Index tranches are highly standardised single tranche CDOs with a credit index (usually iTraxx Europe or CDX NA IG) as their reference portfolio. Unlike ‘bespoke’ single tranches, index tranches have standardised documentation and use standard attachment and detachment points. Index tranches are quoted on all the maturities of the indices, which are three, five, seven and 10 years.
Dealers agreed to trade tranches on these standardised terms in 2003 in an effort to create a liquid product which they could use to hedge their bespoke single tranche CDO business, and which would reflect the market’s view on credit correlation at any given time. However it wasn’t until late 2004 and early 2005 that interest in these products gained momentum. There have also been various attempts to extend tranche trading to other indices, such as those in Asia and emerging markets. However, with the exception of CDX NA HY, tranche trading in indices has so far been limited.
Index tranches are typically delta-hedged using the underyling index. Delta-hedging tranches is very similar in theory to delta-hedging options. This means, for example, that if a dealer sells $10 million of protection on a 0-3% tranche of CDX NA IG it will also buy protection on the regular index in a ratio or delta based on the sensitivity of the tranche to a 1bp move in the index spread. The delta hedge is calculated to leave the dealer with no exposure to small moves in index spreads.
If the delta is 20, for example, the dealer will buy $200 million of protection on CDX NA IG. Note that dealers are still left with exposure to correlation and to large spread moves in the underlying single name credit default swaps.
By convention, index tranches and their index hedges are traded simultaneously in a process known as delta exchange. Although dealers’ proprietary correlation models will produce slightly different calculations of what the delta should be, the delta that is exchanged for each tranche is agreed periodically by a poll of dealers carried out by an interdealer broker.
The main participants in the index tranche market are dealers – which often trade with each other – and a small number of specialist hedge funds. In the early days of the market, much of the trading flow consisted of dealers buying protection on the equity (0-3% tranche) and selling protection on the junior mezzanine (3-6% or 3-7% tranche) with hedge funds as their counterparties. This was known as the ‘mezz-equity’ trade.
The driver of this trade was the fact that the majority of investors wanted to invest in or sell protection on bespoke mezzanine tranches, leaving dealers implicitly long the equity and super-senior tranches. In other words, dealers were exposed to a move in correlation assumptions.
In an effort to reverse their correlation position, dealers sought to buy equity tranche protection, and sell mezzanine tranche protection, offering attractive levels for these positions. Hedge funds took the other side of the trade, looking to take advantage of the potential mispricing that a skewed demand created. Dealers were only too happy to offset the correlation exposure built up in their correlation trading books.
However, following the downgrades of Ford and General Motors in April and May 2005, and the subsequent losses experienced by some dealers and hedge funds as a result of this trade, the index tranche market has seen a broader range of trading strategies and an increase in the number of participants (despite the well publicised exit of a handful of hedge funds such as GLG and Silverback Asset Management).
Among the most popular strategies are trading tranches against individual names, trading tranches of the different series of indices against each other and, as the range of quoted maturities has increased, trading five, seven and 10-year tranches against each other.