Covid crisis triggers most credit insurance payouts since 2009

A corner of the $11.5 trillion market for credit protection that was all but written off after the financial crisis is thriving amid the coronavirus pandemic.

Credit-default swaps, used by investors such as Bill Ackman, Seth Klarman and Boaz Weinstein to insure debt or bet on creditworthiness, are paying out at the fastest pace since 2009. Contracts linked to 19 borrowers have been settled this year as national lockdowns and social distancing measures push more companies into bankruptcy or restructuring, compared with an annual average of 10 over the past decade.

Compensation is also higher, with contracts on U.K. restaurant chain PizzaExpress and U.S. retailer J.C. Penney Co. paying almost 100% of the value insured. In total, protection buyers have recouped at least $6 billion globally this year, more than three times the total for all of 2019, according to data compiled by Bloomberg.

“If you own CDS, you are really getting paid,” said Sean George, chief investment officer at hedge fund manager Strukturinvest in Stockholm. “In times of stress, it’s a go-to product and we’ve seen a lot of stress this year.”

The median bond recovery set in U.S. derivatives auctions this year was a record low of 3.5 cents on the dollar, compared with the average of 23.4 cents between 2005 and 2019.

Ackman, the founder of Pershing Square, is increasing credit wagers after making $2.6 billion buying index protection, while value investor Klarman made $1 billion and Weinstein’s Saba Capital Management posted double-digit gains in part by using swaps to bet against companies.

Trading in the broader credit derivatives market is surging, even as activity in bonds slumps. The Federal Reserve and European Central Bank are buying securities to prop up markets, making it often easier to trade swaps than bonds, according to Jochen Felsenheimer, managing director at XAIA Investment in Munich.

“Central bank purchases are sapping liquidity out of the bond market, so credit swaps have become the place to be,” he said. “CDS is having a very active year.”

Still, the total size of the market is less than a third of its $34 trillion peak in 2008. Volumes plummeted as global rules intended to make the system safer — including mandatory trading through clearinghouses and compression of trades — caused banks to retreat.

The Pope linked swaps to “extremely immoral actions” for their role in the financial crisis and more recently, they have been at the center of a crackdown on manufactured credit events, where investors entice companies to miss bond payments they could otherwise make.

Historically, unpredictable payouts have hurt protection buyers, even after an overhaul in 2014 sparked by glitches settling insurance on Greece and Dutch lender SNS Reaal NV. Traders risked missing a payment linked to U.K. travel operator Thomas Cook last year and experienced months of delays to settle contracts linked to Banco Popular Espanol SA in 2017.

Unlike those situations, this year’s high rate of defaults and lofty payouts are causing pain for protection sellers. The $3 billion flagship fund of London-based CQS, run by billionaire trader Michael Hintze, suffered at least a 30% slump in the first quarter. One of the fund’s main strategies is to sell short-dated credit-default swaps on investment-grade and high-yield bonds.

“Some of the incentives to sell CDS have changed,” said Mahesh Bhimalingam, senior European credit strategist at Bloomberg Intelligence. “For those that are selling protection in a punt that the payoff will be very low and that they can make money on credit swaps versus the underlying bond, that will not work as well as it used to.”

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