Asset AllocationJuly 11, 2014

Is it Time to Reconsider Credit Default Swaps?

An increasingly illiquid bond market requires a new way of managing new capital, argues Hermes Fund Managers.

Reported by Featured Author

Investors need to reassess their liquidity management in the light of falling bond market liquidity, according to Hermes Fund Managers.

Since the onset of the financial crisis a number of investment banks have pulled out of acting as market makers for fixed income trades, making it harder for investors to trade large amounts.

In a newsletter to clients, the group warned that liquidity was “the most acute risk” to investors as it would magnify a selloff in bonds—something which is expected when interest rates finally begin to rise.

Hermes—which is wholly owned by the BT Pension Scheme—said investors should look to the growing credit default swaps (CDS) market to access more liquid securities.

CDS provider Markit is adding more issuances of the contracts—which are effectively an insurance against a bond defaulting—to its indices, which Hermes said was broadening investors’ options and improving trading conditions.

“We’ve long argued that exposure to well-performing, but expensive, bonds can be gained by selling the corresponding CDS contracts,” Hermes said. “In addition to finding cheaper ways of accessing credit risks, we’ve observed that improving liquidity in the CDS market has quickened the tempo of price discovery so that it is more rapid than in the bond market, where trading is slower.”

Fund managers and consultants have been warning of reduced bond market liquidity since 2012, while some have gone as far as to question whether the largest fixed income funds are, in fact, too large.

In March Deutsche Bank warned investors to expect a “market wobble” in the second half of this year as markets anticipate imminent increases in interest rates.