Opinion Credit derivatives

Kelley Baum

III Capital Management/AVM

The past two years have brought a great deal of change in credit derivative markets. For a start, since many systematic credit volatility sellers blew up in March and April 2020, out-of-the-money implied credit volatility has remained elevated as dealers have been unable to offload hedging flow to programmatic volume sellers.

Bespoke issuance is concentrated in the two-to-three-year maturity range, both due to equity investor appetite for shorter-dated jump risk and because of bank capital charges that typically make shorter maturity issuance more efficient for dealers. Because of this, bespoke demand has a meaningful impact on CDS curves. High bespoke issuance can drive steeper front-end curves, while low issuance can lead to flatter curves.

Distress flattens front-end CDS curves

Recently, front-end curves have been at exceptionally flat levels, especially considering how tight credit spreads were (until the recent widening). But bespoke issuance has started to increase in 2022, especially as overall spreads have widened slightly and investors can hit higher all-in yield targets. Some dealers are projecting that full year 2022 issuance will climb to $30-40 billion, which is encouraging steeper front-end curves.

Another change, which has been developing more slowly, is the presence of commodity trading advisors (CTAs) in the credit markets. While CTAs don’t follow identical strategies, many employ momentum or trend-following approaches.

Historically, credit was too illiquid for CTAs. But with higher liquidity, electronic trading and mandatory clearing, credit indices have become an arrow in many CTAs’ quivers. Due to their fund locations, CTAs are most active in Europe, in particular in the iTraxx Main on-the-run five-year index, as it is the deepest European credit index.

Dealers have noted that over the past few months, especially on volatile days, CTA flows have been 25-50% of total market flows, meaning that five-year spreads are leading the way both tighter and wider as the market starts to move. With front-end (3s5s) curves, that means the combination of increased bespoke issuance at slightly wider spreads, plus CTA de-risking in the five-year index, leads to steepening 3s5s. In 5s10s, traditionally the curve steepened into an initial widening as longer-term default concerns increased. If spreads continue to widen significantly and more immediate default concerns pick up, then curves generally should flatten.

In recent months, it seems the pivot point of 5s10s has changed. The curve is flattening quicker in an initial move wider, due perhaps to CTA focus on the five-year point.

CTAs are also impacting the relationship between US and EU credit. While there are stressful fundamentals looming for both regions, European IG credit has markedly underperformed US IG. In Europe, there are geopolitical tensions between Russia and Ukraine, as well as the prospect of the ECB removing its bond-buying programme following the Bank of England’s decision to sell its corporate bonds. In the US, rate hikes are imminent, supply chains are stressed, and IG index quality is near historic lows from both a ratings and a duration perspective.

In my view, the relative underperformance of Europe has potentially been exacerbated by the CTA need to de-risk in iTraxx Main.

Credit indices will be more volatile