Everything Rally Hits Derivatives Market

Bond fund managers find themselves awash with excess cash, leading them to explore the derivatives market as a means of deploying these funds. This trend has resulted in a decline in the cost of protection against defaults, reminiscent of levels observed during the early stages of central banks' interest rate hikes.

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The inclination towards tightening credit-default swap spreads reflects the prevailing optimism pervading markets. Credit investors, buoyed by ample liquidity, have been actively acquiring significant volumes of new debt, effectively pushing back the previously concerning "maturity wall" that loomed just six months ago. Utilizing credit derivatives indexes such as the Markit CDX North American Investment Grade Index has become a favored strategy among money managers seeking desired exposure.

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Scott Kimball, chief investment officer at Loop Capital Asset Management, highlights the liquidity and accessibility of CDX as a means to manage credit risk amid a scarcity of available cash bonds. He notes that recent tightening largely stems from institutional investors seeking to invest more capital than bonds available in the market.

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Fraser Lundie, head of fixed income at Federated Hermes, anticipates a short-term boost in the credit derivatives index market due to a forthcoming "roll" of credit default swap contracts at the end of March. This roll involves the release of new indexes tracking a refreshed basket of companies, which typically increases trade volume. Lundie explains that this presents an opportunity for investors to extend exposure and capture additional spread, while also potentially prompting a reassessment of negative views among certain investors.

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Mohammed Kazmi, portfolio manager and chief strategist at Union Bancaire Privee, favors synthetic indexes like CDX.HY and iTraxx Crossover to express his bullish outlook on the junk bond market. He emphasizes their liquidity and favorable valuation compared to cash bonds, highlighting the wide spreads of derivatives as an attractive feature.

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Despite the broader tightening of spreads, certain segments of the market exhibit fragmentation. Euro-denominated bonds from firms rated CCC and below, considered high-risk, have not participated in the general rally. Additionally, S&P Global Ratings reports a notable uptick in corporate failures in 2024 compared to previous years, indicating underlying challenges despite market optimism.

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Bank of America Corp. strategists Ioannis Angelakis and Barnaby Martin advise utilizing CDS options as a hedge against market euphoria, particularly in high-grade credit. However, calls for wider default swap spreads have not materialized, with credit continuing to rally unabated. With traders scaling back expectations of rate cuts and no immediate looming threats, the outlook remains relatively sanguine.

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In summary, the surplus liquidity among bond fund managers has prompted increased activity in the derivatives market, leading to a decline in the cost of protection against defaults. While optimism prevails in credit markets, challenges persist in certain segments, necessitating caution and strategic hedging against excessive market exuberance.

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