Less than a decade after the most recent major banking crisis, Goldman Sachs Group Inc. and JPMorgan Chase & Co. are offering investors a new way to bet on the next one.
The two financial giants are now making markets in derivatives that allow investors to bet on or against high-risk bank bonds that financial regulators can wipe out if a lender runs into trouble. Others are also planning to start trading the contracts, known as total-return swaps, in the coming weeks, according to Max Ruscher, the London-based director of credit indexes at IHS Markit Ltd., which administers the benchmarks that the swaps are linked to.
At a time when financial markets are racing from one high to another, and even the new Nobel laureate in economics is wondering aloud about investor behaviour, the development is at once a sign of the headlong global race for investment returns and nagging worries that the investors may be getting ahead of themselves.
Underlying these trades are securities known as additional Tier 1 notes, which banks started issuing after the European debt crisis. They seek to protect taxpayers from bearing the cost of government bailouts, bringing with them relatively high yields. In an era of near-zero interest rates, they've become sought after by debt investors around the world, ballooning into a $150-billion (U.S.) market.
The average yield on the debt is about 4.7 per cent, or around 10 times that for senior bank bonds, based on Bank of America Merrill Lynch index data.
Tier 1 capital is a "shock absorber" that banks can use to boost their balance sheets in an emergency, while imposing losses on creditors, Jim McCaughan, chief executive officer at Principal Global Investors, said in an interview. That could create a negative "feedback loop" for traders, he said.
"I don't believe it's a danger yet because I don't think there's that speculation going on in a big way," he said. "But watch this space and be very wary of this."
At least some of the demand for the new derivatives is coming from investors looking to protect themselves should prices of the debt drop – or should another banking crisis erupt. Those risks emerged in June, when AT1s issued by Banco Popular Espanol SA were wiped out as part of a bank rescue.
"Some participants are looking to get exposure to an asset class while others are hedging their positions," according to a report on IHS Markit's website. "On one side of the TRS trade, the index buyer anticipates that the total return of the index will rise. The index seller on the other side takes the opposite view."
Wall Street and City of London banks have a long track record of creating derivatives around debt markets as investors grow nervous that they're becoming too exposed. Before the financial crisis a decade ago, they created credit-default swaps tied to subprime mortgages, enabling the trade that Michael Lewis made famous in his book The Big Short. Other swaps created around the same time have since become used to bet against commercial mortgages that are heavily exposed to shopping malls.
AT1 notes can't be hedged with credit-default swaps because banks can skip coupon payments on the bonds without triggering a default.
The total-return swaps allow investors to hedge a basket of AT1s, and traders can make amplified gains – or potentially outsized losses – without having to own the underlying notes or tie up large amounts of collateral.
Goldman Sachs is making markets in swaps tied to an iBoxx index of U.S. dollar-denominated bank-capital notes and a gauge of similar euro bonds, Mr. Ruscher said. The two indexes include AT1s issued by lenders such as Banco Santander SA, Deutsche Bank AG and HSBC Holdings PLC.
The swaps on bank-capital note indexes "will be a very useful addition to the toolkit that our clients use in managing risk and taking broad-based exposure to the AT1 market," said Manav Gupta, Goldman's co-head of European credit flow trading, who confirmed that the bank is making markets for the trades.
A spokesman for JPMorgan confirmed the bank is also offering swaps on iBoxx indexes. Deutsche Bank started trading total-return swaps referencing Bloomberg Barclays indexes last month and plans to trade on iBoxx gauges, a spokesman said.
Total-return swaps are being introduced now because of the growth of the AT1 market and investor demand, Mr. Ruscher said. Still, the index swaps may be more useful for investors looking to reduce exposure to the market than those seeking to gain. BlueBay Asset Management, for example, prefers to select individual bonds and avoid weaker issuers that may enter indexes.
"It will be useful to have if we ever feel the need to hedge the asset class, but right now we remain confident this is a structural long position we want to run," said Marc Stacey, a London-based fund manager at BlueBay, which oversees $57-billion. "We don't think we will be active users at the outset."
In a total-return swap, buyers usually pay sellers the London interbank-offered rate. If the index goes up over the period of the contract, the buyer gets money from the seller; if there's a decline, the buyer pays an extra sum to the seller. Either way, larger index changes lead to larger payments.