Credit Default Swaps - soon available to retail investors

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DetroitRed
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Credit Default Swaps - soon available to retail investors

Post by DetroitRed » Sun Jun 01, 2014 5:58 pm

Retail investors will soon be able to invest in ETFs tied to the main credit default swap (Markit) indexes.

See - http://www.etftrends.com/2014/05/prosha ... swap-etfs/

I'll be interested to see whether this becomes a recommended part of may recommended asset allocations. CDSs are a unique asset class. They have a lot of upside potential when the world starts falling apart.

My biggest problem with them currently is that CDSs still trade OTC so there's counterparty risk. Hopefully in the near future they'll trade on exchanges and a lot of the counterparty risk will be removed.

kenner
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Re: Credit Default Swaps - soon available to retail investor

Post by kenner » Sun Jun 01, 2014 6:29 pm

DetroitRed wrote:Retail investors will soon be able to invest in ETFs tied to the main credit default swap (Markit) indexes.

See - http://www.etftrends.com/2014/05/prosha ... swap-etfs/

I'll be interested to see whether this becomes a recommended part of may recommended asset allocations. CDSs are a unique asset class. They have a lot of upside potential when the world starts falling apart.

My biggest problem with them currently is that CDSs still trade OTC so there's counterparty risk. Hopefully in the near future they'll trade on exchanges and a lot of the counterparty risk will be removed.


Fascinating.

A word of caution from Bloomberg:

http://www.businessweek.com/articles/20 ... ault-swaps

Calm Man
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Re: Credit Default Swaps - soon available to retail investor

Post by Calm Man » Sun Jun 01, 2014 8:29 pm

I am salivating at the opportunity to buy credit default swaps. OK, I admit I was making a joke. Are you kidding? This is the wrong site for that type of thing. Good luck if you buy them though..

DetroitRed
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Re: Credit Default Swaps - soon available to retail investor

Post by DetroitRed » Sun Jun 01, 2014 8:38 pm

kenner wrote:
A word of caution from Bloomberg:

http://www.businessweek.com/articles/20 ... ault-swaps


Bloomberg seems to see CDSs as only being useful to day traders (in fairness to them, that's the primary ProShares user).

I see them as doing a lot of the same things as gold or US Treasuries.

CDSs and gold have a similar weakness - no income stream. And the same strength - value should increase in times of market turmoil. The North American Investment Grade CDS index that ProShares will follow went from around 30 in January 2007 to 279 in December 2008, almost a tenfold increase (I looked up the pricing on a Bloomberg terminal). Treasuries obviously have an income stream.

Gold's spot price had a low of around $600 in Jan 2007 and went over $950 in March 2008. A very good return during a volatile market period, but nowhere near the return from CDSs.

Of course if your CDS counterparty goes bankrupt and the federal government doesn't bail them out (hello AIG!), then your CDSs would be much, much worse than gold in a time of crisis.

kenner
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Re: Credit Default Swaps - soon available to retail investor

Post by kenner » Sun Jun 01, 2014 8:48 pm

DetroitRed,

I'm pretty sure about a couple of things:

There is a role for credit default swaps in the investment universe.

It is probably not advisable for average investors to "swim in that pool".

All best,
Ken

veekay
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Re: Credit Default Swaps - soon available to retail investor

Post by veekay » Sun Jun 01, 2014 11:25 pm

A bit of a bummer. These are just CDS indices. I'm saving up all my money so one day I can go all in and buy leveraged CDS on Berkshire Hathaway.

Valuethinker
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Re: Credit Default Swaps - soon available to retail investor

Post by Valuethinker » Mon Jun 02, 2014 2:29 am

kenner wrote:DetroitRed,

I'm pretty sure about a couple of things:

There is a role for credit default swaps in the investment universe.

It is probably not advisable for average investors to "swim in that pool".

All best,
Ken


I believe this view is correct.

I believe also we will wake up one day to find some 'prudent' and 'professional' institutional investor like a university endowment or a state pension fund has lost a *lot* of money on investing in CDS as a 'diversifying asset'. Maybe it has already happened.

