one quarter of the Bloomberg Global Aggregate Corporate Total Return Index. There are over 350 names distributed more or less evenly between North America and western Europe that benefit from liquid, investable CDS contracts.

Active management informed by fundamental credit research can maximise the value of credit selection, limiting exposure to safe but very low-spread index names, and winnowing out those triple Bs that pose fallen angel risk. By contrast, it can pluck out alpha-generating opportunities from double B names that enjoy an investment-grade trajectory (mortgage insurers, MGIC and Radian and telco, T-Mobile, all made the leap to IG in the third quarter).

With prudent leverage, CDS-based strategies can be tailored to meet a fund’s return target, typically offering higher return per unit duration than a bond portfolio, with greater flexibility and liquidity across a range of short-dated tenors, allowing for the optimisation of risk/return profiles. In market dislocations CDS will also typically outperform bonds as investor funding considerations come into play. The potential advantages conferred by synthetic credit strategies make their pursuit anything but trivial.

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Global credit funds & CLO's

January 2023 | Issue 251

Published in London & New York.