Investment Strategy Debate: Credit Default Swap Indices as Equities Alternatives Examined
In the world of finance, understanding the differences between credit and equity investments is crucial for investors seeking to build a well-balanced portfolio. This article offers a comprehensive look at the long-term return differences between these two investment types, shedding light on the aspects of risk, volatility, and expected returns.
## Long-Term Return Differences
Equity investments, such as stocks, have historically offered higher average long-term returns compared to credit investments. However, this higher potential comes with greater volatility and risk. Equity returns are characterised by significant fluctuations and are highly sensitive to economic conditions, corporate earnings, and market sentiment.
Credit investments, including corporate bonds and related instruments, tend to yield lower, but more stable returns compared to equities. Returns from credit instruments are generally more predictable and less volatile, as they are tied to interest payments and principal returns rather than variable earnings or stock prices. While credit investments are less risky than equities, they are not risk-free, subject to interest rate risk, credit risk (the risk of default), and inflation risk.
## CDS Indices: Credit Perspective
Credit Default Swap (CDS) indices, such as the CDX (U.S.) or iTraxx (Europe), are used to track the credit risk of a basket of companies or entities. Investing in CDS indices directly (by selling protection and collecting premiums, or buying protection as a hedge) is fundamentally a credit play, not an equity play. Long-term returns from selling protection on CDS indices tend to be lower than long-term equity market returns but reflect the premium for taking on default risk. In practice, actual returns can be volatile during periods of economic stress when defaults spike.
## Comparison Table
The table below summarises the key differences between equity and credit investments:
| Investment Type | Long-Term Return | Risk Level | Volatility | Relevant Index Examples | |-----------------------|------------------|----------------|------------|-----------------------------| | Equities | Higher | High | High | S&P 500, MSCI World | | Credit (Bonds, Loans) | Lower | Moderate | Low | Bloomberg Agg, CDX indices | | CDS Indices (Protection Seller) | Moderate to Low (depends on cycle) | Moderate to High (default clustering) | Can be moderate/high during crises | CDX, iTraxx |
## Summary
In summary, equities generally offer higher long-term returns but with greater volatility and risk. Credit investments, including exposure via CDS indices, provide more stable but typically lower returns, with risk mainly linked to default rates and credit events. CDS indices specifically allow investors to take on or hedge credit risk, with returns determined by the premiums received and the incidence of defaults—these returns are typically lower than equities but can fluctuate significantly during credit crises.
Over the very long term, equities have historically outperformed credit investments, though credit products (including CDS) are valuable for diversification and risk management within a portfolio. 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.
The unfunded nature of CDS indices allows for levering the high risk-adjusted return into a high absolute return. Credit investments directly benefit from higher risk-free rates, while equities do not. Long-term equity returns are driven by earnings, earnings growth, and the change in valuation multiples. Tight credit spreads do not necessarily make credit an unattractive investment.
Many institutional investors are considering alternatives to equities due to significant drawdowns and volatility in equity markets worldwide, along with high valuations of US equities. The article on credit allocations and their benefits is a guest article written by Danny White for Hedge Funds.
In the 2000s, high yield corporate bonds returned an annualized 8.2%, while global equities were close to flat with an IRR of only +0.2%. Corporate bond spreads (global IG and HY) are currently tight, ranking at the 14th percentile of the past 10 years, while CDS index valuations are less extreme, with investment grade CDS index spreads at the 36th percentile and high yield equivalents at the 50th percentile. Selling protection on CDS indices can generate income in credit markets with high liquidity and diversification.
Incorporating 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. Over the long term, the correlation between credit returns and equities is considerably lower than in the short term.
When assessing the attractiveness of credit investments, looking at projected Internal Rate of Return (IRR) rather than just credit spread levels provides a more comprehensive view, as the IRRs of credit investments are considerably more attractive relative to history than an assessment solely based on credit spread levels would suggest. In 2025, average daily volumes of Credit Default Swap (CDS) indices are $149 billion. Danny White is Senior Portfolio Manager at TabCap Investment Management.
Institutional investors may find credit investments, such as corporate bonds and Credit Default Swap (CDS) indices, appealing due to their lower but more stable returns compared to equities. These investments provide a means to diversify a business's portfolio and manage risk, as they are less volatile and not tied to variable earnings or stock prices, unlike equities.
Selling protection on CDS indices, specifically, allows investors to directly take on or hedge credit risk, offering returns that are typically lower than equities but can fluctuate significantly during credit crises. This option is especially attractive to institutional investors looking for alternatives to equities due to their potential drawdowns, volatility, and high valuations, as witnessed in the 2000s when high yield corporate bonds returned an annualized 8.2%, while global equities were close to flat.
