The Alphabet Soup of Credit Derivative Indexes

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The Alphabet Soup of Credit Derivative Indexes

Many fixed-income participants seem to be communicating in code. They use terminologies like ABX, CMBX, CDX, CDS, MBS, and LCDX. What the hell are they on about? This article will walk you through the alphabet soup of credit derivative indexes and explain why market players could utilize them.

Key Takeaways

  • The world of credit derivatives is strewn with terminology, yet all credit derivatives do is give some type of protection against a credit event.
  • The value of a credit derivative is determined by the price and credit risk reflected by an underlying securities or issuer known as the reference obligation.
  • A number of benchmark indices have been created to provide openness and liquidity in the otherwise opaque and arcane realm of credit derivatives.

Digging into Derivatives

To comprehend credit derivative index products, one must first grasp what a credit derivative is. A derivative is a securities whose value is determined by or derived from one or more underlying assets. As a result, a credit derivative is a security whose price is determined by the credit risk of one or more underlying assets.

What does this mean in layman’s terms?

While a security, a credit derivative is not a tangible asset. As a result, derivatives, unlike arebonds, are not readily purchased and traded. With derivatives, the buyer enters into a contract that enables them to profit from the underlying reference obligation or physical security’s market movement.

Credit Default Swaps

A credit default swap (CDS) is a financial derivative. Credit default swaps with a single reference business were introduced in 1994 but did not trade in considerable volume until the end of that decade. In 2002, the first CDS index was formed, which was based on a basket of single-issuer credit default swaps. The Credit Default Swap Index is the current index (CDX).1

As the name indicates, the underlying asset or reference obligation in a single-name CDS is a bond issued by a single issuer or reference firm. A CDS is also referred to as a “bilateral contract.” This simply implies that the swap exchange has two sides: a buyer of protection and a seller of protection. If the reference entity of a CDS suffers a credit event (such as bankruptcy or downgrading), the buyer of protection (who pays a premium for that insurance) may be paid by the seller of protection. This is desired since the price of such bonds will fall as a result of the negative credit event. There is also the option of physical trade settlement, rather than cash trade settlement, in which the underlying bond or reference obligation really changes hands, from the buyer to the seller of protection.

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It’s vital to understand that when it comes to credit default swaps, buying protection is a short and selling protection is a long. This is due to the fact that purchasing protection is equivalent with selling the reference responsibility. The market value of the purchase protection leg behaves similarly to a short, in that when the price of the CDS falls, so does the market value of the transaction. The sell protection leg is the inverse.

The Major Indices

CDX, ABX, CMBX, and LCDX are the key traded benchmark indexes in the credit derivatives industry. The CDX indexes are divided into investment grade (IG), high yield (HY), high volatility (HVOL), and emerging market segments (EM).1 Consider the CDX. NA.HY is an index composed of single-name high-yield credit default swaps from North America (NA). 2

The CDX index is updated every six months, and its 125 names enter and exit the index as needed. 3 For example, if one name is upgraded from “below investment grade” to IG, it will be rebalanced from the HY index to the IG index.

The ABX and CMBX are credit default swap baskets based on two securitized assets, asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (CMBS).The ABX is based on ABS home equity loans, while the CMBX is based on CMBS. 4 5 For example, the ticker ABX.HE.AA signifies an index based on a basket of 20 ABS Home Equity (HE) credit default swaps with ‘AA’-rated reference obligations. 6 Separate ABX indexes exist with ratings ranging from “AAA” to “BBB-.” 7 The CMBX is divided into rating indices as well, but it is based on a basket of 25 credit default swaps that reference CMBS assets. 8

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The LCDX is a credit derivative index comprised of single-name, loan-only credit default swaps. The loans in question are leveraged loans. The basket has 100 names. 9 Although a bank loan is secured debt, the names that often trade in the leveraged loan market are of poorer quality. (They would issue in standard IG markets if they could.) As a result, the LCDX index is primarily employed by investors seeking exposure to high-yield debt.

IHS Markit manages all of the indexes mentioned above. 10 These indices must be sufficiently liquid in order to function. As a result, the issuer has agreements from the top dealers (large investment banks) to supply market liquidity.

How the Indices Are Used

Different fixed-income participants employ different indexes for varied reasons. They also differ in terms of whose side of the transaction they are on: purchasing protection or selling protection. Single-name credit default swaps are ideal for portfolio managers who want to hedge a particular exposure. For example, suppose you possess a bond and feel its price will fall owing to the issuer’s credit degradation. You might purchase protection on that name using a single-name CDS, which will rise in value if the bond’s price falls.

A credit-derivative index, on the other hand, is more often used by a portfolio manager. Assume you wish to go into the high-yield industry. On the CDX, you might enter a sell protection trade. NA.HY (which, if you remember from earlier, would effectively function as a long in high yield).This manner, you won’t need to have an opinion on certain credits, nor will you need to acquire many bonds — one deal will enough, and you’ll be able to join and leave it fast. This emphasizes the primary benefits of indexes and derivatives in general: In times of market crisis, indexes’ liquidity is advantageous. The CDS indexes allow you to swiftly increase or reduce exposure to a large category. And, like with many derivatives, there is no need to tie up your funds when you join the deal.

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Some market players are speculating rather than hedging. This implies they will not hold any of the underlying bonds and will instead join the credit derivative transaction naked. These speculators are often hedge funds, which do not have the same shorting and leverage constraints as most other funds.

The Bottom Line

Who are the most common consumers of securitized product indexes? It might be a portfolio manager seeking to obtain or decrease exposure to this area fast, or it could be another market player, such as a bank or financial institution that makes home equity loans. ABX might be used in both sides’ hedging tactics.

New credit derivatives are in the works. Demand will dictate what gets innovated next, so keeping track of it with tools like IHS Markit is always a smart idea.

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