CDS or ETFs – which provides liquidity most cost-efficiently?

While high-yield (HY) bonds’ attractive spread, carry and income should deliver strong performance, overall returns tend to be hampered by problems relating to liquidity, performance and cost.

In previous articles, we explained the issues with HY investing and why our efficient, low-cost ‘liquid credit strategy’ may offer much better liquidity and potential long-term outperformance from HY markets. In this article we will explain why we believe this approach can also provide a more defensive return profile in times of market stress and avert punitive costs for end investors.¹

Read also: A superior credit exposure: how CDS can help solve performance problems in high yield

The context: liquidity often disappears when it’s needed most

A febrile investing environment has already resulted in bouts of volatility in fixed-income markets in recent years. Given ongoing uncertainty at both a macroeconomic and geopolitical level, adverse events such as the abrupt sell-off in the wake of the Donald Trump’s ‘Liberation Day’ tariff announcements are likely to be a recurring feature of bond markets for the foreseeable future. During selloffs, negative sentiment can spiral rapidly, spurring a ‘dash for cash’ that can cause a major liquidity event.

The problem: not even ETFs can provide liquidity efficiently in a crunch

Volatility-induced liquidity crunches can be particularly damaging in credit markets. As we discussed in a previous article on the key problems with HY bond investing, fixed-income markets have suffered a structural decline in liquidity since the 2008 global financial crisis (GFC), due to a severe drop in the volume of bonds held by market makers.

On top of the day-to day costs associated with poor liquidity in HY corporate bonds, the issue of illiquidity is amplified during periods of market stress, with sellers potentially unable to find willing buyers.

This can become a particularly damaging scenario in high-yield credit markets, where carry-focused¹ strategies can become squeezed as a large number of investors seek to unwind their positions. Not only do these events impact high yield mutual fund investors through the performance drawdown itself, but also via punitive costs such as swing pricing or gating.

Read also: Key problems with high-yield bond investing – and steps toward a solution

Fixed-income ETFs are not the answer to liquidity issues, despite claims to the contrary. Exchange-traded funds (ETFs) have become popular as a cost-efficient, easily traded means of gaining exposure to a range of asset classes. However, unfortunately, in the fixed-income segment, ETFs create their own issues. 

ETFs have two prices: the secondary market price accessible to investors, and the net asset value (NAV) of the underlying assets. Differences between the two create ‘price-NAV dislocation’, a phenomenon that increases significantly on both the upside and downside during major liquidity crunches.

For example, the largest HY corporate bond ETF, which tracks USD HY bonds,² saw gaps of almost 10% between end-of-day prices at the peak of the global financial crisis, and gaps of more than 15% during the recovery (see Figure 1, chart A). Similarly, intraday gaps of more than 7% were experienced during the Covid-19 crisis by the equivalent euro-denominated ETF (iHYG). The consequence of these price-NAV gaps, driven by demand for liquidity, is a loss of as much as 10% relative to the underlying benchmark if an investor exited and then re-entered the position, our analysis shows. Considering that these gaps occur at times of elevated fund flows (see Figure 1B) it’s clear that such losses are indeed realised by many ETF investors during such crisis-then-recovery periods. 

Essentially, financial engineering is insufficient to make a fundamentally illiquid asset class like corporate credit more liquid. This is an important consideration for HY investors seeking to position themselves defensively in a volatile environment.

FIG 1. Drawdown of HY bond benchmarks and the largest US HY bond ETF, HYG³ 

Read also: Think high-yield bonds, but with better liquidity – 3 advantages of a more efficient approach

The solution: accessing higher trading volumes when it matters most

Higher trading volumes can significantly lower the impact costs of trading during market shocks. The much higher trading volumes of derivatives such as credit default swaps (CDS) indices during periods of market volatility makes them a far more suitable instrument for navigating uncertain periods in a cost-efficient manner.

As shown in Figure 2, during stress periods, trading volumes for HY derivatives rise significantly, eclipsing the total trading volume of all cash bonds. Note that trading volumes are in notional terms for derivatives, and we calculate the median notional traded each month, as this removes the impact of volume spikes on roll days.⁴ Meanwhile, for cash bonds. we use the trading volume of all US cash bonds reported from the Trade Reporting and Compliance Engine system (TRACE), which considers more than 5,000 HY bonds. 

Trading volumes are strongly correlated to rises in credit spreads as volumes spike in periods of macro shocks. As a result, a liquid credit strategy can provide increased liquidity in stressed periods – just when it is most likely to be required. This removes the need for end investors to incur the punitive entry/exit costs that plague many HY funds.

FIG 2. High-yield trading volumes vs credit spreads⁵

As a result, a liquid credit strategy shows significant outperformance over ETFs and bond indices in stressed periods. Figure 3 shows the performance of our solution overlayed with HY cash bond and ETF performance during the financial crisis and Covid-19 sell-off. 

Chart A shows that a fundamental lack of trading liquidity saw both US HY cash bonds and ETFs suffer massive drawdowns of over 30% on 15 September 2008, as the bankruptcy of Lehman Brothers triggered a dash for cash. However, the event resulted in a significant outperformance versus cash bonds and ETFs for unfunded instruments such as the CDS indices on which our liquid credit strategy is based. In fact, our modelling shows it would have experienced a far lower drawdown for US HY of only 10%.

Similar (if less extreme) price patterns were in evidence at the onset of the Covid-19 crisis in 2020. On that occasion, maximum drawdowns for our liquid credit strategy were 5% lower than those of benchmarks and ETFs for both US and EUR HY, as shown in charts B and C respectively.

FIG 3. High-yield cash bond, ETF and credit-derivative performance during the global financial crisis and Covid-19 downturn⁶

Conclusion: accessing liquidity and performance potential when it matters most

In addition to providing the potential for better long-run, risk-adjusted returns than HY cash bonds, a liquid credit strategy has the ability to deliver short-term performance benefits in liquidity shocks. Our analysis shows that it can cope well during major market events such as the financial crisis and Covid-19 sell-off – just when  ETF approaches tend to underperform and penalise investors via price-NAV dislocations.

The increased trading volumes of CDS indices during liquidity shocks allow investors to be more agile in these periods without facing highly punitive costs. CDS indices also reduce the impact of fees, such as entry-exit costs, which eat away at end investors’ realised returns.

Taken together, the improved liquidity, long-term outperformance and more effective defensive positioning in crises made possible by a liquid credit strategy makes it a highly attractive alternative to traditional HY bond portfolios, in our view.