Bonds, ETFs or CDS – in high yield, which is more resilient to liquidity shocks?

The volatility spurred by Liberation Day and its aftermath reminds investors of the risk that sharp selloffs can suddenly become liquidity events, in which negative sentiment spirals and triggers a ‘dash-for-cash’. In credit markets, this can be particularly damaging for carry-focused¹ strategies that become squeezed as this often-crowded trade gets unwound. This begs the question: can carry-based allocations be positioned to better deal with the threat of a sharp downturn?

In a previous article, we explored the use of derivatives as an alternative to cash bonds for accessing HY market carry. We found that using CDS delivers both outperformance and superior liquidity compared to cash bond indices. Now, we build on this analysis to assess whether broad market regimes play a role in the relative performance of the two instrument types – and more specifically, how they behave during liquidity crises. Given the increased liquidity of ETFs as corporate-bond vehicles, we also look at how these instruments fit into the spectrum of performance and liquidity.

Can a CDS-based approach to HY offer superior liquidity in a crisis?

Profiling CDS-based approaches during liquidity shocks

To answer our question, we start by calculating the six-month performance of a CDS-based approach relative to the global HY benchmark index (see Figure 1).

FIG 1. Six-month rolling relative performance – CDS-based vs bond-based HY²

As you can see, the performance pattern indicates strong mean-reverting behaviour, particularly within the basis, with periods of outperformance followed by underperformance and vice-versa. Note that since we use six-monthly rolling data, visually we will tend to see mean-reverting behaviour. To remove this confounding effect, we calculate partial autocorrelations with monthly returns and their lags.³ The partial autocorrelation results show short-term trending behaviour, with the length reflecting the usual timespan of a liquidity shock of around one to two months. Over the medium- to long-term (three to 12 months), we see a strong mean reversion in the performance of CDS-based HY over the benchmark bond index.

The pattern of mean reversion can be explained by the liquidity characteristics and the unfunded nature of credit derivatives. In the initial stages of a crisis, market participants use credit derivatives to hedge, resulting in potential underperformance of CDS versus the benchmark. The archetypal example of this was seen in June-July 2007 and February 2008 with the collapse of Bear Stearns.⁴ Similar reactions were also observable during the Greek elections in May 2012, the Chinese stock market crash in June 2015, and at the start of the war in Ukraine in April 2022.

During the next stage, when a ‘dash for cash’ results in an increase in fund outflows, derivatives tend to outperform. At this point, bonds tend to underperform, owing to their less liquid and funded nature. Here, the key examples are in September to December 2008 during the global financial crisis and from July to October 2011 during the eurozone sovereign-debt crisis. Similar derivative outperformance was also observed between November 2015 and January 2016 during the commodities crisis, at the time of the US Federal Reserve’s policy mistake in November to December 2018, at the start of the Covid pandemic in March 2020, during the period of steep rate hikes from May to June 2022, and at the time of the Silicon Valley Bank crisis in March 2023.

Subsequently, in the final stage, we see a reversal of the liquidity shock, during which CDS-based strategies underperform.

CDS-based HY: outperformance in liquidity shocks

CDS-based HY shows lower volatility than cash-bond equivalents, largely because of its behaviour during liquidity shocks. There have been a handful of liquidity shocks in recent decades, with the global financial crisis of 2008-09 and the Covid-19 crisis of 2020 being the most prominent.⁵

In Figure 2, we track the performance of CDS-based HY through these two liquidity shocks. Additionally, rather than comparing with the cash-bond based HY index alone, we also compare with HYG, the US high-yield ETF, as HYG should represent the most liquid access to cash-bond HY.

FIG 2. Performance through liquidity shocks – HY bond index vs HY ETF vs CDS-based HY⁶

Clearly, cash bonds and HYG experienced a massive drawdown as Lehman Brothers went into bankruptcy in September 2008. This drawdown was largely driven by a dash for cash, which resulted in the HY bond index declining by over 30%. By comparison, CDS-based HY saw a far more modest drawdown of 10%.

The fundamental lack of trading liquidity in cash bonds, along with a severe dash for cash, resulted in significant outperformance by unfunded instruments such as CDS indices. While not as extreme, patterns were broadly similar for HY during the Covid crisis, with CDS-based drawdowns 5% lower than for HY benchmarks and ETFs.

The fundamental lack of trading liquidity in cash bonds, along with a severe dash for cash, resulted in significant outperformance by unfunded instruments such as CDS indices.

ETFs: where liquidity is costly

Above, we showed the performance dislocation of ETFs over the short term. However, ETFs can also have a long-term cost related to liquidity. Most ETFs are not benchmarked to traditional corporate-bond benchmarks but rather to a liquid variant of the standard benchmarks. Cases in point are Blackrock’s⁷ large iShares HYG (US) and iHYG (Europe) ETFs⁸, which are benchmarked to liquid USD and EUR HY benchmarks.⁹

We start by comparing the performance of each ETF gross of fees¹⁰ against its stated benchmark, as well as the standard Bloomberg benchmark. Figure 3 shows that the performance of both ETFs is indeed in line with its stated liquid benchmark. The liquid benchmarks, meanwhile, underperform the traditional benchmarks substantially over time – by more than 0.5% per year over the past 15 years.

FIG 3. Comparing ETFs with liquid and standard cash bond benchmarks¹¹

By calculating the ratios of the liquid and illiquid index levels, we can dig deeper into the relative performance patterns of the two benchmarks considered (see Figure 4).¹²The ratios suggest that the liquid benchmark underperforms in a relatively systematic manner: while we see a jump in the ratio when illiquid assets suffer during liquidity shocks, this pattern then reverses into steadier underperformance, reflecting the long-term cost of liquidity. Overall, the performance data shows that ETF benchmarks have underperformed traditional cash-bond benchmarks by over 50 basis points per year over the past 15 years.¹³

The unique nature of a CDS-based approach delivers liquid access to HY markets without the higher cost that leaves ETFs hamstrung.

FIG 4. Ratio of index values – liquid to Illiquid US HY and EUR HY indices¹⁴

Taking the cost out of liquidity

Ultimately, these findings show that the unique nature of a CDS-based approach delivers liquid access to HY markets without the higher cost that leaves ETFs hamstrung. Investigating performance during liquidity shocks shows that historically, even in the most stressed periods, CDS-based approaches match or outperform cash-bond strategies.

This is particularly true when compared to ETFs, which exhibit the more expected behaviour of liquidity exacting a cost. In an environment where carry is appealing but political volatility increases the risk of tail events, accessing HY markets through CDS indices represents a compelling option for fixed-income investors.