Credit derivatives strategy finds value in capital constraints

With doveish central bank policy in the US and Europe having a tightening effect on yields across a range of asset classes, investors are increasingly seeing the appeal of alternative investment strategies. This is especially true of strategies utilising credit derivatives, which are also being deployed in novel ways that take advantage of regulatory capital constraints experienced by banks.

Seeking to capitalise on these trends, Axiom Alternative Investments launched its Credit Opportunity Fund in December last year, growing it from an initial €20m to almost €100m today. This particular fund is a Luxembourg RAIF structure, but the firm plans to launch a UCITS version later this year, with both investing in the same credit derivatives – namely iTraxx and CDX indices as well as holding some cash, such as treasuries.

David Benamou, cio at Axiom, says the fund captures two main opportunities, with one being a “relatively traditional, long-short strategy” using credit derivatives on indices to capitalise on pricing dislocations in order to drive a return. The other part of the approach is more unusual, coming from “the regulatory need for banks to recycle risks in order to improve their return on capital”.

The portfolio is designed to be positive carry and non-directional, with a positively convex risk profile which could improve performance in case of large market moves. This should, in theory, protect it from disruption in the event of a downturn scenario.

The firm also recently hired CDS veteran Bedis Gharbi as a senior portfolio manager, to support the growth of the fund. On the less traditional side of the fund’s strategy, he comments that it “takes advantage of regulatory constraints [on] banks’ credit derivatives desks.”

He adds: “Investment banks are now very constrained from a regulatory capital point of view and that has impacted their ability to trade indices profitably. As such, we saw an opening for a strategy such as Axiom’s that is also scalable, in a market that needs alternative ways to generate return.”

In general, investment banks are often less able now to sell the super senior tranche of a credit derivatives index, as a result of the low yields offered - they still, however, need to dispose of them to reduce their cost of capital. A willing buyer, however, might then be able to generate yield by holding these tranches.

Of the plans to launch a UCITS version of the fund, Gharbi notes that UCITS funds can bring in a wider investor base, although there are more investment restrictions associated with this structure. He adds that while the underlying assets are the same, the UCITS fund will position towards the more liquid end of the indices, with a lower target return of 5-6%, compared to the hedge fund, targeting 10-12%.

The investor base in the current Credit Opportunity Fund is mainly family offices, hedge funds and wealth management firms; groups that tend to be more knowledgeable about the kind of products the firm offers, says Gharbi. He adds that one hurdle to gaining investment in the fund is that some investors simply aren’t well versed in credit derivatives investment strategies.

As a result, Gharbi says: “We have taken steps to help with this - for example including a glossary in our investment materials. Having said that, tranche trading, index trading and trading on options are very well understood by some investors, who know that it is a very liquid and standardised investment strategy.”

The firm remains optimistic that it will grow the investor base further within the existing fund and note that they have already received a lot of interest for the UCITS fund. In line with this growth, Benamou says the firm is open to new hires, and it also intends to launch some other initiatives later in the year - one in the credit derivative space and another in the fixed income space, but not in credit derivatives.

Richard Budden