The period from 2007 through to 2009 saw many credit markets transform, with credit spreads moving from all time lows to all time highs, a report by Deutsche Bank says.
Prior to the credit crunch these lows contributed to classic credit investments often being subordinated to equity when making portfolio asset allocation decisions. Credit has sharply re-priced since 2008.
The re-pricing of credit is increasingly leading to reconsideration of its role in portfolio construction and asset allocation. Portfolio managers are more vigilant about the potential downside due to credit risk exposure. They also use credit value driven instruments, such as credit default swap indexed products and corporate bond benchmarked products, to extract value from credit yield fluctuations and improve portfolio returns.
Historically, direct access to credit markets via a fund was only possible through cash bond benchmarked products. The European ETF market now houses products that can give access to credit yield related returns both through cash bond as well as CDS index benchmarked products, according to Deutsche Bank. There are currently 34 ETFs benchmarked on corporate bond indices and 25 ETFs benchmarked on CDS indices in the European ETF market.
CDS indices have enjoyed stable and liquid market conditions, with open interest of USD11.4trn as of 15 June, comprising 43 per cent of the overall CDS market open interest. CDS benchmarked ETFs benefit from CDS market liquidity and thus often do away with pricing issues that are prevalent in the wider fixed income market, especially in less liquid segments such as high yield.
2012 ETF cash flows reflect the renewed role of credit in portfolios through the corporate bonds market. Corporate bond benchmarked ETF flows – a sub-category of fixed income – gathered an impressive EUR3.1bn of inflows over the first half of 2012. This accounts for close to 60 per cent of the entire 2012 European ETF industry overall cash flows (EUR5.2bn). This trend also held true for the US ETF market, where corporate bond benchmarked ETFs gathered USD20bn of inflows over 2012, accounting for close to 30 per cent of the US ETF market’s YTD inflows.
CDS indexed ETFs in the European market are a relatively new and less used product. They have gathered marginal flows of EUR50m this year. However Deutsche Bank believes that they represent an interesting addition to the ETF investor’s tool box given current credit market conditions. The elevated role of credit returns when making asset allocation decisions is relevant both when taking risk-on as well as risk-off views.