The Case for Credit Default Swap Index Strategies as an Alternative to Equities

Credit default swap (CDS) indices are highly liquid, centrally cleared standardised contracts for gaining exposure to corporate credit risk, with average daily volumes of $149bn so far in 2025 (based on J.P. Morgan data). While many market participants buy protection on CDS indices in order to hedge credit risk, selling protection on CDS indices can be an effective way of generating income in credit markets with a high degree of liquidity and diversification.

Significant drawdowns and volatility in equity markets worldwide this year, alongside US equities being at historically high valuations, have prompted many sophisticated institutional investors to consider alternatives to equities in their portfolios. We think there is a strong case for CDS index-based strategies as an alternative or complement to global equity portfolios, and that this is much more the case in the current world of higher short-term interest rates and over-extended equity valuations.

However, this is a nuanced topic and we often find that there are a number of common misconceptions in this space. We will address the three main ones in turn and then offer some concluding thoughts.

Aren’t credit returns highly correlated with equities?

In the short term (i.e. over days, weeks or months), yes, because credit spread changes are correlated with equity moves over these periods. Over the long term, where changes in credit spreads make far less difference, this correlation is considerably lower. Long-term credit returns have an entirely different generation mechanism to equities, being driven by a combination of the risk-free rate, the excess credit spread premium over defaults and the impact from rolldown and composition effects. Long-term equity returns are driven by earnings, earnings growth and the change in valuation multiples.

The 2000s was a very good example of a 10-year period where short-term credit and equity returns were very highly correlated but there was very little correlation in the long-term returns of these asset classes over the full decade.

Indeed, despite the “credit”-focused global financial crisis taking place in the second half of this decade, high yield corporate bonds returned an annualised 8.2% over this period (we use high yield bonds as an example as the iTraxx and CDX indices did not launch until the middle of this decade). By comparison global equities were close to flat over the 2000s with an IRR of only +0.2%, even after including dividends. This outperformance came in spite of the month-by-month correlation of high yield bond and equity returns being relatively high at 71%.

Aren’t long-term credit returns lower than in equities?

For corporate bonds and in most markets, yes. However, we believe that CDS index risk-adjusted returns are typically higher than equity returns, largely thanks to the additional contribution of curve rolldown in evergreen CDS index-based strategies. The unfunded nature of CDS indices means that levering this high risk-adjusted return into a high absolute return is a viable investment approach.

Furthermore, long-term equity returns are highly dependent on starting valuations – it is far harder for equities to perform well in an environment where initial price-to-earnings multiples are elevated. On top of this, credit investments directly benefit from higher risk-free rates while equities do not.

Doesn’t the fact credit spreads are tight make credit an unattractive investment?

Firstly, corporate bond spreads are indeed tight (global IG and HY spreads are both at their 14th percentile of the past 10 years), but CDS index valuations are far less extreme, with investment grade CDS index spreads trading at their 36th percentile and their high yield equivalents at their 50th percentile.

Secondly and in our view, more importantly, credit spread levels are only one small part of long-term credit returns, with the risk-free rate driving a large part of the return and, in the case of rolling CDS index strategies, the rolldown component also being responsible for a large part of total returns. If we instead look at where projected IRRs – rather than purely just spreads – are in their 10 year range we can see that the IRRs of credit investments are considerably more attractive relatively to history than an assessment solely based on credit spreads levels would suggest.

In conclusion, the benefits of including a credit allocation (via a levered CDS index strategy) in an equity portfolio over the next two years is dependent on the final price-to-earnings multiple and credit spread levels at the end of the period; the higher the final P/E ratio, the less beneficial a credit allocation would be.

We can get an idea of how much difference a credit allocation can make by carrying out an efficient frontier analysis over different final P/E values for global equities, keeping the credit spread outcome constant for each case (i.e. assuming credit spreads revert to their median over this time).

In the event that the global equity P/E ratio reverts to a level of 20x or less over the next two years this efficient frontier approach suggests an allocation of 100% to the credit strategy. Even under a scenario where global equity P/E remain at their current elevated level of 21x (already the 83rd percentile) for next two years, a credit allocation still receives a weight of 77%. This is a compelling case for the difference that including liquid credit in a portfolio can make.

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Danny White is Senior Portfolio Manager at TabCap Investment Management

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group