The newsflow has sometimes prompted indiscriminate selling, causing the sudden reappearance of liquidity risk, or rather illiquidity risk, as a major factor in investment decisions. However, during the recent turmoil, CDS indices have confirmed their status as liquid market instruments, comfortably passing the Covid-19 crash test.
Stress and falling liquidity across all asset classes
Both equity and bond markets have seen a decline in liquidity, caused by market stress and forced selling. All liquidity indicators, such as the difference between bid and ask prices (the “bid-ask spread”), point in the same direction: there is less liquidity for mid-cap stocks and, much less intuitively, for US and European large-cap stocks too (based on the S&P 500 and Eurostoxx 50 indices). Corporate bonds have also been affected.
Credit: sharper drop in liquidity during the Covid-19 crisis
All segments of the credit market have been affected. Technical factors have made the situation worse for short-term US investment-grade credit, because investors use these securities (as well as US Treasuries) as collateral for leveraged positions. Volatile market conditions result in margin calls, and so investors cash in these holdings. Since this market segment is also one in which investors park their cash and have less tolerance for risk, selling of these positions has snowballed. When liquidity falls, bid-ask spreads tend to widen and both buying and selling become more difficult during volatility spikes. This is shown by bond ETFs, which have seen their prices uncouple from their benchmarks. However, CDS indices have stood apart from bonds because of their stable liquidity profiles.
CDS indices have remained liquid: a review of liquidity indicators
Firstly, CDS index transaction costs (as shown by bid-ask spreads) are a fraction of those incurred when trading bonds, which drag down returns, particularly in the high-yield segment. For high-yield CDS indices, the bid-ask spread is 15-25 cents. CDS indices also represent around 80% of daily trading volumes in the euro-denominated credit market. Finally, trading volumes for CDS indices increase during times of stress. In March 2020, volumes for the high-yield CDS index in Europe went from €5 billion per day on average to €20 billion per day, a jump of 300%. For the investment-grade index in the US, volumes surged almost 400% from $24 billion to $118 billion.
Why focus on liquidity and CDS indices when seeking credit exposure?
More liquid instruments perform better during times of stress. Conversely, less liquid instruments fare worse. This has been clearly confirmed during the recent Covid-19 crisis. CDS indices have proven more resilient than traditional bonds, as shown by both bond indices (which are by their nature non-investable) and ETFs (investable). This liquidity advantage is seen during times of stress but also during recoveries when investors unwind credit hedges, and over the medium term, particularly because their transaction costs are almost zero.
The Covid-19 crisis has been a real-life crash test for CDS indices, which have passed it with flying colours. It has confirmed the liquidity benefits of these instruments for investors, either alongside or instead of traditional bond strategies.
Olivier Debat
Senior Investment Specialist
Global & Absolute Return Fixed Income