The time is right for credit futures

Key Takeaways

• Risk management is a key driver in demand for credit futures
• Futures tied to US corporate debt offering could be a catalyst
• Ideal time for credit futures due to electronification, futurization

Credit futures, which allow investors to hedge against or speculate on the credit risk of an underlying asset, are slowly gaining traction.

Their ability to provide a transparent and standardized way to manage credit exposure and their effectiveness in helping investors strategically navigate and optimize investments in volatile markets are big draws for what is still a relatively recent offering.

New products targeting the huge US corporate bond market might be a game-changer and lead to more widespread adoption.

Early days

Back in September 2021, Eurex launched credit index futures to meet the growing demand for listed products that offered a new method to access the euro credit derivatives market and improve risk management.

Lee Bartholomew, the global head of derivatives product R&D for FX and Fixed Income at the German derivatives exchange, said in a June newsletter that a ‘keen buy-side appetite’ for credit index futures in the US and European markets is accelerating demand for product development.

Active managers are feeling the pressure from the rise of passive investment vehicles and are seeking alternative liquidity pools to reduce execution costs. They are focusing on products that are fungible, liquid, and transparent, Bartholomew said. The electronification and indexing of trades through portfolio trades and exchange-traded funds (ETFs) have enhanced price discovery and liquidity in fragmented credit markets.

The adoption of credit futures in the US is anticipated to drive adoption globally. The US dollar, the denomination of more than 70% of global debt, plays a significant role.

Tapping US corporate bonds

The CME Group, the world’s largest derivatives marketplace, introduced credit futures in June targeting US investment-grade and high-yield corporate bonds.

The US corporate bond market is one of the largest globally, with a daily trading volume last year of USD 40 billion, supported by the growth of ETFs and other financial products.

The deep markets for companies seeking debt financing ‘coupled with ongoing electronification and futurization across a number of credit markets, make now an ideal time for participants to deploy credit futures,’ CME says on its website.

Investors can use credit futures to manage their investments in constantly changing markets efficiently. Other benefits include:

• Capital efficiency: They enhance capital efficiency by allowing margin offsets with other cleared products, reducing overall margin requirements and improving portfolio management.
• Flexibility: They effectively manage duration risk through intercommodity spreads with US Treasury futures, isolating credit risk from interest rate fluctuations.
• Liquid investments: They trade on regulated exchanges, reducing uncertainty and offering investors more efficiency and liquidity.
• Portfolio management: They allow investors to manage their portfolios agilely and efficiently by adjusting the credit risk exposure.
• Price transparency: Futures markets provide transparent pricing. This helps the price discovery process for underlying credit risk, leading to more efficient markets.
• Regulatory compliance: Regulated futures markets offer a level of security and compliance.
• Risk management: They work in a systematic manner to protect investors from the various risks of the market; investors can quickly change positions and increase their chances of profitability.
• Speculation opportunities: They have the potential to attract traders. They provide opportunities to speculate on the direction of the credit spread and allow investors to hold positions in the market without the underlying bond.

Credit futures aim to boost capital efficiency through margin offsets with other cleared products and facilitate duration risk management through intercommodity spreads with US Treasury futures. This dual approach isolates credit risk from interest rate fluctuations, offering strategic flexibility in managing financial portfolios.

But, as with all financial products and strategies, there are challenges, including:

• Market complexity: Trading in credit futures requires considerable investment experience. Hence, navigating the complexities of markets can be a barrier for less experienced investors.
• Leverage risk: Investors must understand and carefully manage the requirement of margins, as the presence of leverage in future trading amplifies both profits and losses.
• Compliance burden: Credit futures, a recent innovation in the market, creates an operational burden owing to stringent regulatory compliance.
• Market access: Trading in credit futures is not straightforward. It requires credible brokers and a recognized trading platform, which increases the associated costs and complexities.
• Volatility: There is considerable uncertainty over how the market will receive the rise of credit futures. This means that they can experience significant price swings, at least in the initial phase.

What’s next for credit futures?

A few days after launching its credit futures offering, CME said more than 400 contracts had traded. One fixed-income portfolio manager said, “The opportunity to isolate credit or duration risk while benefiting from margin offsets with CME Group’s deeply liquid futures markets enables us to hedge our portfolios and provide greater liquidity to a greater number of clients.”

Looking ahead, some believe that the adoption by the Commodity Trading Advisor (CTA), also known as the managed futures market, where professional money managers typically take long or short positions, might be the next big step. The CTA market, worth USD 350 billion, could enhance the credibility of credit futures. A PGIM executive, writing in the FT last year, said that in these times of macroeconomic uncertainty investors should hedge their bets by including managed futures investment strategies.

With regulators laying out more stringent rules to mitigate risk and measure stress in capital markets following financial crises, the buy side and sell side might heed the message to hedge their exposure as the Basel Committee’s Fundamental Review of Trading Book (FRTB) is rolled out next year.