Frank Partnoy's FIASCO is a salutary discussion of how professional derivatives traders at the big banks slaughter institutional clients. All based on his time at Morgan Stanley. Don't think the game has been completely changed-- the same motivations and the same asymmetries (in rewards and expertise between buy and sell side) are still out there. Read about some of the CLO buyers in The Big Short.

My impression and experience of derivatives trades for small investors is that they lose more than they win-- it's not a level playing field. The odds are with the 'house' ie the market intermediaries.

ubermax
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Re: Credit Default Swaps - soon available to retail investor

Post by ubermax » Tue Jun 03, 2014 7:00 am

Not a CDS pro but the way I remember it the CDS was originally an inexpensive way to hedge default risk for institutional fixed asset investors - then zillions of mortgages were packaged and securitized and the CDS entered the speculation realm - and then Paulson and the boys bet big against housing and made a ton of money .

With tightening credit and underwriting after '07-'08 I would think CDS contracts would be back to being relatively cheap again, i.e. small default risk - but I don't see where the opportunity exists for a big killing like before - where's the bubble , any bubble ?
Last edited by ubermax on Tue Jun 03, 2014 11:22 am, edited 1 time in total.

Valuethinker
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Re: Credit Default Swaps - soon available to retail investor

Post by Valuethinker » Tue Jun 03, 2014 8:07 am

ubermax wrote:Not a CDS pro but the way I remember it the CDS was originally an inexpensive way to hedge default risk for institutional fixed asset investors - then zillions of mortgages were packaged and securitized and the CDS entered the speculation realm - and then Paulson and the boys bet big against housing and made a ton of money .

With tightening credit and underwriting after '07-'08 I would think CDS contracts would be back to being relatively cheap again, i.e. small default risk - buy I don't see where the opportunity exists for a big killing like before - where's the bubble , any bubble ?


Salutary tales in Michael Lewis of the big banks rigging CDS prices to protect their balance sheet values. If you are playing against that, what hope do you have?

Michael Bury (hedge fund manager in in The Big Short) had his investors pull their money, in part because the banks on the other side had rigged prices so it looked like his massive shorts were going wrong.

The purpose of derivatives is to hedge cash positions. The rest is speculation. If you don't own the credit risk, why would you buy the CDS? (other than to profit from a speculative arbitrage?).

Valuethinker
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Re: Credit Default Swaps - soon available to retail investor

Post by Valuethinker » Wed Jun 04, 2014 2:57 am

ubermax wrote:Not a CDS pro but the way I remember it the CDS was originally an inexpensive way to hedge default risk for institutional fixed asset investors - then zillions of mortgages were packaged and securitized and the CDS entered the speculation realm - and then Paulson and the boys bet big against housing and made a ton of money .

With tightening credit and underwriting after '07-'08 I would think CDS contracts would be back to being relatively cheap again, i.e. small default risk - but I don't see where the opportunity exists for a big killing like before - where's the bubble , any bubble ?


The trick as you say is to buy the CDS when the credit spreads are small and CDS prices are low. However post crash with a less liquid market, changes in terms (more upfront by the protection buyer), and also (in theory at least) greater visibility, it's hard to see that you will get on the right side of that trade.

Ie when the spreads are low, they may go lower (CDS prices fall then). There will be a greater 'risk premium' built into the pricing for the protection seller (a gap between the priced rate of default and the lower actual rate of default). There are unlikely to be AIGs in the future (huge sellers of protection at way too low a price).

It's one of those things where you will probably get cyclical opportunities-- every few years. But you could take some real pounding if you are early.

