More investors are utilizing derivatives to make up for liquidity concerns in the fixed-income market. For example, PIMCO is using credit-defaults swaps as an alternative in its flagship fund, but the exchange traded fund version has been left out.
According to Pacific Investment Management Co.’s quarterly report, Bill Gross has increased his usage of credit-default swaps in the second quarter, selling protection against credit losses.
Credit default swaps, or CDS, provide a way to play the creditworthiness of the riskiest to the safest corporate debt issuers. Essentially, CDS hedge against possible issuer default on bonds. CDS buyers pay sellers until the contract matures. In turn, the seller agrees to compensate the buyer in the event of default.
More money managers are dipping into credit default swaps to gain exposure to the notoriously illiquid fixed-income market. CDS allow investors to quickly access investment-grade and high-yield bonds, which trade less as a proportion of the overall debt outstanding, with banks utilizing less of their money to make markets.
The PIMCO Total Return Fund (PTTRX) raised the amount of protection it sold against losses on corporate debt in the three months ended June 30, raising a measure of risk tied to credit-default swaps by 62% compared to the first quarter, reports Lisa Abramowicz for Bloomberg.
However, the PIMCO Total Return ETF (NYSEArca: BOND), an actively managed ETF version of PTTRX, does not include futures, options and swaps, according to PIMCO.
The BOND ETF’s exclusion of swaps may have helped the fund outperform the flagship fund. BOND has gained 4.6% year-to-date and is up 5.6% over the past year, whereas PTTRX is up 3.7% so far this year and rose 4.4% over the past year. [Bill Gross ETF Topping Mutual Fund Counterpart]
Derivatives help make it easier to place bets over the short-term, but the contracts also exacerbate potential losses in a weakening market. Additionally, if defaults rise, swap sellers would have to compensate their counterparties for any losses, which can further weigh on bond funds that hold the derivatives.
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Max Chen contributed to this article. Tom Lydon’s clients own shares of BOND.