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We are pleased to offer you a myFT Daily Digest email that provides you with the latest news on Credit Default Swaps every morning. As more companies face default on their debts, traders at banks and hedge funds are returning to the market for individual companies’ credit-default swaps (CDS) as a form of insurance against default.
You may recall the boom in CDS before the financial crisis and how they contributed to the downfall of AIG. Well, they’re making a comeback! According to Barclays, CDS trading volumes for a group of investment-grade bond issuers increased by 62% in the first half of 2023. The bank also found that CDS volumes for a group of junk-bond issuers rose by 41% compared to the previous year.
It’s important to note that this surge in activity doesn’t necessarily indicate imminent corporate-debt chaos. We came across a commentator’s alarming social-media post about the share of investment-grade corporate bonds trading below par, but it’s essential to consider that fixed-rate bond prices decrease automatically when rates and yields rise. Therefore, the only conclusion we can draw from the post is that the Fed has raised rates quickly.
The bigger picture here is that until this year, traders primarily hedged against broad credit markets, as corporate bonds were losing value overall due to the aforementioned Fed rate hikes. Moreover, after a few orchestrated defaults designed to trigger payouts for CDS holders, the market became relatively inactive. However, this has changed in 2023. According to Barclays credit and credit-derivatives strategist Jigar Patel, the net notional amount of CDS outstanding for American corporate borrowers (excluding Latin America) has reached its highest point since at least 2018. This indicates that the greater risks now lie in individual companies’ bonds rather than the market as a whole.
Barclays’ credit strategists previously noted in a July report that this shift is a result of the “credit cycle continuing to mature,” meaning that defaults are expected to increase, along with “idiosyncratic” risks like this year’s concerns about banks’ unrealized bond losses. Along those lines, there are several interesting names that have experienced the most CDS trading activity so far in 2023, based on average weekly volume.
Among the borrowers that have seen the largest increase in their notional CDS outstanding this year, one notable name is Bank of America. Patel explains that a significant portion of the increase in Bank of America CDS volumes can be attributed to heightened hedging demand during the regional bank crisis. Approximately 42% of BAC’s trading activity in the first half of the year occurred within a five-week period from mid-March to mid-April.
While it is true that one of the most common uses for CDS is hedging by a company’s lenders, this was also the case last year, as Patel points out. So, what has changed in 2023? Patel believes that the willingness of other investors, particularly hedge funds, to provide an outlet for hedging demand has contributed to the increased activity. This, in turn, creates a virtuous cycle of activity. One potential reason for investors’ increased willingness could be changes in standard CDS-contract definitions that make it more difficult to execute the types of tactics that previously upset many people. However, these changes were implemented in 2019, and the significant uptick in CDS activity has only been observed this year. Therefore, the primary explanation for traders’ renewed interest in single-name CDS appears to be the mature “credit cycle” and “idiosyncratic” risks highlighted by Barclays in July. In other words, investors are engaging in more single-name CDS trading because they believe that certain companies may struggle to manage their debt burdens and will seek restructuring options with the fed funds rate above 5%.
So, is a busier CDS market a bad sign? It’s safe to say that it conveys a sense of impending doom compared to bond prices falling when yields rise. We have chosen not to link to the aforementioned social-media post because we are still embarrassed on their behalf, and there is no need to drive more traffic to it.
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