How the XAIA team filters appropriate credit default swaps for the portfolio of XAIA Credit Curve Carry. Source: XAIA Investment

Credit risk free return opportunities

Author: Ulrich von Altenstadrt and Timo Lüllau-Mortensen

XAIA Investment is specialised on alternative credit strategies. The Munich-based firm uses credit default swaps (CDS) to generate risk premiums in the credit market. In the interview with ChampionsNews, Ulrich von Altenstadt, managing partner of XAIA Investment, explains how the XAIA team filters appropriate credit default swaps for the portfolio of XAIA Credit Curve Carry (ISIN LU1174032117 / LU1174032547) from the universe.

ChampionsNews: Mr von Altenstadt, you focus on market disruptions and credit default swaps as the means to protect against such disruptions. How do you apply this principle to the XAIA Credit Curve Carry (ISIN LU1174032117 / LU1174032547 )?

Von Altenstadt: The XAIA Credit Curve Carry benefits from the steepness of the credit default swap curves. It generates returns by selling CDS protection with longer maturities of, for instance, five years. This position is hedged by the purchase of short-dated CDS that typically mature within one year. By protecting all positions against a potential issuer default, we can invest in the CDS curves of issuers with higher default probabilities and, as such, higher risk premiums. This makes the spread differential between the fund position and its protection a significant source of returns. In addition, the positions also contribute meaningfully to the overall return due to the so-called roll-down effect that results from the declining time to maturity and the related spread tightening the sold CDS positions experience over time. This enables the fund to capture attractive risk premiums in the credit market without having to take interest rate, foreign exchange and default risks all of which are major credit risk components.

The positions contribute meaningfully to the overall return due to the so-called roll-down effect.

Ulrich von Altenstadt

ChampionsNews: How do you pinpoint appropriate credit default swaps for the fund portfolio? How large is the universe of potential CDS candidates?

Von Altenstadt: The investment universe contains all liquid, tradeable CDS on companies and governments worldwide, which corresponds to a range of approximately 2000 issuers. For these, we analyse the attractiveness of all CDS curves on a daily basis. We calculate the potential return for all potential points on the curve that results from the spread differential and the roll-down along the curve. The portfolio will invest in the 20 to 30 most attractive curves, always taking into account diversification and company specific aspects, of course. We constantly adjust the portfolio so that we are always invested in the most attractive curves.

ChampionsNews: How do you protect yourself against a potential issuer default?

Von Altenstadt: Every CDS protection that we sell will be hedged by buying CDS protection in the same nominal volume but with shorter maturity. In the event of an issuer default, the compensation payment due under the CDS we have sold corresponds exactly to the compensation payment we will obtain from the CDS we have bought. As with all insurance products, the question of how long the insurance cover would have remained in place in the future is entirely irrelevant in a claim event. We always renew the CDS protection we have bought well in advance to ensure that it will be in place for significantly more than six months. This avoids a situation where a credit event is foreseeable but the compensation payment can only be claimed after the expiry date of the protection we have bought.

ChampionsNews: What differentiates the fund from other directional credit strategies?

Von Altenstadt: The XAIA Credit Curve Carry has a contrarian risk profile that is aligned with the market level of the credit markets. In short: the lower the spreads, the higher the setback potential tends to be. We aim to minimise this risk by reducing the fund’s exposure along with any spread tightening as measured by the relevant credit index.

ChampionsNews: What is your annual return target for the XAIA Credit Curve Carry?

Von Altenstadt: Since the fund is subject to market fluctuation while operating with a contrarian exposure, its performance potential must be considered over a horizon of several years. For this strategy, we aim to deliver five percent over the three month Euribor after the deduction of costs. 

Author: Ulrich von Altenstadrt and Timo Lüllau-Mortensen
Date of issue: 12/14/2018