Corporate fixed income managers can achieve 0.5% above benchmark if they employ credit default swaps (CDSs) to short bonds, according to research from investment bank JPMorgan*.
One major player, AXA Investment Managers, has responded by claiming that it can achieve this target.
CDSs enable investors to separate credit risk from interest rate risk. They can either buy or sell credit exposure to an individual company, sector or index, providing a whole new flexibility to fixed-income portfolios.
The JPMorgan research, which was based on model portfolios, suggests that shorting individual bonds adds the most alpha. But because this is a risky strategy, JPMorgan advocates a mixture of sector and individual bond bets. Jonny Goulden and Lee McGinty, who carried out the analysis, reckon that this mixture could offer average excess returns of 58 bps and an exceptional information ratio of 1.39.
Such numbers might be mouth-watering but to discover whether they are a true oasis or merely a mirage, fixed income investors would need to take a couple of steps forward; first, loaning to companies and second, employing CDSs.
The risk of default has dissuaded many institutions from lending money to companies rather than national treasuries or international bodies such as the European Bank for Reconstruction Development. This fear seems justified in the wake of disasters such as WorldCom, Tyco and Parmalat.
The very risk of loaning to
corporates, however, ought to make investors think about employing CDSs. They will not prevent executive fraudsters obtaining loans but they can give perceptive investors the opportunity to trade their credit exposure up or down. European houses such as AXA have been using CDSs since 1997. Like most initial investors, AXA began by selling protection. This means buying CDSs in the expectation that the bond will not lose much value or default. For so doing, the buyer receives a premium that is not sensitive to interest rates and hence does not alter the portfolio’s duration risk. Selling protection can be considered akin to offering insurance.
The opposite side of the trade is buying protection, which is tantamount to shorting a bond. The CDS is sold in expectation that the underlying bond will underperform the market. It is not necessary to hold that underlying bond to effect the trade, which makes trading CDSs easier than shorting equities.
Of course you are able not only buy and sell protection within the same portfolio, as sophisticated managers such as AXA now do. You can also buy and sell contracts on the same stock in order to reflect longer-term views on it. Thus, if one thinks a company faces a crucial 24 months, buy protection on a two-year contract to cover the uncertainty and possibly sell a longer-term contract on the presumption that if the company makes it through the next two years the worst will be behind it.
As ever with new financial instruments, they are only as good as the managers who use them – and there has to be someone on the other side of the bargain.
Undoubtedly CDSs add to
the number of tools a fixed income portfolio manager can employ. The JP Morgan modelled returns are based on the differences between a long-only
European credit portfolio and
one which was permitted to short stocks by buying protection. While a portfolio which could short by sector and by bond
delivered the average excess return of 58 basis points, its long-only peer managed just 28 bps.
Finally, one ironic but potential use for buying protection is when fiduciaries wish to have a bulwark against the risk of a sponsor’s demise. Pessimistic as it sounds, selling a swap based on the sponsoring company’s debt would ensure that beneficiaries received some financial return from any anticipated corporate meltdown rather than resorting to lawyers or state guarantee funds. Alas, pension fund members tend not to rank well in legal lists of creditors.
* The Value of Active Management in European credit.
Contact: jonathan.m.goulden@jpmorgan.com

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