ETF Brings Credit Derivatives Loved by Hedge Funds to Masses

(Bloomberg) -- After revolutionizing the way investors buy everything from equities to gold, ETFs are now threatening to disrupt the trillion-dollar market in credit derivatives.

A decade on from the financial crisis, a London-based provider of passive products is testing whether the speculative trading strategy has appeal beyond a rarefied group of institutional debt investors.

Tabula Investment Management listed an exchange-traded fund on Sept. 7 that tracks a gauge of credit default swaps on European corporate bonds, joining only a handful of ETFs that offer similar exposure.

The Tabula European Performance Credit UCITS ETF, ticker TCEP, provides a long position in the region’s credit markets by selling protection against default on a group of investment-grade and high-yield companies. The fund earns a coupon with this strategy, though in the event of a default or other credit event, it could be forced to pay out -- causing losses.

ETF Brings Credit Derivatives Loved by Hedge Funds to Masses

The prospect of bringing speculative credit trading to more mainstream investors -- even the Mom and Pop crowd -- would displease Pope Francis, who rebuked the market in May as a “ticking time bomb."

In April, European regulators warned that investors who have presided over a “deterioration’’ in the overall quality of European corporate debt could be caught off-guard by monetary tightening.

Why invest in an index of swaps rather than a gauge of cash bonds? Simple: the former strips out interest-rate risk from the equation, according to a release from Tabula.

“Specialist credit managers can isolate and manage credit risk using credit default swap indices,’’ said Michael John Lytle, chief executive officer of Tabula. “This is a liquid and efficient market, but it isn’t accessible to all asset managers.’’

With ECB asset purchases set to conclude in December, most economists predict euro zone policy makers will increase the deposit rate by September next year -- a challenge for bondholders accustomed to relentless stimulus.

Volumes tied to CDS indexes have surged as money managers seek more liquid alternatives to cash bonds. Respondents to a recent Greenwich Associates survey said they preferred index swaps to single-name CDS. Amid an uptick in volatility, U.S. credit derivatives trading volume jumped 65 percent year-on-year in the first half of 2018, according to JPMorgan Chase & Co.

Aside from a handful of passive products, the only way to gain exposure to CDS indexes is via derivatives and structured notes, instruments that allow investors to take short positions as well. The Tabula ETF has nearly half of its long exposure to BBB names that some hedge funds have targeted with short positions.

While a clutch of XTrackers ETFs that track indexes of European CDS have managed to gather hundreds of millions of euros in assets, others have been less successful. In the U.S., ProShares closed one of a pair of long/short products tied to North American CDS indexes, while the remaining fund, the ProShares CDS Short North American HY Credit ETF, holds less than $5 million in assets.

The Tabula ETF charges an annual fee of 0.5 percent.

©2018 Bloomberg L.P.