Although I might sound a bit technical for the first few sentences of this article, rest assured you do not have to be a professional reader to understand where I am going.
Simply speaking, in the high yield fixed income market exposure to an issuer can be built by purchasing a bond or else by entering a derivative contract for which payoffs depend on whether a given issuer defaults or not. The most common derivative used in this vein is the Credit Default Swap (CDS), which is basically a form of insurance against a credit event. More specifically, through such a contract, one can seek protection from the default of a given issuer by paying an upfront premium (i.e. CDS premium).
Hence, selling for example a Fiat CDS (i.e. selling default protection) or buying Fiat bonds exposes one to broadly similar risks, as in both cases a loss will occur if the issuer defaults. For this reason, the CDS premium should be in line with the bond spreads observed, considering of course similar maturities. However, in the high yield market, bond spreads are usually above the CDS reflecting the lower liquidity, interest rate risks and the higher transaction costs that characterize the `cash` market (i.e. bonds).
Let’s get more practical. Although this exercise is not without shortcomings, I look from time to time at the Markit iBoxx EUR Liquid High Yield Index and contrast it with the iTraxx Crossover 5 Year Total Return Index (a high yield CDS index). The two indices have consistently traded with a gap, reflecting differences in members and the general prevalence of a negative CDS basis in the high yield space. However, in early 2014 and early 2015 the divergences were particularly large.
Year to date, the return of the CDS Index is 4.65% whereas the High yield bond index (let’s call it the cash Index) has accumulated a return of 2.6%. For Q1 2014 the two indices returned 3.6% and 2% respectively.
What does this tell us? The way I see it is that in a risk-on environment the CDS market benefits from the greater prevalence of lower rated names and lack of call constraints.
Starting with the former, the CDS Index has over 35% in B rated bonds while the cash index has some 25% in such notes. We know for a fact that the lower rated bonds (i.e. Bs) outperformed the higher rated ones (i.e. BBs) so far this year as they reversed the overdone correction experienced in the second part of 2014. Probably a similar force was at work in the CDS space as the ECB’s bold movement nudged investors into taking more risk.
Another factor that enhanced the return for the CDS investors was in my opinion the fact that the CDS premiums, although akin to credit spreads, are not constraint by call options. Many of the high yield bonds give the issuer the option to redeem the bonds prior to maturity at a given price; however, as the bond market rallied this means that many bonds are now close to their call price and this limits further gains. To get a feeling of how meaningful this constraint is in the European high yield market at the moment I think it is enough to say that the average effective duration of the asset class is now 3 years.
In contrast, the CDS contracts have certain defined maturities which makes them more alike non-callable bonds. For instance, the index I made reference to earlier is built using 5 year CDS contracts. In my opinion the relative outperformance of this index underscores the disadvantages of the callable bonds in an environment where risk taking is in full swing.
For those who are in agreement with me I think that the immediate conclusion is that the high yield bond market is enjoying a rebound in investors’ sentiment and that their willingness to take on credit risk is somewhere close to the early 2014 levels. In addition I think that as long as the bullish market sentiment prevails investors should take into account that a portfolio shewed towards bonds trading close to the call price is prone to underperformance. Finally, I would say that a position in an ETF tracking the CDS Index could as well be considered as an alternative for a high yield portfolio. Such an ETF is XTXC GY.
Just a side note, in a risk-off environment the CDS index tends to outperform the bond index because of greater liquidity and lack of small issuers (which could be perceived as more vulnerable).
Disclaimer:
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.