Overcoming Liquidity Issues in Managing Corporate Bond Exposures

Since 2008, several regulations have limited the balance sheet capacity of bond dealers, resulting in a rapid reduction of corporate bond liquidity during times of stress. This poses a significant concern considering the upcoming refinancing needs in 2024/2025.
During the same period, credit indices like the US CDX and European ITRAXX have experienced substantial growth, with a record trading volume of $36 trillion in 2022. These indices offer deep liquidity, even during challenging periods such as the COVID-19 pandemic and the banking stress in March 2023.

Originally designed as hedging tools, these indices can also be utilised to gain credit exposure by selling protection on the underlying indices. This raises the question of whether this strategy can effectively replicate the performance of traditional corporate bonds, especially for investors aiming to mitigate idiosyncratic risks through diversification.
Our objective is to replicate the performance of US investment-grade (IG) and high-yield (HY) bonds. To achieve this, we allocate 90% of the cash to US Treasuries ETFs to approximate the duration component. The remaining 10% of cash is used to finance a short protection position on either the US IG CDX or the US HY CDX. This approach allows us to construct a ‘Synthetic US IG Exposure’ with a duration of approximately 5.9 years, and a ‘Synthetic US HY Exposure’ with a duration of about 3.3 years.

Both the Synthetic IG and HY strategies have outperformed their respective ETF counterparts by a significant margin, even after adjusting for the total expense ratio (TER) to match the highest-cost ETF. This outperformance is particularly notable during periods of market stress since 2010. Coupled with their deep liquidity, these instruments prove to be highly effective in managing corporate exposure from a top-down perspective, as we do in the RAM GBTR strategy.

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