NEW YORK, April 30 (IFR) - Historically low volatility in credit default swap indices offers a cost-effective opportunity for investors to start hedging their bond positions through credit options in case of a liquidity crisis, some strategists say. But with prices failing to reflect any panic, many think it's not worth the trouble - or expense - just yet.
Fears of a credit-market liquidity crisis have mushroomed in tandem with this year's surge in debt issuance.
Many bank strategists and others worry that the market will be exceptionally vulnerable to a sell-off once the Federal Reserve finally decides to start hiking rates.
"A less liquid market will be vulnerable to gap risk at turning points in the cycle," Phanikiran Naraparaju, a credit analyst at Morgan Stanley, wrote in a research note last week.
"A fundamentals-driven liquidation leads to a more severe drawdown as everyone heads to the exits at the same time, causing bigger gap risk."
He and others are pointing investors towards the CDS market for protection, believing there will be less of a liquidity problem there than in the cash bond market if the sell-off occurs.
So far, though, the volatility markets are not showing any sign that investors are heeding the call to hedge.
Credit volatility - which determines the cost of a credit option that in turn provides protection on bond portfolios - remains near its lowest levels since the financial crisis.
Three-month implied volatility on Markit's Five-Year High-Yield CDX Index is at 6%, slightly above post-crisis lows of 5% - and well under the five-year peak of 21%.
"It's very hard to find the right size for a hedge that isn't going to completely cut into your returns."
The same measure on the iShares iBoxx US$ High-Yield Corporate Bond exchange-traded fund is at 8%, also just above post-crisis lows of 5.5% compared with highs of 25%.
Using CDS options as a hedge is not a new idea, strategists say, but the instruments are particularly appealing right now because they are readily available - and cheap.
About US$80bn notional of credit swaptions traded in March 2015 versus US$40bn in March 2013, according to Barclays, which also came out in favour of the instruments as a hedging tool in a recent report.
Not surprisingly, one main argument against piling into a hedge right now is that it will cut down on profits.
"The possibility of a liquidity crisis is very real." said the head of trading at one investment management firm with more than US$300bn in assets under management.
"But it's very hard to find the right size for a hedge that isn't going to completely cut into your returns." Others note that a US rate hike might cause turmoil in the markets - and in times of stress, derivatives sometimes diverge in performance from the underlying cash market.
When oil prices dropped some 60% in the fourth quarter of 2014, for example, the Markit HY CDX Index sold off four percentage points less than the Barclays US HY Corporate Index, according to Barclays data.
"The CDS market often seems to have a life of its own," said Peter Aspbury, high-yield bond portfolio manager at JP Morgan Asset Management.
"Indices and single-name contracts might be a more liquid means of managing credit risk but by their very nature CDS products are not a true proxy for bonds or bond markets," he told IFR.
"There's no perfect hedge for the cash market."
A version of this story will appear in the May 4 edition of IFR Magazine, a Thomson Reuters product. (Reporting by Mike Kentz; Editing by Shankar Ramakrishnan and Marc Carnegie)