CalPERS ponders using derivatives

The California Public Employees’ Retirement System is considering using derivatives to speculate on declines in the creditworthiness of corporate bond issuers.

The pension agency would start with a pilot program in which the derivatives, known as credit-default swaps, would be limited to a small fraction of its $49-billion fixed-income portfolio, according to a report prepared for the agency’s investment committee.

If successful after a year, CalPERS should consider expanding the program, the report said.

CalPERS currently gains from its recognition of “overvalued” bonds only by not investing in them, the report says. The new program would provide another way of profiting “from a decline in the price of an issuer or instrument.”

Credit-default swaps, which act like insurance, are bought by bondholders to protect themselves from default. The market value of the swaps rises as the bond issuer’s financial health declines.

CalPERS, however, would be buying the derivatives without holding the bonds they cover, so it would profit from a decline in the market value of the bonds.

CalPERS, with $240 billion under management, is looking at generating greater returns as the cost of covering retirement and healthcare benefits for public workers grows.