A credit derivative index is a basket of single name credit default swaps with standardised terms. Unlike other multi-name credit default swaps, such as first-to-default baskets, index swaps provide unleveraged exposure to the names in the basket.
The indices act as a global set of benchmarks, allowing investors to buy and sell a cross-section of the credit market much more efficiently than they could if they were buying and selling individual credits. There are credit default swap indices in Europe, North America, Japan, Australia, non-Japan Asia and emerging markets. Unlike in most equity and cash bond indices, constituents are not selected on the basis of their market size, but by specific rules set out for each index. For the main indices, constituents are chosen by liquidity, for example. They are also (for most indices) equally weighted.
A new credit derivative index is launched every six months, usually in March and September, to reflect the names in the credit derivative market that fit the rules for each index at that time. On these ‘roll’ dates, a new basket of credits is created, with constituents selected by an independent index administrator based on input from dealers. Usually, only a handful of names change from one series to the next.
Source: B&B Structured Finance Ltd |
The current series of the index is known as the ‘on-the-run’ index and is usually much more liquid than the off-the-run versions. However, some off-the-run indices continue to trade actively after they have ceased to be the current version.
Index trades are intended to be highly standardised to ensure liquidity. Not only do all counterparties trade the same list of names for each six month period, they also trade using a fixed spread for the life of the series. If, as is usually the case, the market spread is different from the coupon, the counterparties exchange money upfront to account for this difference.
Maturities are also standardised, with three, five, seven and 10-year maturities traded for the biggest indices. However, few index trades are held to maturity. In order to ensure that their positions are as liquid as possible, most counterparties ‘roll’ into the new version of the index every six months.
For example, a firm that bought protection on series 5 of the CDX NA IG index in January 2006, and wanted to keep a position in the on-the-run index, would have unwound this trade at the 20 March 2006 roll date and put on a new trade referencing series 6 of the index.
Indices are among the most actively traded credit derivatives because they provide a way to buy or sell diversified credit risk quickly and with low dealing costs. The main indices trade with bid-offer spreads of one-half of a basis point.
These patterns of trading give credit indices their own trading dynamics. Although there is little fundamental reason why the spread of the index should not be the same as the average spread of its constituents (its ‘theoretical value’) in practice indices often trade wider or tighter than their theoretical value.
When the market price of the index is higher than its theoretical value, it is said to trade with a positive basis to theoretical. When the index price is lower than the average of the single names, the basis is said to be negative.
One reason for the existence of a basis is that indices, because of their ease of execution, tend to react more quickly to changes in market sentiment than single names. And while the basis should present an opportunity for traders to put on arbitrage trades to narrow the gap, the execution cost of trading single names against the index makes this an expensive and difficult strategy (although it is one that some participants implement).
In fact, the index basis acts as a barometer for credit markets. A positive basis typically occurs when most participants want to buy protection on the market as a macro hedge, reflecting a bearish sentiment. (One of the times that the index had its largest positive basis was around the time that Parmalat defaulted in December 2003, reflecting nervous market sentiment.) A negative basis typically occurs when most participants want to go long the market, pushing index spreads below their theoretical value due to high demand for credit risk, reflecting a bullish sentiment.
Although the first tradable credit derivative index was JP Morgan’s Hydi, which referenced high yield names, most credit index trading to date has been in the investment grade indices, especially North America’s CDX NA IG and iTraxx Europe.
The low spreads and low volatility of investment grade credit since 2003 have encouraged the creation of a number of new indices (typically subsets of the main index) which consist of riskier investment grade names and those whose spreads have a tendency to move around more than the market as a whole. In both North America and Europe, HiVol inidices (comprising high volatility credits) and Xover (pronounced ‘crossover’) indices (including some high yield names) are now actively traded.