I think the actual logic here would be a closed end fund that sold protection. Would generate a regular income. *however* I'd have to think about whether that income was uncorrelated (default is correlated with the economy and therefore with the stock market, and this fund goes down when defaults go up). It might be a diversifying income stream (but I have just argued it is not). If it all goes wrong, the CEF would just go bust. You'd lose your investment (but no more).

richard
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Re: Credit Default Swaps - soon available to retail investor

Post by richard » Wed Jun 04, 2014 4:58 am

DetroitRed wrote:<snip>I'll be interested to see whether this becomes a recommended part of may recommended asset allocations. CDSs are a unique asset class. They have a lot of upside potential when the world starts falling apart.<snip>

I usually think of a diversified portfolio as consisting of direct interests in the underlying companies or governments (stocks and bonds) rather than including derivatives, which are a step removed. (Mutual funds are bundles of direct interests.) Just because something behaves differently from stocks and bonds doesn't mean it's a good idea to invest in it.

Valuethinker
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Re: Credit Default Swaps - soon available to retail investor

Post by Valuethinker » Wed Jun 04, 2014 5:06 am

richard wrote:
DetroitRed wrote:<snip>I'll be interested to see whether this becomes a recommended part of may recommended asset allocations. CDSs are a unique asset class. They have a lot of upside potential when the world starts falling apart.<snip>

I usually think of a diversified portfolio as consisting of direct interests in the underlying companies or governments (stocks and bonds) rather than including derivatives, which are a step removed. (Mutual funds are bundles of direct interests.) Just because something behaves differently from stocks and bonds doesn't mean it's a good idea to invest in it.


I am thinking buying a CDS index is a pure investment in credit risk. So you are diversifying along the credit risk axis?

However there's no holding return in that-- the money gets paid to the sellers of protection, not the buyers (I would guess the index tracking is done synthetically ie with a series of swaps with investment banks?).

That makes me worry about it. Normally you get paid for holding credit risk: a higher yield on the underlying instrument.

Presumably as the CDS index rises that means risk of default is falling? Credit spreads dropping?

richard
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Re: Credit Default Swaps - soon available to retail investor

Post by richard » Wed Jun 04, 2014 6:14 am

You would be diversifying along the credit risk axis, but is that a good axis for diversification?

Another possible way to look at it is whether your investment is a zero sum game. Essentially direct interests in underlying economic assets are not zero sum games - with stocks and bonds you own a piece of a business that can increase in value. That's not the case with CDSs. I'm sure there are edge cases, but it could be a reasonable principle.

If you were to diversify along the credit risk axis, would you take the long or short position? Perhaps a proper diversification along this axis nets to zero.

Valuethinker
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Re: Credit Default Swaps - soon available to retail investor

Post by Valuethinker » Wed Jun 04, 2014 6:23 am

richard wrote:You would be diversifying along the credit risk axis, but is that a good axis for diversification?

Another possible way to look at it is whether your investment is a zero sum game. Essentially direct interests in underlying economic assets are not zero sum games - with stocks and bonds you own a piece of a business that can increase in value. That's not the case with CDSs. I'm sure there are edge cases, but it could be a reasonable principle.

If you were to diversify along the credit risk axis, would you take the long or short position? Perhaps a proper diversification along this axis nets to zero.


That is a very good way of thinking about it. Thank you for clarifying my thoughts.

That's precisely what went wrong in the Crash (we had believed we had diversified away risk, when in fact we had simply passed it along ie forgotten that it was zero-sum, and in the process 1). lost interest in monitoring and controlling that risk (asymmetric information/ 'pass the parcel') 2). left it in the hands of people who were *not* able to bear it (or had moral hazard) such as AIG.

If you have a long exposure to credit risk, it may be a diversifying factor: that is Rick Ferri's argument for holding HY bonds. Empirical evidence is, I think, it is a small diversifier.

There is greater evidence (but also considerable train wrecks during the Crash by university endowments and other institutions that read too much into the research/ weren't prepared for the downside) that liquidity is a diversifying factor (ie going long illiquidity can provide higher returns).

If you hold assets with risk of default you are picking up a credit premium. You can hedge that by buying a CDS or CDS index. But it will therefore pay away your credit premium.

Tanelorn
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Re: Credit Default Swaps - soon available to retail investor

Post by Tanelorn » Thu Aug 07, 2014 12:27 pm

Proshares offerings will be TYTE (long credit) and WYDE (short credit), tracking high yield credit spreads.

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