A mix of troubling factors is converging on credit markets. A conflict in the Middle East shows no signs of slowing, a surprisingly weak US jobs report has raised concerns about consumer strength, and the long-term disruptive potential of artificial intelligence looms over entire industries. With risks piling up, some investors and strategists are deciding now is the time to buy protection against a potential downturn, while such hedges remain relatively inexpensive.
This week, strategists at a major financial institution recommended buying credit default swap protection on the US high-yield index. To offset the cost, they suggested a combination of trades known as a payer swap. Another large bank has recently proposed similar hedging strategies.
These suggestions appear to be gaining traction. The cost of buying protection on high-grade corporate bonds rose noticeably this week, even as the spreads on the actual bonds tightened slightly. This divergence signals that market participants are turning to derivatives for protection against credit risk, rather than aggressively selling off corporate bonds due to default fears.
“There needs to be a material catch-up between the risks the market is worried about and the risks being reflected in corporate bond spreads,” said one portfolio manager. “This is a very good time to be looking at credit hedges.”
The geopolitical tensions are contributing to a rise in oil prices, which could translate into higher inflation. This, in turn, might force the Federal Reserve to slow its pace of interest rate cuts, or even consider hikes again—a move that would negatively impact credit markets.
At the same time, the unexpected loss of jobs across a wide array of US industries is casting doubt on the resilience of consumer spending. Meanwhile, fearful investors are beginning to pull money from certain private credit investments.
Data analyzed by another financial firm shows that bullish bets in credit derivatives have been eroding for weeks, partly due to anxiety over the software sector. A recent jump in trading volumes and spreads suggests this shift in positioning is continuing, likely amplified by recent geopolitical events.
Some money managers have been proactively cutting risk for months as valuations climbed and potential problems grew. One asset management company, for example, reported its lowest-ever allocation to speculative-grade bonds back in June.
“We don’t want to be in a position where we have to be reactive during a market downturn,” said a fixed income strategist at the firm. He added that this cautious stance puts them in a position to snap up bargains if they arise.
For now, widespread panic is absent. The cost of protection has risen, but it remains below levels seen during previous market scares. This lack of extreme fear may actually present an opportunity for investors to reposition.
“Investors can still reposition for risks that appear skewed to the downside,” commented another portfolio manager. “Recent geopolitical events, along with concerns about AI and private credit, are increasingly interconnected. That’s likely to create clearer winners and losers.”
