Corporate bonds are becoming more popular than credit default swaps, as the influence of hedge funds and other leveraged investors declines and money managers seek out more traditional fixed income investments.
Healing equity and credit markets have sparked a surge of new corporate bond supply as investors that had been hoarding cash amid volatile markets gain more confidence in an economic recovery.
"The demand we're seeing for credit is almost exclusively in bonds," said Eric Beinstein, strategist at JPMorgan.
Investors burned by losses on volatile equity markets and alternative investments in 2008 are increasingly allocating funds to fixed income, and these investors prefer debt to derivatives, Beinstein said in a conference call on Friday.
"There has been a shift of ownership from prop desks or hedge funds to cash investors," he said. "This investor base appears to prefer to use 'basic' products and to keep counterparty risk as low as possible, given recent history."
Credit default swaps have been denounced for the role the contracts played in spreading the risks of bad mortgages and other assets, in many cases with extremely high leverage.
Concerns that counterparties on the contracts may be unable to make good on their obligations also came to the fore after the collapse of Lehman Brothers and problems at American International Group, accelerating moves to clear the contracts through central counterparties.
"The lesson from last year is (investors) kind of like owning a bond, there's no counterparty risk," Beinstein said. In many cases bonds also offer covenant protections that CDSs don't have, he said.
Taking long views in credit via CDSs had been favored by investors such as hedge funds as the position requires only a portion of money upfront, unlike bonds which require the entire investment to be funded at the outset of the trade.
CASH INVESTMENTS
Much of the recent demand for corporate debt is from investors that may be restricted from investing in CDSs, said Byron Douglass, senior analyst at Credit Derivatives Research in Walnut Creek, California.
"I don't think that's necessarily investors choosing bonds over CDSs, some are just investors that have been out of the market and are restricted by cash-only mandates," he said.
At the same time as demand for bonds heats up, structured investors that have traditionally taken the long view on credit via CDSs have left the market.
"As we move toward the more normal environment we are missing a natural seller of protection. That person used to be structured credit and that's not happening any more," said Sivan Mahadevan, head of credit derivatives research at Morgan Stanley in New York.
"If we don't have a return of some form of structured investing through CDSs then it would change the credit scene very, very much," Mahadevan said.
Structured investment vehicles had been the key driver pushing CDS spreads tighter from 2003 to early 2007.
ARBITRAGE
As corporate bonds gain at the expense of CDSs, an arbitrage relationship that has created the most popular trading strategies for hedge funds and bank prop desks may also reverse.
So-called basis investors have taken advantage of CDS trading cheaper than the yields paid on the bonds of the same company, known as a negative basis, which allowed them to buy the debt and also buy protection, locking in a positive gain while removing the default risk.
The average basis of investment grade companies has narrowed to negative 100 basis points, from negative 274 basis points at the end of last year, according to JPMorgan.
"This trend is going to continue until we get to a basis that's flat or even positive," said Beinstein.
Investors will want spreads on credit default swaps to exceed those on bonds before they will prefer that exposure, he said.
Morgan Stanley's Mahadevan, however, believes sellers of protection may return to the market, investing in simpler, less leveraged products.
"We still have a long way to go to reverse the negative basis, I don't think we're going to get there any time soon, and it will be a very different world when we do," he said.
(Editing by James Dalgleish)
