The declining use of credit default swaps among investors to hedge credit risks has fuelled a drive to use other products such as exchange traded bond funds, according to a study by Greenwich Associates published on Wednesday.
The decline of credit default swaps as the go-to market for hedging counterparty risks marks a turnaround for a financial product that was widely seen as a leading cause of the global financial crisis in 2008. In a survey conducted among 60 North American and European asset managers and hedge funds between May and June 2018, the study found that less than half the respondents used CDS to hedge credit risks.
Forty percent of the ones who responded viewed exchange-traded funds (ETFs) as the best method for gaining credit exposure against 27 percent for indices of CDS and 22 percent for single name CDS. "Aside from the expected decline in CDS usage, this also shows that the proportion of investors hedging credit is greater than the proportion using CDS," Ken Monahan, a senior analyst on the market structure team at Greenwich Associates said.
"This implies that some investors have begun using other products for hedging purposes," he said. While the origins of the CDS market at the turn of the century was rooted in the desire by large financial institutions to hedge their credit exposure of a basket of securities, the product became quickly popular among hedge funds who discovered a cheap way to take bets in the corporate debt markets.
Alongside the hedge funds, banks and other institutions such as insurer AIG wrote billions of dollars of credit default swaps on increasingly exotic financial instruments such as mortgage-backed securities and collaterised debt obligations.
When they became almost worthless, the sellers of CDS faced huge payouts.
Post-financial crisis regulations which aim to inject more transparency into the murky world of derivatives have hit volumes hard as banks and hedge funds have to set aside increasingly costlier capital to execute CDS transactions.
Respondents in the survey said exchange traded bond funds are increasingly taking the place of single-name and index CDS as a way to hedge their corporate debt exposure.
The use of bond ETFs have taken off in recent months as rising interest rates globally, particularly in the United States, and negative yields in some parts of the world, notably Europe, have prompted investors to demand such products, although they are still a tiny portion of the overall market. For example, total bond ETFs in the United States are about 2 percent of the outstanding size of the US market while global assets under management in these products are about one percent of the total market, according to various surveys.