- Despite the steady decline in trading of credit-default swaps (CDS) over the past 12 years, CDS usage surged during the March 2020 depths of the COVID-19 crisis.
- The long-standing liquidity advantages of CDS baskets over single-name CDS grew as credit conditions worsened.
- Deteriorating liquidity conditions in the single-name-CDS market contributed to market dislocations in credit spreads.
In the years since the 2008 global financial crisis (GFC), market observers have frequently expressed concern about the health and future of credit-default swaps (CDS).1 Could institutional investors find the liquidity they needed to hedge credit risk in subsequent periods? The dramatic increase in the volume of traded CDS seen in the March 2020 COVID-19 sell-off showed that the market could in fact ramp up in time of need. The resiliency of the market was most evident in the CDS-index market, which demonstrated that large volumes could be traded at relatively low transaction costs. But investors seeking protection in specific underlying companies via single-name swaps had to incur significantly higher costs.
Record Global Trading in CDS in March
Monthly aggregated traded notional value (denominated in USD) of corporate and sovereign single-name CDS and CDS indexes. Source: IHS Markit, MSCI.
After the GFC, CDS trading steadily declined.2 This decline dramatically reversed with the onset of the coronavirus pandemic, as market participants sought protection against the quickly deteriorating credit outlook. The USD 4.6 trillion in traded notional value during March was 116% higher than the previous elevated levels experienced in September 2019, as shown in the exhibit above.3 Most of this dramatic growth was due to increased trading in CDS indexes, while trading volume for single-name CDS rose only slightly.
Index Liquidity Suffered, but Rebounded Quickly
CDS indexes have consistently been the most liquid segment of the CDS market. Prior to the onset of the coronavirus pandemic, the most recently issued series in the CDS-index market were trading at bid-ask spreads of approximately 1-2 basis points (bps).
Things changed in late February when COVID-19’s spread began to significantly impact the market. During the worst days of March, the quoted bid-ask spread spiked to around 10 bps for the most liquid Markit CDX North American Investment Grade Index.4 The liquidity shock proved to be shorter than the credit shock, and trading costs reverted back to much tighter levels within several weeks, as the exhibit below shows. Meanwhile, the bottom chart in the exhibit below shows that credit spreads remained elevated, but gradually tightened to pre-pandemic levels.
Tighter Bid-Ask and Credit Spreads on Index vs. Underlying Basket
The top chart shows the bid-ask spread of CDS indexes against the median bid-ask spread of their underlying single-name CDS, quoted on the spread. The bottom chart shows the quoted spread of CDS indexes, the credit spread of the underlying basket of single-name CDS and the basis between the two. Source: IHS Markit, MSCI.
Liquidity in Single-Name CDS Lagged
Liquidity in single-name CDS deteriorated much more than that for CDS indexes, with the average bid-ask spread quoted on single names increasing from its pre-pandemic level of 5 bps to 20 bps by late March. And the recovery in single-name liquidity was also much slower, with the current bid-ask still several basis points wider than pre-pandemic levels.
Credit-Spread Basis Was Slow to Recover
The market stress caused dislocation between CDS indexes and single-name CDS. Credit-spreads widened much more for a basket of single-name CDS than for the corresponding index, pushing the so-called spread basis to -62 bps on March 24.5
Arbitrageurs wanting to take advantage of this dislocation might have had an incentive to sell protection (and receive the credit spread) on single names and to buy protection on the index. But the high transaction costs of putting on the trade and then exiting might have deterred such arbitrage and helped delay the gradual recovery in the basis. In other words, the dislocation in liquidity conditions may have directly contributed to the deterioration in the credit-spread basis between CDS indexes and single names.
A Trade-off Between Liquidity and Specificity
The credit-derivatives market was alive and well and provided credit protection during the COVID-19 crisis. CDS indexes offered much more liquidity during the crisis than single-name default swaps, and liquidity in the indexes also rebounded significantly faster. Investors may want to consider the trade-off between the specificity provided by single-name CDS and the liquidity benefits offered by CDS indexes.
1See, for example: Rennison, J. “Wall St eyes revival of crisis derivative.” Financial Times, May 19, 2015.
2Aldasoro, I. and Ehlers T. “The credit default swap market: what a difference a decade makes.” BIS Quarterly Review, June 5, 2018.
3In both months, new series of CDS indexes were issued, and newly issued indexes have typically contributed to elevated trading activity.
4The bid-ask spread is calculated as a weekly average of daily bid-ask spreads, quoted on the spread.
5Index basis (or skew) is the difference between the spread of the index quoted on the market versus the credit spread of the underlying CDS basket that replicates the index, representing the relative price of protection between the index and the underlying basket of single names.