Options are picking up where credit default swaps left off
Yet the market for CDSs is now just a shadow of its former self. In its place, traders looking to hedge their corporate bond risks are taking on good old-fashioned options against the equity side.
A credit default swap is basically an insurance policy in case a borrower suffers a credit event. For example, a bondholder would buy a CDS so that if the company gets downgraded, that bondholder would get a payout to help compensate for the drop in value – even if the company doesn’t actually default.
CDSs came to the fore during the financial crisis when many bond-like mortgage-backed securities were downgraded. Large financial institutions had a tough time paying up on all the CDSs taken out against the downgraded MBSs.
Because of post-crisis regulations and a bad rep, the CDS market has tumbled to $14.6 trillion from its 2007 level of $58.2 trillion, notes a new report by Callie Bost, an analyst at the Tabb Group. At the same time, the total of U.S. corporate bonds outstanding have gone from $5.3 trillion to $8.1 trillion.
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That doesn’t mean traders are leaving their bond positions unhedged. Rather, they are diving into more liquid markets. “They’re looking toward equity options, they are looking toward ETFs, and they’re looking toward futures,” said Bost.
The energy sector, for example, has seen a huge jump in options activity over the past couple of years as declining oil prices add more risk for both bond and equity owners alike.
And it’s not just single-stock options that are seeing a rapid rise in volume. Options trades on some exchange-traded funds are also soaring as traders hedge some of their highly correlated positions. Bost points out that options volume on iShares iBoxx $ High Yield Corporate Bond ETF (HYG) have quadrupled over the past two years while those on its investment grade counterpart (LQD) have gone to 197,000 contracts from just 12,000 in that time frame.
But those fearing the start of another crisis caused by the upsurge in options volume can breathe easier for the time being. Bost doesn’t expect options holders to take on such massive hedge positions in the underlying securities that they would wreck the market. In other words, she doesn’t see the options tail wagging the underlying bond or stock dog any time soon.
“Right now, it hasn’t been as much of a concern,” said Bost “It’s definitely not at the level that CDSs were at before the financial crisis, so it’s not something people should be worried about just yet.”