Goldman Sachs and J.P. Morgan 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, which administers the benchmarks that the swaps are linked to.
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 market.
AT1 (additional tier 1) 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 dollar-denominated bank-capital notes and a gauge of similar euro bonds, Ruscher said. The two indexes include AT1s issued by lenders such as Banco Santander, Deutsche Bank and HSBC. 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.