Credit hedges for Brexit

CDS indices and CDS index options to the rescue

Ahead of the UK’s EU referendum, Greg Venizelos presents some hedging options for credit investors who may wish to protect their portfolios from downside risks in case of a ‘leave’ outcome.

We would like to acknowledge the valuable contribution of Amaury Boyenval (Solutions & Structuring Group) and Frederic Suhit (Derivatives Management Team).

The most simple protection for a credit portfolio against widening spreads is to reduce exposures, either by selling holdings or by hedging some credit risk via credit default swaps (CDS). Investors who may wish to retain a more asymmetric risk/reward profile by keeping the potential upside while protecting the downside, can employ CDS option instruments (swaptions). These can present attractive strategies that either reduce the cost of hedging or provide a proxy portfolio hedge at a macro level when other ‘vanilla’ hedges are unavailable. For euro credit the derivatives market is relatively deep, meaning investors can find reasonable levels of liquidity in terms of significant transaction size, reasonably narrow bid-offer spread and limited execution delay. The instruments in question are single-name CDS, CDS indices or CDS index options (eg in iTraxx). Today, euro credit investors can hedge a credit portfolio of 5-year maturity by buying protection in the iTraxx Main 5y CDS index, at an annual cost of 85bps vs a portfolio spread annual income of 90bps. Following the event being hedged and the associated repricing in risk premia, investors could unwind the hedge at a wider spread than what they paid for protection, and crystalise the mark to market gains. This will offset some or all of the adverse valuation impact on their cash portfolio. Euro investors could also explore the use of CDS swaptions to benefit from a potential spread widening in euro credit in a more cost efficient way. In their simplest form, swaption strategies may involve the purchase of outright payers (buying a put on a CDS index), which gain increasingly in mark to market terms above their strike price, once the option premium has been recouped. Investors who believe that spread widening will be capped (say due to the Corporate Sector Purchase Programme backstop) can reduce the cost of their hedge by selling a payer at a wider strike (selling a put further out of the money). In such a strategy, mark to market gains level out if spreads widen beyond the wider strike, as further gains on the long payer are offset by losses on the short payer. Exhibit 1 shows indicative pricing information for some typical payer and payer spread strategies with July and September expiries.