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More companies are defaulting on their debt. So traders at banks and hedge funds are jumping back into the market for individual companies’ credit-default swaps, or CDS, to insure against default.
Laypeople reading this may remember the boom in CDS before the financial crisis (and how they helped sink AIG). And hey, they’re back! CDS trading volumes rose 62 per cent for a group of investment-grade bond issuers in the first half of 2023, according to Barclays. A group of junk-bond issuers’ CDS volumes rose 41 per cent in 1H compared to the year before, the bank found.
To be clear, the surge in activity doesn’t necessarily mean imminent corporate-debt chaos; we’re still cringing at a commentator’s doomy social-media post* about the share of investment-grade corporate bonds trading below par. (Fixed-rate bond prices go down automatically when rates and yields go up, meaning the only thing we can conclude from the post is that the Fed has raised rates fast.)
The bigger picture is this: Until this year, traders were doing most of their hedging against broad credit markets, Barclays says. This made sense for a couple of reasons. First, corporate bonds were losing money across the board because of the aforementioned Fed rate hikes. And second, after a handful of gimmicky defaults engineered to trigger payouts for holders of CDS, the market had become a bit of a ghost town.
That has changed in 2023. The net notional amount of CDS outstanding for American corporate borrowers (excluding Latin America) has climbed to the highest since at least 2018, according to a note from Barclays credit and credit-derivatives strategist Jigar Patel:
This shows that the bigger risks now are in individual companies’ bonds, not the market as a whole. In a prior note from July, Barclays’ credit strategists attributed this to the “credit cycle continu[ing] to mature”, meaning defaults are expected to keep rising, and “idiosyncratic” risks, like this year’s panic about banks’ unrealised bond losses.
Along those lines . . . there are some interesting names that have been busiest so far in 2023, going by average weekly CDS volume:
And among the borrowers that have seen the biggest increase in their notional CDS outstanding so far this year:
Here’s Patel on one of those names:
We believe that much of the increase in [Bank of America CDS] volumes can be attributed to elevated hedging demand during the regional bank crisis. About 42% of BAC’s 1H trading activity occurred in a five-week stretch from mid-March to mid-April.
Of course, the most straightforward use for CDS is hedging by a company’s lenders. Why not insure against a borrower’s default if you can? But that was true last year as well, as Patel points out. So what’s different now?
“What appears to have changed in 2023, in our opinion, is the willingness of other investors (especially hedge funds) to provide an outlet for that hedging demand, which in some cases helps create a virtuous cycle of activity,” he wrote.
One reason for investors’ willingness could be changes in standard CDS-contract definitions meant to make it tougher to pull off the types of gimmicks that made lots of people mad. (See the clever controversial GSO / Hovnanian trade from five years ago). But those changes happened in 2019, and the real pick-up in CDS activity only started this year.
That leaves the main explanation for traders’ renewed interest in single-interest CDS as the mature “credit cycle” and “idiosyncratic” risks that Barclays mentioned in July.
In other words, investors are trading more single-name CDS because they think it’s more likely that some companies will struggle to manage their debt burdens and look for restructuring options with the fed funds rate above 5 per cent.
So maybe a busier CDS market is a bad sign? We can at least say it’s doomier than bond prices falling when yields rise.
*We aren’t linking to the post because we’re still embarrassed on their behalf, and there’s no reason to direct more traffic anyway.
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