Capturing high-yield carry: the benefits of a CDS-based approach

In the zero-interest-rate world of the 2010s and early 2020s, bond investors were fixated on the search for yield. Now, on the other side of the 2022 hiking cycle, we are in an environment of structurally higher yields and where credit spreads are at near-record tights. With yield levels largely attributable to elevated cash rates, a new search is underway. 

Investors now seek carry, or the excess yield over the risk-free rate.

The investment incentives of both searches are extremely similar, with investors moving down the credit spectrum, looking for the best opportunities to access yields in excess of cash rates. As a result, HY markets are an important allocation, with HY corporate-bond funds being the obvious choice. However, HY bonds come with a complex set of considerations, from default risk to illiquidity. Are there more efficient ways to access their attractive carry? 

In this article, we make the case for using of CDS indices as a vehicle for accessing this carry, namely via iTraxx Crossover in Europe and CDX HY in the US. We set out the liquidity benefits these products can bring and analyse how they perform versus traditional HY corporate-bond indices, as well as assessing in what environment they may be the best suited mechanism for accessing HY carry.

“Increased adoption of CDS indices is testament to the ease of access to high-yield markets – at high volumes and reasonable costs – they provide.”

Illiquidity is costly

Corporate bond markets have grown massively in the last 20 years, with the US market alone increasing almost fivefold. Yet over that same period, banking regulation to strengthen balance sheets has seen dealing desks become more like brokerages. The result has been a 90-95% collapse in the level of corporate-bond inventories held by primary dealers (see Figure 1A). This impact is particularly acute in HY, where balance sheet usage for bank desks is most elevated. 

These contrasting dynamics have made liquidity conditions within corporate-bond markets extremely challenging, keeping trading costs in the form of bid-ask spread elevated despite innovations in broader market trading capabilities (see Figure 1B). 

FIG 1. Corporate bond market liquidity conditions and costs²

Read also: Fixed income in 2025: a balancing act featuring carry, credit and duration risk

This dynamic does not exist in the CDS index space, however. In fact, the disparity in liquidity between HY corporate bonds and HY CDS indices is enormous. On average, CDS indices offer bid-ask spreads 10 times lower than corporate bond indices in the HY space, across both euro and USD-denominated markets (see Figure 2A). This is supported further by an increasing volume in CDS indices – so much so that CDS index trading volume is now comparable to that of the entire corporate-bond index combined (see Figure 2B). 

The increased adoption of CDS indices is further testament to the ease of access to HY markets – at high volumes and reasonable costs – they provide.

FIG 2. Corporate bond market liquidity conditions and costs³ 

Outperformance as well as liquidity

While the increase in liquidity is welcome, does it rule out an illiquidity premium for holding illiquid or less-liquid assets in the long run? According to financial theory, a long-term position in HY corporate bonds should be expected to outperform a strategy which continually rolls a sell-protection position in CDS indices.⁴  

But this is not the case. Figure 3 shows the performance of US dollar and euro HY indices versus a strategy of selling CDS HY (iTraxx Crossover) combined with a duration exposure to match the HY index. With the duration exposures matched, potential outperformance is generated by the HY credit exposure via CDS indices over corporate bonds. 

This analysis indicates that selling protection on HY CDS indices could significantly outperforms the excess returns of a long HY corporate bond index over time and across both currencies – in absolute terms and on a risk-adjusted basis, with and a Sharpe ratio that is more than 50% higher.

FIG 3. CDS-based HY returns vs HY corporate bond benchmark returns⁵

Read also: 4 passive pitfalls: why fallen-angel bonds need active management

All about the basis

What drives this outperformance potential? First, there are large constituent differences between the two investment vehicles. CDX High Yield and iTraxx Crossover contain 125 and 75 underlying single-name instruments respectively, while the Bloomberg US Corporate High Yield and Pan-European High Yield indices have almost 900 and 400 underlying tickers respectively. As a result, the two universes clearly have very different sector and ticker compositions, which will result in performance discrepancies. We call this the composition effect. We calculate this as the difference in return between the relevant bond benchmark and a CDS index-matched bond portfolio. 

What exerts a greater impact on potential returns is the basis effect, which is the difference between the performance of the CDS index and the aforementioned CDS index-matched bond portfolio. Figure 4 shows the outperformance of the CDS strategies decomposed into these two subcomponents.⁶ As you can see, it is in fact the basis, and not composition, which is the overwhelming source of outperformance for the CDS strategy – as well as the main source of volatility in tracking error between the two.⁷ This implies an advantage over corporate bonds embedded within the CDS instrument itself that generates outperformance, rather than just a sectoral or security selection play.

FIG 4. Basis versus composition in CDS-based strategies – cumulative performance (Dec 2004 – Oct 2024)⁸

Read also: Fixed income opportunities – globally, in Asia and Switzerland

A question of timing

One component of basis, which drives short-term performance patterns, is the spread difference between CDS and bond indices. The average spread differential through time has been roughly zero, so is not attributable to the long-run, persistent outperformance of CDS indices. However, the spread difference does deviate throughout the cycle – quite significantly at times – and ultimately acts as a source of volatility in the tracking error between the two strategies. 

Figure 5 plots a scatter chart of the spread difference (CDS spread less index spread) against the 12-month forward outperformance of CDS versus bonds. There is a strong positive correlation between the spread difference and the future performance, suggesting that in times of higher CDS spreads versus bond spreads, CDS will outperform. We are currently in such an environment, with CDS spreads moderately higher than corporate-bond spreads.

Figure 5. CDS versus bond spread difference plotted against future performance⁹

An alternative route to HY carry

In a search for carry, an allocation to HY credit is vital. However, the way in which investors access it is often overlooked, with corporate bond indices being the go-to option. We believe that accessing HY markets through CDS indices is an extremely compelling option, offering both enhanced liquidity and potentially higher realised risk-adjusted returns. With CDS spreads also currently providing a value incentive over corporate bonds, a CDS-based HY allocation should be a strong consideration for fixed income allocators seeking carry, in our view.