The use of credit default swaps (CDS) is back on the rise, as investors take risks in the search for extra returns amid low volatility.
A CDS is where the seller of a derivative receives additional payments from the buyer but takes on all the risk in the event of a default.
According to the Financial Times, the issuance of CDS bundles tied to corporate debt has reached $US20-$30 billion so far this year.
It’s on track to more than double the $US15 billion issued for whole of last year, up from $US10 billion in 2015.
The prevalence of credit default swaps came to be viewed as one of the main causes of the global financial crisis in 2008.
In particular, insurer AIG required a government bailout after it was unable to pay its obligations on credit default swaps for structured mortgage products that subsequently defaulted.
The Financial Times said that the investor base for the latest wave of CDS contracts is limited mainly to credit-focused hedge funds, because the products aren’t graded by the ratings agencies.
However, traders said that more recently pension funds from Canada and New Zealand have entered the market.
For the riskier CDS tranches, buyers can make percentage returns from the high-single digits to the mid-teens. Currently, the highest-yielding corporate bonds return 5.8%.
With the return on credit default swaps for low risk corporate debt only around 0.5%, buyers can leverage their position by making smaller payments up-front.
While that strategy was one of the main causes of the financial crisis, traders told the FT that the overall use of leverage is lower this time around.
In addition, although the increasing number of credit default swaps adds an element of risk to the market, corporate debt has proved to be a safe investment in recent years.
The Financial Times cited research from Fitch ratings, which showed that the annual default rate on corporate bonds fell below 2% this month for the first time since March 2014.
In discussing the risk of more defaults, “it terrifies me”, one trader told the FT. “But I don’t think it will happen.”
With predominantly hedge funds on the buy-side of the transactions, Citigroup is the largest bank counter-party to the trades.
The FT said that JP Morgan Chase and French bank BNP Baripas were also active in the market, with Goldman Sachs looking to expand its operations as well.
The banks involved in structuring the deals said they were being more careful not to leave themselves with large balance sheet exposure in the event of debt defaults.
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