We are at a significant turning point in the evolution of the private credit market: why are we so convinced? Several major Wall Street banks, including JPMorgan, Barclays, Morgan Stanley and Citigroup, have begun trading credit default swaps (CDS) linked to private credit funds managed by firms such as Blackstone, Apollo and Ares.
This innovation allows investors to:
1. hedge against the risk of default by private credit funds;
2. bet on a downturn in the sector;
3. express a negative view on private credit without directly holding the underlying loans.
This development comes at a delicate time marked by rising redemption requests and the cost of leverage for funds, growing regulatory scrutiny, not to mention fears of credit deterioration, particularly in sectors such as private equity-backed software, which is under pressure due to the implications of artificial intelligence.
In parallel, S&P Global has launched the new CDX Financials Index, which includes exposures to banks, insurers, REITs and private credit funds, creating a standardised basis for trading protection in the financial sector.
With that in mind, we wish to explore CDSs and the CDX Financials Index in greater depth.
How a CDS works
A Credit Default Swap is a derivative that transfers a debtor’s credit risk from one party to another.
There are two counterparties: the buyer of the derivative, who pays a periodic premium (CDS spread) to purchase protection, and the seller, who collects the premium and undertakes to compensate the buyer if a credit event occurs (bankruptcy, missed payments, debt restructuring such as extending maturities with an increase in returns for the creditor). The mechanism is similar to an insurance policy. For example, if an investor holds 10 million bonds in a fund, by purchasing a CDS – at 300 bps per annum (3%), say – they benefit from capital protection in the event of the fund’s default; the CDS seller will cover the loss.
The price of the CDS is expressed in basis points (bps) per annum on the notional amount: the higher the perceived risk, the wider the spread, which reflects the implied probability of default and therefore represents the market’s perception of credit risk.
Why CDSs are important in private credit
Private credit is inherently illiquid because investor exits are slow, and opaque because the loans are unlisted, valuations are not public and there is no continuous market price.
The introduction of CDSs radically alters this balance in that:
• it introduces a market risk price by creating an observable spread, and thus a daily measure of perceived risk;
• it allows investors to take short positions in the sector to adopt a bearish stance on private credit – an option that was previously unavailable;
• it increases mark-to-market pressure because if spreads widen, the market signals deterioration even if the funds’ NAVs remain stable.
This is a sensitive issue as it can create a divergence between the book value of the funds and the risk value implied by the CDSs
What is the CDX Financials Index?
The CDX Financials Index is a CDS index, i.e. a standardised basket of credit derivatives covering multiple financial institutions. It forms part of S&P Global’s CDX index family, which includes:
• CDX IG for investment grade
• CDX HY for high yield
• CDX EM for emerging markets
• CDX Financials for the financial sector
The CDX indices enable efficient trading of credit risk across liquid, standardised baskets. In particular, the new index (the last on the list) includes 25 North American financial entities, including:
• banks,
• insurance companies,
• REITs,
• BDCs/private credit vehicles.
Around 12% of the basket is linked to private credit vehicles from Apollo, Ares and Blackstone. This is the first time a CDS index has directly incorporated exposure to private credit funds. This index is strategic because:
• it makes it possible to trade private credit risk via a liquid benchmark;
• it produces a synthetic price for credit risk in the sector;
• it allows banks and funds to hedge against sector deterioration;
• it enables bearish strategies to be implemented.
In practice, the market is constructing a ‘risk thermometer’ for a sector that has hitherto been lacking in transparency. This development is positive in terms of transparency, but it also introduces risks, including:
• greater volatility because CDSs can amplify signs of stress;
• the stigma effect. If spreads rise, the market interprets this as greater risk, even without actual defaults;
• a vicious circle in spread dynamics: rising spreads imply more expensive funding, which in turn leads to higher credit risk, generating even higher spreads.
This is why the launch of the CDX Financials is significant: it is not just a new product, it is a sign of the sector’s maturity but also of its fragility. It represents a turning point because it makes private credit more “tradable” and creates transparency regarding risk; it allows for risk hedging and short selling; but it increases the sector’s sensitivity to market sentiment.
Wall Street, with its investment banks, is bringing private credit into the logic of listed markets. This improves risk measurement, but exposes the sector to market discipline — and volatility.
We conclude by suggesting some useful websites for further reading on the topics outlined in this analysis.
S&P Global – CDX Indices Overview
Official overview of the CDX indices:
S&P Global – CDS Indices
Documentation on CDS index products:
S&P Global – CDS Pricing
How CDSs and spreads are priced:
Reuters – launch of the CDX Financials
Article on the new index:
Disclaimer
This post reflects the personal opinions of the Custodia Wealth Management staff who drafted it. It does not constitute investment advice or recommendations, nor does it constitute personalised advice, and should not be regarded as an invitation to trade in financial instruments.
