Credit futures and swaps complement each other by providing investors with different but interconnected tools to manage credit risk, hedge exposures, and to gain synthetic access to corporate bond markets.
Managing credit portfolios can be made easier if the portfolio manager and trading team are able to use derivatives to better express and manage risk issues around the underlying debt, but both listed and over-the-counter (OTC) derivatives have different strengths and weaknesses that should be considered in order to deliver the best outcome for a portfolio.
Futures are based on investment grade (IG) or high yield (HY) index products rather than individual securities, meaning their activity correlates closely with exchange traded funds (ETFs). They offer standardised, exchange-traded efficiency with all of the support for price transparency and liquidity that entails.
Credit default swaps (CDS) are more bespoke, over-the-counter products and can be single name swaps providing protection against a default, by making the holder good on the value of the contract bought, which settles when a default occurs.
A more commonly traded instrument is the credit default index product (CDX), for which a default adjusts the value of the product rather than settling it. As these are standardised and reflect credit risk across a broader range of instruments, they tend to be more liquid and trade on a tighter spread than a single-name CDS would.
By trading both swaps and futures, investors can effectively hedge their positions using single name CDS to hedge specific credit risks and then trading credit futures to hedge against broader market spread movements and can short sell futures to offset systemic spread widening.
Arbitrage opportunities can be created due to the different speeds of trading between negotiated swaps and exchange traded futures. Basis trades between futures pricing and CDS spreads can be exploited to generate returns, simultaneously increasing market liquidity.
Yet the electronic trading of swaps on swap execution facilities (SEFs) and futures on exchanges substantially reduces the friction that more manual trading can create around timing and price discovery.
Effectively, credit traders can combine the trading of both swaps and futures to optimise regulatory and capital costs while also maintaining optimal risk coverage.
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