Derivatives Market Impacted by Broad Market Rally

Bond fund managers are currently facing a surplus of cash, prompting them to delve into the derivatives market to utilize these funds effectively. This development has led to a decrease in the cost of protection against defaults, reminiscent of levels seen during the early phases of central banks’ interest rate hikes.

The trend of tightening credit-default swap spreads mirrors the prevailing optimism in the markets.

Credit investors, buoyed by abundant liquidity, have been actively acquiring substantial amounts of new debt, effectively pushing back the previously worrisome “maturity wall” that loomed just six months ago.

Money managers are increasingly using credit derivatives indexes like the Markit CDX North American Investment Grade Index as their preferred strategy to achieve the desired exposure.

Derivatives Market Impacted by Broad Market Rally
Corporate failures up in 2024, signaling challenges amidst market optimism, S&P reports. (Credits: Harvard Business School)

Scott Kimball, chief investment officer at Loop Capital Asset Management, emphasizes the liquidity and accessibility of CDX as a tool for managing credit risk amid a shortage of available cash bonds.

He notes that the recent narrowing primarily stems from institutional investors aiming to invest more capital than what is currently available in the bond market.

The head of fixed income at Federated Hermes, Fraser Lundie, anticipates a temporary increase in the credit derivatives index market, driven by an upcoming “roll” of credit default swap contracts set for the end of March.

This role involves the introduction of new indexes tracking a refreshed basket of companies, typically leading to increased trading activity.

Lundie suggests that this presents an opportunity for investors to expand their exposure and capture additional spread, potentially prompting a reevaluation of negative sentiments among certain investors.

Portfolio manager and chief strategist, Mohammed Kazmi, at Union Bancaire Privee, favors synthetic indexes such as CDX.HY and iTraxx Crossover to express his optimistic view of the junk bond market.

He highlights their liquidity and attractive valuation compared to cash bonds, pointing out the wide spreads of derivatives as a compelling feature.

Despite the widespread tightening of spreads, certain segments of the market are experiencing fragmentation. Euro-denominated bonds issued by firms rated CCC and below, deemed high-risk, have not participated in the general rally.

Derivatives Market Impacted by Broad Market Rally
Bank of America suggests CDS options as a hedge; credit rally defies wider spread calls. (Credits: Mint)

Furthermore, S&P Global Ratings reports a noticeable increase in corporate failures in 2024 compared to previous years, indicating underlying challenges despite the prevailing market optimism.

Strategists Ioannis Angelakis and Barnaby Martin from Bank of America Corp. suggest using CDS options to hedge against market euphoria, especially in high-grade credit.

However, despite expectations for wider default swap spreads, credit markets continue to rally without any hindrance. With traders tempering their expectations of rate cuts and no immediate looming threats, the outlook remains relatively optimistic.

The surplus liquidity among bond fund managers has led to increased activity in the derivatives market, reducing the cost of protection against defaults. While optimism prevails in credit markets, challenges persist in certain segments, highlighting the need for caution and strategic hedging against excessive market enthusiasm.

Michael Manua
Michael Manua
Michael, a seasoned market news expert with 29 years of experience, offers unparalleled insights into financial markets. At 61, he has a track record of providing accurate, impactful analyses, making him a trusted voice in financial journalism.
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