Strategies based on Credit Default Swap Indices as a Potential Equity Alternative: Rationale and Implications
In the ever-evolving world of global finance, a growing number of institutional investors are considering alternatives to equities, driven by significant drawdowns and volatility in equity markets, high valuations of US equities, and the search for more stable returns. One such alternative gaining attention is credit investments, particularly Credit Default Swaps (CDS) indices and multi-asset credit (MAC) strategies.
An efficient frontier analysis by Danny White, Senior Portfolio Manager at TabCap Investment Management, suggests a compelling case for the difference that including liquid credit in a portfolio can make. According to White, if the global equity P/E ratio reverts to a level of 20x or less over the next two years, a 100% allocation to the credit strategy could be optimal. Even under a scenario where global equity P/E remains at their current elevated level of 21x for the next two years, a credit allocation still receives a weight of 77%.
CDS index risk-adjusted returns are typically higher than equity returns, largely thanks to the additional contribution of curve rolldown in evergreen CDS index-based strategies. The unfunded nature of CDS indices makes levering this high risk-adjusted return into a high absolute return a viable investment approach. Selling protection on CDS indices can generate income in credit markets with high liquidity and diversification.
Credit investments directly benefit from higher risk-free rates while equities do not. Despite a high correlation between high yield bond and equity returns being relatively high at 71%, high yield corporate bonds returned an annualized 8.2% from the 2000s while global equities were close to flat with an Internal Rate of Return (IRR) of only +0.2%. Projected IRR of credit investments are more attractive relative to history than an assessment based solely on credit spread levels would suggest. Credit spread levels are only a small part of long-term credit returns, with the risk-free rate and rolldown component playing a significant role in total returns, especially in rolling CDS index strategies.
Credit returns, especially those from multi-asset credit (MAC) strategies, aim to deliver strong income with less than high-yield equity-like risk. Such strategies allow dynamic allocation across a broad universe of credit instruments to capture relative value and incremental returns, potentially offering attractive risk-adjusted returns compared to equities. In contrast, equity returns, particularly from value stocks, are expected to provide higher absolute returns over the long term, but with typically higher volatility.
The long-term correlation between credit returns and equity returns is generally moderate but not very high, and it can vary, especially during periods of market volatility. Studies on Collateralised Loan Obligations (CLO) ETFs and broadly syndicated loans note that while these credit instruments and equities are intuitively expected to be correlated, significant divergence in their returns can occur during volatile periods, indicating that other factors beyond simple correlation influence their performance.
In conclusion, credit investments can provide diversification benefits and potentially more consistent income with less downside risk, making them a valuable complement to equity exposure in long-term portfolios. However, as with any investment, it is crucial to conduct thorough research and consider the specific risks and rewards associated with credit strategies.
The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group.
[1] Source: The Sortino Group's Hedge Funds Guest Articles, a copyrighted publication. [2] Source: BlackRock Investment Institute. [3] Source: TabCap Investment Management. [4] Source: Moody's Investors Service.
Institutional investors are exploring credit investments as an alternative to equity investing in the business realm, driven by global finance concerns such as equity market volatility and high valuations. Danny White, Senior Portfolio Manager at TabCap Investment Management, suggests that a 100% allocation to credit strategies may be optimal under certain global equity P/E ratio scenarios, due to credit investments' potential for higher risk-adjusted returns.
