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High yield investors sitting on 50% returns this year have one all-consuming objective over the next 60 days; protect the gains. While some are simply selling out through a slew of portfolio auctions, those that must remain invested are increasingly turning to exotic CDX swaptions to lock in their profits, multiple sellsiders and buysiders told Debtwire.
Trading of puts and calls with December expiries on the HY CDX – an index comprising the 100 most liquid single-name credit default swap contracts – picked up significantly in recent weeks, said two analysts and a trader. The index itself reflects the risk of the referenced credits, meaning that its buyers are actually selling credit default protection (long credit) and sellers of the index are actually long protection (short credit).
The growing use of HY CDX options to hedge long credit risk cut the bid/ask spread on the instruments in half to 20bps last week from 40bps two months ago, the analysts and trader said. That new demand hasn’t gone unnoticed by Wall Street and Morgan Stanley, Goldman Sachs and JPMorgan have all begun to actively support markets in HY CDX options. All three banks declined to comment.
While consensus grows that junk bonds are overbought, the timing of a correction is anybody’s guess given the technical factors driving the current rally. As a result, some investors are also putting on swaptions with March expiry to hedge in 1Q10. Trading in the later-dated options remains light relative to December puts and calls with a bid/ask spread of 35bps, said the first analyst.
Investors are turning to puts and calls on the index rather than buying protection outright because swaptions are far cheaper and offer more flexible maturities.
Buyers of protection through the index must typically put on contracts lasting at least six months while options can range as little as one month. Swaptions also cost less because they don’t involve the coupon incurred by buying protection outright and because their shorter duration translates into far smaller upfront payments.
Not just I-grade anymore
Specialist funds have traded CDX swaptions in investment grade for years. The massive liquidity and low volatility in that market allows them to bet on the range the IG index will trade in with relatively little risk. Range trading also took off in the highly followed European Crossover index that combines investment and speculative grade credits.
But, until now, the illiquid CDX HY market in the US provided little interest as a swaption play because it was too choppy to play safely or in size. CDX options still make for an unattractive range play, but they’re drawing a new audience as a straightforward hedge.
The average ticket size for high grade option trades is USD 25m-USD 50m in notional amount while high yield tickets are USD 5m-USD 15m and growing, said a sellside CDX trader. “Our motivation to push this market has been to make it one where it’s not just one or two dealers anymore,” he added.
CDX swaptions give the holder the right to buy or sell the index at a certain time in the future and the cost of the option is a one-time payment expressed in basis points. Unlike options on stocks, a put on the CDX allows the holder to buy the index in the future – selling the underlying credit risk – at a pre-determined strike price in the future. A call gives the holder the option to sell the index in the future.
One of the most popular strategies pitched to the Street has been bearish risk reversals. To put the trade on, a high yield investor will buy out-of-the-money HY CDX puts to hedge downside market risk and sell out-of-the-money calls to fund the puts, creating a very low cost hedge. If high yield bonds perform well rather than correcting downward, the swaption holder still profits through the call.
Take the money and hedge
The subtext to the rise of HY CDX swaptions is the mounting worry about how long junk bonds can keep up their record run.
Net flows into high yield bond funds rose 40% in 2009 year-to-date, bringing total assets under management to USD 82bn, according to AMG data. That’s the biggest annual percentage change since 1992 – the second largest was a 28.6% jump in 2003. The current stock of assets in the industry ranks third behind the USD 99bn logged in 2004 and the USD 90bn logged in 2005.
While those inflows reflect the broader trend, they only represent 20% of the total investment dollars piling into high yield from hedge funds, sovereign wealth funds, banks and institutional investors, among others, said several analysts.
The speed and intensity of the inflows – and the resulting rally of bond prices – are not sustainable and small signs of a slowdown are already cropping up.
Inflows into high yield funds dropped a marginal 8.5% to USD 1.26bn in October from USD 1.37bn in September, according to AMG data. The number of new high yield bonds tracked by Debtwire gapped roughly 50% to 28 in October from 63 in September.
Another important indicator is the growing gap between realized – or current – volitality in the HY CDX index and implied volatility three months into the future. At the depths of the downturn in February, realized 90-day volatility hit a high of 23% with implied volatility 2-3 points higher, estimated a credit derivatives analyst.
Both realized and implied volatility tightened in dramatically since then to 11% and 16%, respectively. But the six-point spread between the two expresses options investors’ greater uncertainty about the future.
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